Avoiding Financial Suicide

What business owner would intentionally destroy their business?  Yet, that is essentially what is being done when an owner intentionally neglects to use the key financial reports that are basic to their business.  While I contend that an owner should master all of the financial statement triad, I have been shocked at the number of owners that don’t bother to use the cash flow statement.  That, I believe, is tantamount to financial suicide.  Perhaps you think that is a bit overzealous.   Allow me to make my case.

Most businesses operate (or should operate) using an accrual basis for accounting.  Under this method, income is recorded when an invoice is sent to a customer and expenses are recorded when a bill is received from a vendor.  Neither have anything to do with cash coming in or cash going out.  So what, you say?  It’s all about timing.  Let’s look at the revenue side of the business.

You sell a product to a customer, with the understanding that they will pay you in 30 days.  You have a great bookkeeper and he/she bills the customer as soon as the product is shipped.  This results in the recording of Income and the creation of a current asset called accounts receivable.  Prior to the sale and up to the point at which you receive a payment from the customer you are incurring costs for labor, material, overhead, selling and administrative expenses.  If this were your first customer, you would have had a lot of money going out and none coming in.  However, your income statement would show that you had earned income.  Your income statement might look like this.

Revenue from the sale                                             1,000

Less Cost of goods sold

Material                                  200

Labor                                       300

Overhead                                100

Total COGS                                         – 600

Gross Income                                                    400

Less Selling expenses                                               –   50

Less Administrative expenses                                 -150

Net Income                                                        200

So you made money, right?  Lucky you, you get to pay taxes on the income you made.  But what about cash flow.  What does it look like, assuming you actually had to pay half the expenses reported on the income statement?

Cash coming in:                                                               0

Cash going out:

Materials                                    100

Labor                                           150

Overhead                                      50

Selling expenses                         25

Administrative expenses          75

Total Cash out                                     400

Cash balance                          -400

So what’s the big deal?  It will all work out when the money starts coming in, right?  Maybe, maybe not!  It is very possible for a business to have increasing sales and go bankrupt.  How can that be?  A business can be on a path of increasing sales, which showS up as revenue and a growing accounts receivable (you are being a bank for your customers).  However, if customers are not paying on time or there is insufficient cash reserves (line of credit) to pay the ongoing expenses of the business, the owner can find themselves in a negative cash position.  Unless some kind of relief is found, the business will be bankrupt.

Sound far-fetched?  That is exactly what happened to a foundry (a company that made bronze castings for artists) here in Northern Colorado.  During the interview the owner stated:  “I didn’t see it coming.  I looked at my income statement and it showed I was making money.”  Yet, his business was declared bankrupt and the assets seized.  If the business owner had been monitoring a cash flow statement, he would have realized he was heading for a cliff.  In essence, he committed financial suicide.

Some may say, but there are many businesses that use a cash basis for accounting.  This isn’t a problem for them, right?  Yes, professionals such as attorneys, CPAs, physicians, chiropractors and others use cash based accounting and that is appropriate.  Without getting into a lot of detail, they should not ignore the cash flow statement either.  While software such as QuickBooks does a good job of tracking cash in and out, there are some non-cash expenses, such as depreciation, that can show up income statement.  They would be wise to review a cash flow statement as well.

Tags: , , , ,

Share This: