Cash Flow

Actual Cash

Cash flow means precisely what the name implies.  It refers to the actual cash that is taken in and paid out.  For most individuals, cash inflow primarily consists of wages or salary, along with any income earned on investments, such as dividend and interest income.  We typically pay out cash when we pay our rent or make a mortgage payment, repay other loans, and pay our insurance premiums. We may also pay for our food, clothing, utilities and entertainment expenses with cash.  Bear in mind, however, that credit card purchases are not included in our cash outflow since our cash doesn’t flow out until we pay our credit card bill. The same applies when we purchase any other asset or liability, such as a new home or automobile, on an installment plan.  The cash outflow occurs only when the cash is actually paid.

The same pertains to businesses.  The bottom line of the income statement of a corporation provides us with the firm’s net income.  A firm’s net income does not tell us how much cash the company has available, however, because some of the items included in the revenues are not really cash inflows and some of the items included in expenses are not cash outflows.  Most firms use what is called accrual accounting, which means that revenues are recognized when a sale is made, not when the cash is actually received.  Similarly, expenses are recorded when the expense is incurred, not when the bill is paid. For example, if you purchase a pair of slacks at Macy’s using your Macy’s credit card, it is recorded as a sale on Macy’s books, even though you haven’t paid your credit card bill yet.  When Macy’s buys inventory from a supplier, it doesn’t immediately write a check for the goods; it uses what is called trade credit.  Regardless, that amount is included as an expense on the income statement when the inventory is sold.  One typically large non-cash expense that gets factored into net income is the depreciation expense.  When a firm buys a piece of equipment, accounting rules dictate that it cannot write off the cost all at once, but must expense it over a period of time.  Thus, even though the cash outflow occurs at the time of purchase, the full amount is not recorded on the income statement in one lump sum. 

Business Cash Flow

A firm’s cash flow from operations adjusts for these non-cash items by deducting any increase in accounts receivable or inventory from the net income reported on the income statement.  Accounts receivable is the amount your customers still owe you for purchases they made, an amount that has been included in “Sales” on the income statement. An increase in the inventory account represents an investment in cash that has been made to generate future sales, but this isn’t expensed out on the income statement until the inventory is sold.  Conversely, any decrease in these accounts is added to net income to calculate cash flow since they represent cash inflows.  On the other hand, any increase in accounts payable or accrued expenses is added to net income, while a decrease in these accounts is deducted to arrive at cash flow from operations.  Both are amounts you owe your suppliers and others that have been included as expenses on the income statement, but for which you have not yet written a check. The depreciation expense is added to net income since it is not an actual cash outflow. To illustrate, consider the following information taken from the income statement and balance sheets of the hypothetical Nevis Marine Goods Stores, Inc.:

Nevis Marine Goods select income statement information for the year ended December 31, 20×2

Sales $2,700,000

Depreciation expense         180,000

Net income $   313,200

Nevis Marine Goods select balance sheet Information as of December 31:

20×2 20×1

Accounts receivable $488,000 $420,000

Inventory   443,400   219,000

Accounts payable   135,000   125,000

Accrued expenses       75,000     80,000

The cash flow from operating activities of Nevis Marine Goods for the year ended December 31, 20×2 is calculated as follows:

Net income $ 313,200

add depreciation expense   180,000

subtract increase in accounts receivable   (68,000)

subtract increase in inventories (224,400)

add increase in accounts payable     10,000

subtract decrease in accrued expenses     (5,000)

Net cash flow from operating activities $ 205,800

It is important to examine the items included in the cash flow from operations of a firm individually.  This can reveal issues that may be hidden in the income statement, particularly if you look at the trends.  For example, the sales growth of a firm may look attractive, but if the accounts receivable of a firm is continually increasing, it may hint at a growing number of uncollectible accounts.  Too, if you observe a large increase in the cash flow from operating activities, identify the source.  If it’s due to a substantial increase in accounts payable, it may mean that the firm is having some financial difficulties and is not paying its suppliers on time.

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