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Franchisee Guide

How to Read a Cash Flow Statement

05-14-2021 by Sam Walker
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Why is a cash flow statement important? 

 

Cash flow is the lifeblood of a business. As a franchise business owner, you will need to meet payroll, pay suppliers, service loans, pay taxes, and keep the product or service moving so your customers are happy.

 

Of the big three financial statements, the statement of cash flows is the one that will help us understand the causes of the inflows and outflows of cash. Successful franchise owners have this statement produced monthly, quarterly, and annually. 

 

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Accounting for Cash Flow 

 

When Wall Street analysts discuss a company’s earnings, they are talking about its net income. Found on the income statement, this is referred to as a company’s bottom line.

 

This is a significant number, but it does not reflect the full picture of a company’s financial health, because most businesses in the US use accrual accounting.

 

Accrual accounting recognizes revenue when it’s earned, not when cash is received. It also recognizes expenses when they are billed, not paid (like a credit card). 

 

Although this allows well-run companies to plan budgeting and inventory maintenance more efficiently and take tax deductions, accrual accounting is also susceptible to manipulation and cash flow uncertainties if invoices are not paid on time.

 

The balance sheet is also important but only shows the amount of cash a company has stockpiled and does not indicate how that cash is used over the business year. Therefore, a thorough analysis of the statement that shows cash inflows and outflows is required.

 

Woman reviews cash flow statements for her franchise business

 

Defining Key Terms

 

In preparation for a thorough understanding of the cash flow statement, let’s define some key terms.

 

There are three main sections of the cash flow statement. They are operating activities, investing activities, and financing activities. The components of each section are defined and listed below.

 

I have included a plus or minus sign to show whether each section should be added or subtracted to get the final number for each section.

 

1. Operating Activities:

The first section of the statement of cash flows is operating activities. It is how much money the business generates from its regular business activities, including the sale of goods and services. It is the first section of the cash flow statement. Its components are:

 

  • Net Income: the “bottom line” of a company’s earnings, its revenues minus its expenses. This number comes from the income statement. 

(+)

  • Non-Cash Expenses: any accounting expenses that don’t involve a cash payment, including depreciation and amortization, depletion, stock-based compensation, and asset impairments.

 (-)

  • (Closing Working Capital – Opening Working Capital): The difference between a company’s current assets and liabilities at the end of the accounting period minus the beginning. Common listed current assets include inventory, accounts receivable, and prepaid expenses. Common listed current liabilities include accounts payable, accrued expenses, and unearned revenue (note: from one period to another, increases in current assets and decreases in current liabilities are cash outflows, and decreases in current assets and increases in current liabilities are cash inflows).

 

= Cash Flows from Operating Activities

 

2. Investing Activities

The second statement of the statement of cash flows is investing activities. This describes how much cash has been generated from investment activities, including purchasing and selling physical assets and securities.

 

  • Purchase and Sale of Fixed Assets: Tangible property or equipment a firm owns and uses to generate income.

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  • Purchase (outflow) and Sale (inflow) of Marketable Securities: Marketable securities are financial instruments that can be quickly converted into cash. This includes stock, money-market funds, and treasury bills.

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  • Mergers & Acquisitions (outflow) and Divestiture (inflow): Companies acquire businesses and merge with a target company’s operations when they want to grow quickly or divest an existing line of business to refocus.

 

= Cash Flows from Investing Activities

 

3. Financing Activities

The third section of the statement of cash flows is financing activities. It is how much cash has been generated to fund the company. This includes the purchase and sale of equity and debt, as well as the issuance of dividends.

 

  • Debt Issuance: The process of raising cash through the issue of debt to investors, scheduled to be paid in full over a period of time.

(+)

  • Equity Issuance: The process of raising cash through the sale of shares of stock to investors for immediate cash.

(-)

  • Dividend Issuance: The distribution of a company’s earnings to a class of shareholders.

(-)

  • Repurchase of Debt or Equity: Company bond and stock repurchases. 

 

= Cash Flows from Financing Activities



How to Read a Cash Flow Statement, Illustrated

 

See a simple sample of a cash flow statement below. Let’s break down the statement. 

 

Cash Flow Statement example

See each of the three sections in bold and the final number at the end. As explained in the previous section, operating cash flow starts with net income, and non-cash expenses (depreciation) and changes in working capital are accounted for. 

 

Notice how (in the operating activities section) increases in current assets (accounts receivable, inventory, and prepaid expenses) are recorded as cash outflows, and increases in current liabilities (accounts payable, accrued expenses, and unearned revenue) are recorded as cash inflows.

 

The purchase of property and equipment is the sole investing activity, which is recorded as a cash outflow. 

 

The final section, which includes financing activities, mistakenly shows a cash inflow from payments on a line of credit. It also shows proceeds from a long-term debt issuance as an inflow. 

 

Despite this mistake, Paul’s Guitar Shop did a decent job recording the relevant items under each section. Notice at the end, the beginning cash balance (in this case, zero) is added to the net increase in cash to get the ending cash balance.

 

Building Cash Flow for the Long Term

 

Note that each of these sections, and the overall total, can have positive cash flow or negative cash flow.

 

Negative cash flows may be acceptable for a period of time if they support future growth. Still, consistently negative free cash flows signify more significant business problems that should be investigated. 

 

Sustainable growth in positive free cash flow is an indicator of long-term business health and should be one of the goals for your franchise.

 

Stay tuned for more advice on cash flow statements and how to operate your business successfully. If you are just beginning to explore franchising, here's how to determine how much capital you'll need to open a franchise business!

 

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