In my last post in this series, we looked at debt as a driver of your cash flow. I talked about how borrowing and repaying money is treated in your Cash Flow Focus Report. And I shared these four tips and strategies for managing debt in your business: Recognize that most small business debt is personal debt; consider the downside scenario when borrowing; a revolving line of credit should, well, revolve; and reducing debt is the goal.
In this post, I will talk about some of the other drivers of cash flow that you may see from time to time in your Cash Flow Focus Report. Those drivers include:
- Depreciation and amortization
- Prepaid expenses
- Accrued expenses (accrued liabilities)
- Unearned revenue (deferred revenue) and customer deposits
Depreciation and Amortization
Depreciation and amortization are expenses recorded in your P&L that represent the “spreading” of the cost of an asset you own (the purchase of that asset in a prior period would have shown up in your cash flow as a capital expenditure) over its estimated useful life. Amortization expense is related to intangible assets like patents, trademarks, and copyrights, etc. Depreciation expense is related to fixed assets like machinery and equipment, vehicles, etc. For example, if you bought a large asset like a vehicle for $40,000 last year, that purchase was not recorded as an expense in your P&L at the time you bought it. Instead, it was recorded on your balance sheet as a fixed asset. If that vehicle had an estimated useful life of seven years, then each of the next seven years will include an expense for depreciation of $5,714 in your P&L. The expense in each of those years is “non-cash” in that it does not impact cash in the month or the year it shows up in your P&L.
A positive number – A positive adjustment to cash related to depreciation or amortization reflects the amount of non-cash charges associated with fixed or intangible assets. It is a positive adjustment because it did not impact your cash balance in the period it showed up in your P&L.
A negative number – A negative adjustment to cash related to depreciation or amortization should be rare. It would indicate that there was an adjustment or correction recorded in the accounting system related to depreciation or amortization expense. I would get with the Controller or bookkeeper to learn what kind of adjustment was recorded.
Labeling the Change as Good or Bad – Deciding whether the change, positive or negative, is good or bad is straightforward with depreciation or amortization because it “is what it is”. It is hard to imagine the number being a surprise. So, it will almost always be labeled as good.
Prepaid expenses represent amounts paid to a vendor or supplier in advance of receiving the service. They represent amounts paid out in cash in a month prior to the amount being recorded as an expense in your P&L. They are recorded on your balance sheet as an asset then moved to the P&L as an expense in a future period when the expense for the service is “incurred”. Prepaid expenses can include things like rent, utilities, insurance, and other expenses that are being paid in advance of you receiving the service. They can also include deposits paid in advance to vendors or taxing authorities.
A positive number – A positive adjustment to cash related to prepaid expenses indicates that some prepaid expense amounts were recorded as expense in your P&L for the month even though the cash was actually paid out in a prior month.
A negative number – A negative adjustment to cash related to prepaid expenses indicates that you used some of your cash to prepay certain expenses before they will be recorded as an expense in your P&L.
Labeling the Change as Good or Bad – Deciding whether the change, positive or negative, is good or bad depends on whether the change makes sense relative to what’s going on in the business. In most cases the change related to prepaid expenses would be labeled as good unless the amount is a surprise to you.
Accrued expenses, oftentimes referred to as accrued liabilities, represent expenses that are recognized in your P&L before the amount has been paid. Certain expenses are recorded, or accrued, when you know an expense has been incurred… and you don’t have a vendor invoice that you would normally enter as an accounts payable. It can also include payroll and related expenses that you accrue as costs incurred during the month that will be paid on the next payroll date. You should watch accrued liabilities closely to make sure the accrued liability balance is accurate each month and that the amounts being accrued are valid liabilities.
A positive number – A positive adjustment to cash related to accrued expenses indicates you recorded more expense during the month than the payments you made related to those vendors (or employees). It means your accrued liabilities balance on your balance sheet increased during the month.
A negative number – A negative adjustment to cash related to accrued expenses indicates you paid out more to vendors (or employees) on certain types of expenses than you recorded as an expense in your P&L. It means that your accrued liabilities balance decreased during the month.
Labeling the Change as Good or Bad – Deciding whether the change, positive or negative, is good or bad depends on whether the change makes sense relative to what’s going on in the business. In most cases the change related to accrued expenses would be labeled as good unless the amount is a surprise to you.
