The definition of cash flow is pretty straightforward: It’s the money that comes into your business minus the money that goes out. It’s a part of your CPA-prepared financials and is usually shown in a separate cash flow statement.
Yet cash flow is more than an accounting exercise. It’s a key financial indicator — something your surety company scrutinizes very carefully, as would a bank or prospective buyer of your company.
Without strong cash flow, you can’t pay your bills, meet your payroll, finance new equipment or expand your operation. Let’s look a little closer at cash flow and see how it affects your company.
Three kinds of cash flow
In a financial statement, three kinds of cash flow are listed: operating activities, investing activities, and financing activities. Each of these tells us something a little different about your business.
As you might imagine, operating activities are what it takes to run your company on a day-to-day basis. They include changes in contract receivables, over-and under-billings, prepaid expenses, accounts payable, and accruals.
Investing activities include capital asset purchases and proceeds from selling and buying investments. Financing activities include all proceeds gained from financial institutions, investors, and shareholders, and reflect long-term debt, line-of-credit payments, and distributions.
When viewed over multiple accounting periods, cash flow is a very good measure of a company’s financial health. Cash flow also helps you make decisions as to when to expand or purchase additional equipment. And it gives outside parties ― such as a surety, bank, or investor ― a good way to measure your company’s value and future earning power.
Reasons for a negative cash flow
A positive cash flow indicates there are more dollars coming into the business than going out. A negative cash flow means more funds are leaving than coming in. However, a negative cash flow doesn’t always mean there’s a problem. A company may have made a large purchase or expanded its operation. That’s why it’s important to consider all three categories of cash flow.
For example, you could have a company that generates a lot of operating cash flow, but its net income is really low because it has excessive debt or large accumulated depreciation. If it recorded a large cash transaction but can’t collect the receivable, then the company might have low operating cash flow.
Sureties like to see positive cash flow on a consistent basis over several accounting periods. If it dips for some reason, we want to understand why. Usually, we see a change in the investing or financing section. Often, it’s because the company purchased equipment. Some contractors buy too much equipment, build up debt and then find it hard to service that debt.
Buyers look at cash flow, too
A prospective buyer of your company also wants to see positive cash flow. Most succession plans are funded through a promissory note to the seller, financed over a five-to-10-year period. The company must generate enough positive cash flow to cover its normal expenses, plus make the buyout payments.
Let’s say a company needs to pay $10,000 a month as a distribution to the previous owner over a five-year period. That’s a buyout payment of $120,000 a year. If the company’s made $500,000 every year for the last five years, the new owner should be able to make those debt payments and still grow the company.
Bottom line: Always pay attention to your cash flow statement. Knowing what your cash flow is and what it tells you about the health of your business can help you better manage your operation, expand your company and sell it at a favorable price when it’s time to retire.
