Written by “My company has been showing profit every month this year. Glad to be in the clear!” – Not so fast…
In my most recent video, I go over the financial health of a publicly traded company called Protolabs Inc.
I know what you are thinking, “why would a billion dollar company have anything to do with my small business?”
This level of thinking is what keeps so many business owners down. The path of growth becomes more clear when you have a blueprint to follow. That’s exactly what public companies can be for you!
It is clear that understanding your company’s financial statements is massively important. In this video, I discuss the importance of the statement of cash flows specifically.
Why Is Cash Flow so Misunderstood?
The statement of cash flow is a financial statement that seems disconnected from the all-powerful profit and loss statement that so many business-people have come to know and love.
The profit and loss tells you what appears to be a straight forward statement – you either made money this month or quarter, or you lost money. Simple enough right?
The truth is, the profit and loss can be a misleading indicator of your company’s health. You can have massive profit one month, and be so cash-poor the next that you are unable to pay your light bill. How does this happen?
Enter the statement of cash flows.
The statement of cashflows tells you what categories your money is flowing out of or into at any given moment.
There are three main categories:
- Cash Flows from Operations
- Cash Flows from Investing
- Cash Flows from Financing
A positive or negative cash flow during any given time period within these different categories can have different connotations. Additionally, one “good” scenario for a company in a certain industry at a certain level of maturity might be a bad for another.
Cash Flows from Operations
Cash flow from operations is money coming in and out from daily operations. This includes sales of the underlying product or services, and expenses including, but not limited to, rent, salaries, utilities, subscriptions, etc. For 99% of companies, this category needs to be positive. If not, you need to reevaluate your business. Granted, some industries can get away with a negative cashflow from operations and get away with it (i.e. pharmaceutical companies).
Cash Flows from Investing
Cash flows from investing include money spent or received from purchasing or selling assets. Assets can be anything from equipment to property. This is category of cash flow is something that would actually be encouraged to be negative. Negative cash flows into investing activities suggests that the company is in “growth mode” and looking to expand operations and grow their balance sheet. A positive cashflow from investing activities suggests that the investments made are now producing dividends OR it could be a negative – pointing towards a sale of assets to make up for a lack of cash flow from operations. This is situational.
Cash Flows from Financing
Cash flows from the financing category specifically point towards debt or equity financing in the company. If a company shows a positive cash flow in this category, they are most likely acquiring long term debt or selling equity shares of their company. Neither of which is necessarily bad, in fact it may be warranted for some companies. However, If a company shows a positive cash flow from financing activities, yet a negative cash flow from operations, this is a tried and true signal that the company may be in big trouble.
Conclusion
Understanding the nature of cash flows can give you insight on your company by being able to identify trends and potential pain points. I highly suggest you either learn how to understand them yourself, or get in touch with a professional who can stay on top of it for you.