Unearned Revenue and Customer Deposits
Unearned revenue, oftentimes referred to as deferred revenue, represents invoices sent to customers (or payments you have received from customers) for services or products that have not yet been provided or delivered to the customer. They are recorded on your balance sheet as a liability when you invoice the customer (or receive the money). It then “moves” to the P&L as revenue when the product or service is provided to the customer. Customer deposits are treated in a similar manner.
A positive number – A positive adjustment to cash related to unearned revenue indicates you invoiced more to customers for products or services to be provided in a future period than you recognized as revenue during the month. It means your unearned revenue liability balance on your balance sheet increased during the month. In the case of customer deposits, it means that you received more in deposits from your customers than you recorded as sales in your P&L. For example, assume you received a $10,000 deposit from a customer for work you will not complete and invoice to them until two months from now. You received the cash… but you have not recorded the sale because the work is not complete.
A negative number – A negative adjustment to cash related to unearned revenue indicates you recognized more revenue during the month than you invoiced to customers. It means your unearned revenue liability balance on your balance sheet went down during the month. In the case of customer deposits, assume you received a $10,000 deposit from a customer two months ago for work you completed and invoiced this month. You received the cash in a prior month… but recorded the sale this month. As a result, a portion of the sales in your P&L had no impact on cash… which creates the negative adjustment.
Labeling the Change as Good or Bad – Deciding whether the change, positive or negative, is good or bad depends on whether the change makes sense relative to what’s going on in the business. In most cases the change related to unearned revenue would be labeled as good. If a negative adjustment began showing up consistently it might be a sign that new orders or customer invoicing was slowing down. That might be labeled as bad if it is a surprise to you or if the business is experiencing a meaningful slowdown.
Real World Example
In my next post in this series, I’ll walk you through an example with a small business owner and the objectives they had as they began the journey to understanding the cash flow of their business.
You will see the challenges they faced before they started the process and the benefits and sense of relief and focus they felt after they implemented the three step process to simplify cash flow.
Summary and Links to Other Posts in This Series
Here is a short recap and a link to each blog post in this series on making your cash flow simple and easy-to-understand.
Part 1 – The surprising results of my super-short survey that asked: “How do YOU define cash flow in your business”?
Part 2 – “Cash flow” is not a single number on your financial statements. Now is the time to totally rethink (and greatly simplify) how you go about understanding and managing cash flow in your business.
Part 3 – I use a VERY different, simple approach to defining cash flow. It is an approach where I take my CPA and CFO hat off and speak in a common-sense language that you can relate to.
Part 4 – The Cash Flow Focus Report is a simple, common sense tool for understanding your cash flow that takes 10 minutes a month. It brings focus to your cash flow, simplifies your life, and leads to an understanding and sense of confidence that you will find freeing.
Part 5 – The four reasons cash flow has always been so confusing and complicated for business owners (and for bookkeepers and accountants too).
Part 6 – I show you the 4-step process for completing the Cash Flow Focus Report. I walk through each step in the process using a real-life small business example. It’s a cool little company that was founded almost 20 years ago. It has grown nicely over the years and the owners love the business. Last month, the business showed a profit of $32 thousand. But their cash balance went down during the month by $6 thousand (from $116 thousand down to $110 thousand). The Cash Flow Focus Report shows what caused the change in cash.
Understanding the Drivers of Cash Flow – There are a number of different drivers of cash (in addition to profit or loss) that you will encounter as you complete the Cash Flow Focus Report each month. You will not run into all of them in one month because we are only focusing on the three largest changes, or drivers, of cash for each month. But as each month goes by, you will eventually see each one of these drivers impact your cash.
Understanding the Drivers of Cash Flow – Profit or Loss – Over time, profitability is a super important driver of your cash flow. You want to see profit show up in the list of your three largest drivers of cash regularly. While it is not unusual to have a month where profit does not make the list of top three drivers, profit needs to be there often, or you likely have a problem that needs attention. We also look at a number of ways to improve your profitability.
Understanding the Drivers of Cash Flow – Accounts Receivable – If you sell products or services on terms where customers do not have to pay you at the time you make the sale, you will have accounts receivable. And you will find that accounts receivable show up frequently as one of the three largest drivers of cash each month. I also share four steps for managing accounts receivable wisely.
Understanding the Drivers of Cash Flow – Inventory – If you sell products to customers, then you likely have inventory on your balance sheet. You buy inventory, pay for it, then ultimately sell it to customers. The fact that you buy the inventory weeks or months before you sell it to a customer (and possibly wait even longer before that sale becomes cash), creates a big drain on cash. I also share some tips and strategies for managing your inventory more effectively.
Understanding the Drivers of Cash Flow – Accounts Payable – The rules of accounting require that expenses be recorded in the P&L when they are incurred, not when they are paid. When an expense is recorded, the accounts payable balance on your balance sheet is increased by the amount of the expense. When it is paid, the accounts payable balance is reduced (as well as the cash balance being reduced) by the amount of the payment. I also share some tips on how to avoid the accounts payable trap when cash gets tight.
Understanding the Drivers of Cash Flow – Owner Distributions – Ultimately, the financial success of your business will be defined by the amount of excess cash it generates. That’s why I like to define a Happy Owner as an owner who is receiving healthy and frequent distributions of excess cash from their business. The trick though is how best to define excess cash. I share with you the general rule I use to help business owners think about their cash balance. And how much of their cash they can safely consider “excess” and therefore available to distribute to the owners.
Understanding the Drivers of Cash Flow – Capital Expenditures – A capital expenditure is the purchase of a large asset like a vehicle, or a building, or a leasehold improvement. Capital expenditures do not show up immediately in your P&L. They are recorded on your balance sheet as an asset then depreciated over the estimated useful life of the asset. The expense shows up in your P&L each month as depreciation expense. It’s this accounting treatment for capital expenditures that makes it very important that you manage it closely — very closely.
Understanding the Drivers of Cash Flow – Debt – Debt includes borrowing money and repaying it. Debt can play an important role in business. But it is a double-edged sword that must be managed with care and attention. I’ll share some tips on how to think about debt in your business…. and how to manage the risks that debt creates in your business… and the risks debt creates for you personally.
Philip Campbell is an experienced financial consultant and author of the book A Quick Start Guide to Financial Forecasting: Discover the Secret to Driving Growth, Profitability, and Cash Flow and the book Never Run Out of Cash: The 10 Cash Flow Rules You Can’t Afford to Ignore. He is also the author of a number of online courses including Understanding Your Cash Flow – In Less Than 10 Minutes. His books, articles, blog and online courses provide an easy-to-understand, step-by-step guide for entrepreneurs and business owners who want to create financial health, wealth, and freedom in business.
Philip’s 35 year career includes the acquisition or sale of 35 companies (and counting) and an IPO on the New York Stock Exchange.
Understanding Your Cash Flow – In Less Than 10 Minutes
This online course teaches you the step-by-step process for simplifying your cash flow. I walk you through each lesson while you watch, listen, read and try it yourself using your own cash flow numbers.
The course is very affordable. And there are also some coaching options available if you would like to get up and running fast.
It’s a fantastic way to learn the process.
I take all the risk out of your purchase because I include a 100%, no questions asked, money-back guarantee. You love it or you get your money back in full. Period.
There are two things that are very unique and exciting about this online course.
1. I’ll show you how to understand your cash flow in less than 10 minutes
2. I’ll show you how to explain what happened to your cash last month to your business partner or banker (or maybe even your spouse) in a 2-minute conversation.
I take off my CPA hat and I speak in the language every business owner can relate to. No jargon. No stuffy financial rambling. Just a simple, common sense approach that only takes 10 minutes a month.
Here is how one business owner describes the benefits of the course.
“I googled cash flow projections and found your website online and it appealed to me mainly due to the fact that you speak in laymen’s terms in a way that a non-financially trained person can understand.
The fact that you said you can understand your cash flow in less than 10 minutes a month was also a big reason I bought it. And the fact that you acknowledge that most accountants and CPA’s speak in terms that the normal owner cannot understand and that you would be able to put things in understandable terms really got me.
The monthly cash flow focus report was the best feature for me because learning to do it helped me understand my cash flow statements and the biggest drivers of cash flow.
Another significant benefit is the definitions of cash flow drivers and descriptions of how a negative or positive sway in cash within those drivers affects cash flow. Being able to see at a quick glance monthly what happened to your cash using the focus report is a huge benefit.”