Small Business Taxes & Management

Special Report

Cash Flow Budget-Part I


Small Business Taxes & ManagementTM--Copyright 2012, A/N Group, Inc.


It's All About Cash Flow

Well, yes and no. The ads from the banks, credit card processors, etc. would have you believe they can solve your cash flow problem. But it's not simply selling your receivables or taking credit cards, although such approaches can help. In accounting there are long-term and short-term aspects. In the short term, it is all about cash flow. You could have a 75% gross profit margin and a 50% return on equity and be in big trouble if you don't have enough cash to pay suppliers. On the other hand, in the long term great cash flow won't do you much good if you don't generate adequate profits and return on equity.

Ironically, businesses that are growing the fastest may have some of the biggest cash flow problems. Why? Because they need cash to acquire inventory, purchase equipment, finance receivables, etc. Startups also have cash flow problems because they often generate losses. Mature businesses often avoid cash flow issues because they don't buy equipment and, if sales are declining or at least not expanding, they're generating enought cash from operations to finance receivables and inventory. In fact, such businesses (or product lines) are often referred to as cash cows.

But no matter where in the spectrum your business lies--cash cow or cash starved--you have to have a cash budget and analyze your cash flow as carefully as you would any other aspect of the business. Without one, what's the worst that can happen? Consider a situation where a company is profitable and may even have positive cash flow but can't pay suppliers or make the payments on a business loan. It could result in an involuntary bankruptcy, having a loan called, or, at the very least a big drop in the company's credit rating. While it does take some work, preparing a cash budget can pay enormous dividends.


Cash Flow--What is It?

The old quick and dirty rule was, take your net profit and add back depreciation. Why? Because depreciation is a noncash charge. That is, it's an expense that reduces your profits, but it doesn't result in a cash outlay like salaries. But at some point you purchased the machine on which you're taking depreciation, and that resulted in a cash outlay.

The above rule may work if you keep your books on the cash basis, don't owe your suppliers, don't use credit cards, etc. But it's usually much more complicated. We'll first look at the cash flow statement that your accountant may prepare for you. If you use accounting software such as Quickbooks or Peachtree, and you've entered all your data correctly, the software will produce a Statement of Cash Flows. Here we'll do it the old-fashioned way, and provide some explanations.

The statement of cash flows is divided into three sections--Cash Flows From Operating Activities, Cash Flows From Investing Activities, and Cash Flows From Financing Activities. Keep the titles in mind, but don't worry about the meanings. They'll become clear shortly.

Our company is Madison, Inc., an S corporation that sells mid-range computers to colleges, government agencies and businesses. For the year 2012, it's statement of cash flows looked like this:

  Net Income (Loss)                                               185,640
  Adjustments to reconcile net income (loss) to net cash
    Depreciation                                                   18,356
    (Increase) decrease in:
     Accounts receivable                                          408,507
     Inventory                                                     16,790
     Prepaid expenses                                             (20,650)
    Increase (decrease) in:
     Taxes payable						   10,001
     Customer deposits                                             (6,205)
     Accounts payable                                            (245,900)
     Accrued liabilities                                           35,000


Keep in mind that this is just the first of three parts to the cash flow statement.

The starting point is net income. To that we add back $18,356 in depreciation. That's because depreciation has reduced Madison's net income, but the charge has no effect on cash. The remaining items are derived by comparing the current period balance sheet with the prior. Madison collected on a large order so accounts receivable decreased by $408,507. Madison got the cash in 2012 but the sale was reflected in net income in the prior year. If accounts receivable had gone up it would have decreased cash. (In a minute you'll see the offsetting effect of accounts payable.) Inventory went down slightly, generating cash. Madison deducted taxes, reducing net income, but did not have to pay the city until late January. Thus, the unpaid taxes left cash in the business. Customer deposits dropped as sales were completed and Madison received less deposits than usual. That created a cash outflow because the cash from the sales was included in the net income. Following collection on the large sale, Madison used the cash to pay down the accounts payable balance.

The effect of increases or decreases in the balance sheet items (e.g., accounts receivable) may not be obvious on first read. You've got to remember you're comparing the current to the prior period's balance sheet and it's the difference that counts.

If you maintain your books on a cash basis, the only item you might have to account for is depreciation.

The second part to the statements of cash flow is cash flow from investing activities. This one is easy in comparison. There are rarely more than one or two items and the impact is obvious.

  Purchase of equipment                                            (16,101)
  Sale of SuperGrowth Mutual Fund                                    9,000


This section doesn't need any explanation. Madison bought equipment for $16,101, a cash outflow, and sold some shares of a mutual fund to raise some cash. The net result was an outflow of $7,101.

The third part of the statements is cash flows from financing activities. This section is also pretty obvious.

  Proceeds from borrowing                                           35,000
  Payments on notes payable                                         (6,400)
  Distribution of earnings                                         (37,000)

Madison borrowed $35,000, increasing cash by that amount. It paid off some debt ($6,400) and distributed cash to its shareholders in the amount of $37,000. Resulting in a net cash decrease of $8,400. Caution. Remember that the payments on the notes are almost sure to consist of interest and principal. Only the principal reduction belongs here. The interest was accounted for in the net profit, our starting point.

The next step is to add the three sections--$401,539 (operating activities), ($7,101) (investing), and ($8,400) (financing) for a net increase in cash of $386,038. If you were preparing the statement, you'd reconcile beginning and ending cash using the net increase. That is, cash at beginning of period plus the net cash inflow of $386,038 should equal ending cash.

