“Where does my cash go?” It’s a typical question I hear many times. Along with this one—“My P&L shows I made $400,000, so why don’t I have that much in my bank account?” My favorite graph to illustrate the solution to this problem is the Cash Flow Waterfall.
In the example below, we have used the year-to-date P&L to show the flow of cash so far for the year. We often look at this on a monthly basis, as well. This report shows the operating cash flow, the free cash flow, and the net cash flow. Let’s take a look at each.
Operating Cash Flow
The operating cash flow is looking solely at the total revenue for the business less cost of sales and less expenses. If there were other income or accounts payable, they would be added back in because these add to cash, or do not deplete cash until bills are actually paid. Accounts receivables are also deducted because while the income may be recognized, the money has not yet been deposited into the bank.
Also, if you have loans that you are paying down, the full amount of the principal and interest reduce your cash. On your P&L, the interest expense is reported but the amount of the principal is deducted from your loan account on your balance sheet. Finally, inventory expenses are also subtracted because the cash has been reduced to purchase new inventory. All these cash movements are related to the operations of the business. Hence the subtotal line in the chart below for Operating Cash Flow.
This aspect of the cash flow waterfall holds one of the answers about the difference between your bank balance and your P&L bottom line. When you purchase inventory, the value of inventory on your balance sheet goes up. This activity is not reflected on your P&L if you are using modified cash or accrual accounting. The Cost of Goods are reflected on your P&L, but this is a noncash transaction. It is typically showing the reduction in inventory and the increase in Cost of Goods Sold so that you can better understand the relationship between your revenue and your cost, hence an understanding of profitability. This is important information, but it is not an accurate picture of your cash.
The next section of the report, Free Cash Flow, shows the activity related to Fixed Assets, depreciation and amortization and the change in Intangible Assets and other Non-Current Assets. Most of our ecommerce clients don’t have much activity in these accounts except after their taxes are filed, and we need to book depreciation. If you are growing continuously, your cash may be going to buy new fixed assets. This is another place that would reduce your cash from the number that appears on the bottom line of the P&L.
Net Cash Flow
The final section of the cash flow waterfall report shows the net cash flow. For most of our ecommerce businesses, the Change in Retained Earnings is impacted most. This is where any owner contributions or owner draws are shown, along with the impact they have on your cash position. If you have added personal investments into the business as an owner contribution, it will show up on this report as increasing cash. If you take a draw or distribution out of the business, this will decrease your cash. Neither of these activities are reported on your P&L.
This report allows you to quickly see the movement of cash in your business. The three main areas where ecommerce businesses spend cash that does not impact the P&L are loan principal repayments, inventory purchases, and owner distributions. The Cash Flow Waterfall quickly shows how your cash is deployed in your business. It also provides a visual demonstration of the impact your financial decisions have on your cash.
This is the conclusion of our financial statement series. In our next series, starting in November, we will begin looking at some of the current banking options available that will make it easier to manage and keep more of your cash.