The illustration above shows the approach to computing cash flows for financial statement purposes. It also provides an example of what items you'll have to take into account and how they impact your cash flows. It's also the same type of statement commercial accounting software is likely to give you. There may be more detail, but the approach will look familiar. Analyzed along with your profit and loss statement and balance sheet, you'll get an insight into where your cash is going to and coming from.

Unfortunately the statement shown above is an historical one. And that's also true of the cash flow statement generated by your software or accountant. For cash budgeting purposes you'll have to create a spreadsheet. The good news is that your accounting software may be a big help, if you entered all your customer invoices and vendor bills accurately.


Creating the Spreadsheet

There are a number of different approaches to creating the spreadsheet. We'll use a different approach than the example above by starting out with cash sales rather than income on an accural basis, and we'll split the analysis into just two sections--operating and the rest of the entries affecting cash flow.

   Starting Cash                   
     + Cash sales
     + Collections on accounts receivable
     - Payment of accounts payable and accrued liabilities
     - Cash purchases
     - Gross wages
     - Supplies
     - Repairs 
     - Advertising
     - Rent
     - Telephone
     - Utilities
     - Interest
     - Miscellaneous
     + Other income

   Ending Operating Cash
     - Equipment purchases
     + Sale of equipment
     + Proceeds from borrowing
     - Payments on loans and notes
     - Distributions or owners' draw
     + Proceeds from equity financing

   Ending Cash

The framework above is the starting point for your cash budgeting spreadsheet. You will probably want to make refinements. There a number of differences from the Statement of Cash Flows above. For example, we don't have to analyze the change in inventory because we're deducting the cost of goods directly--either when we pay cash for purchases or by making payments on our accounts payable balance.

For example, Madison purchases $100,000 of shoes for sales to customers in November 2012. It pays $10,000 cash to a small supplier and owes $90,000 to another supplier that must be paid in two months. Madison sells $30,000 of the shoes in November. From an accounting standpoint, Madison's cost of goods sold is $30,000. But only the $10,000 paid in cash affects our cash analysis. For financial and tax purposes you want to match income and expenses. That's of no concern here. Here we want to look at cash. The same reasoning works for prepaid expenses. If you pay six months rent up front, it's a cash outlay and would reduce your cash. But you couldn't deduct that amount for financial statement or tax purposes.

The starting point here is the cash on hand at the beginning of the period. The second item is cash sales. Those are ones you'll collect on immediately, or by the end of the month.

The next item is collections on accounts receivable. They represent sales on account for the prior one, two, or more months that you should be collecting this month. Here's where careful data entry pays off. Your accounting software should show when collection is expected. That will allow you to plug in the number. Otherwise, you'll have to go through your invoices to see what's collectible for the month of analysis.

But for accounts payable and receivable you'll have to track them separately. For example, Madison had cash sales of $125,000 and credit sales of $225,000 in January. The company started the month of January with $210,000 in accounts receivable and collected $195,000 on its outstanding receivables. The cash sales produce immediate cash. Madison has also collected $195,000 from prior months. The $195,000 also increases cash flow. But you've got to keep a running track of accounts receivable like this:

     Beginning A/R               $210,000
     Add: Jan. credit sales       225,000
     Less: Jan. collections      (195,000)

     Ending January Balance      $240,000

More than likely you'll be able to generate the numbers for future periods from historical percentages and your sales estimates. For example, you know that based on several years' of data 30% of sales are cash. That means 70% of sales will be on credit. You also know that you typically collect 90% of credit sales in the following month. Apply that percentage to your credit sales for the current month.

You'll also have to track accounts payable in similar fashion. Again, your accounting software should have a list of invoices that have to be paid in the budget month. That'll give you a number for the upcoming month. If not, you'll have to work up a number.

The remaining items (except for other income) represent items that either usually aren't or may not be set up as a payable. For example, you generally don't set up a payable for rent. You may or may not set up a payable for telephone. If you set the item up as a payable when you receive the bill, it'll be part of the payments on accounts payable. We've broken out a number of costs such as wages, supplies, rent, telephone etc. Most of these are recurring items that you should be able to estimate fairly accurately. Your rent is likely to be the same every month. Utilities will vary, but are still fairly predictable. You may be able to group certain recurring expenses. On the other hand, take the time to accurately predict variable expenses. For example, Madison, Inc. sells teen apparel. Wages will be higher in August and December because of back to school and Christmas selling.

There's no adjustment for depreciation because we're starting with cash sales so it was never deducted to begin with.

Add and subtract the items to starting cash to arrive at ending operating cash.

The next section is usually easy. You've got to take into account your equipment purchases that reduce cash flow. Show the full cost of the equipment, even if financed. Then show the proceeds from the financing as a cash inflow. Show the paydown of any debt not reflected in the first section. Report distributions to owners and any equity financing (contributions to capital). Total this and add it to the subtotal from the first section and you should have your projected cash at the end of the period.


Comments and Points

If you're doing a monthly cash flow you'll have to repeat the process for at least three months if your business is relatively stable. The faster your business is growing or the more volatile sales are, the longer you should stretch the projection. And the more important this analysis is.

Even if you can't accurately predict sales and expenses several months out, you should try to accurately forecast equipment and funding needs. You may be able to borrow 90% of the funds for the purchase of that new machine, but will you have the other 10%? Are you sure you can get financing given your current financial condition? When it comes to these needs, the more time you'll have to take care of them, the better your chances of being able to do so.

If you do need financing, a cash flow budget could go a long way to convincing a lender or investor that your business is a good risk.

We'll continue this discussion in Cash Flow Budget--Part II and will provide a list of ways to improve your cash.


Copyright 2012 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 10/05/12