Cash is the energy that keeps your business flowing, the way electricity powers a lamp. Run out of cash, and your business will soon go out like a light. Without cash on hand, you will not be able to pay essential expenses, even while the income statement says you are earning a profit. If your phone is cut off, it will not matter what the income statement says. The success of your business will depend on cash, from start-up through its entire existence. Cash is essential for the initial investment, ongoing operations, and growth. Managing cash is more critical than managing sales, because sales without cash receipts are a recipe for disaster. Cash truly is the lifeblood of a business.
The income statement shows you what the situation is with sales and profits over a period of time. It tells you how much revenue has come in and how it relates to the cost of goods sold and operating costs. The balance sheet is a snapshot of your business. It shows your assets and liabilities and net worth at one moment in time. Each of these statements and the associated ratios is important, but without a firm handle on the cash situation, business success will be elusive.
The Income Statement Does Not Show Available Cash
Once you start a business using the accrual method of accounting, you may notice that sometimes when the income statement says you are making a profit, you have no cash. There is often a time lag between making a sale and getting paid. With the accrual method, if you make a sale and the customer promises to pay you in a week, the sale is recognized on the income statement immediately—but you will not have the cash until the check is received, deposited, and available at the bank. Also, there may be a lag between paying for labor and/or materials and receiving payment for the finished goods. Thus, a company may show a profit and have a negative cash flow. Cash and profit are not the same.
For all the good information and guidance a monthly income statement will provide, you cannot base your business’s daily operations on the income statement alone. You will also need a cash flow statement that summarizes the cash coming into and going out of the business over a specified time frame.
You can calculate your cash balance by subtracting cash disbursements from cash receipts, as you do when balancing your checking account. Your goal is never to have a negative cash balance. A negative balance means that you are overdrawn in one or more of your bank accounts. This will reflect poorly on your banking relationships, can trigger the accumulation of fees and penalties, and result in bounced checks to critical vendors. Fundamentally, a negative cash balance means there are problems with your cash flow.
Because the cash flow statement records inflows and outflows of money as they occur, it is a critical financial control for a business. If a sale is made in June, but the customer does not pay until August, the cash flow statement will not show the inflow until August, when the cash “flows” into the business. If you use the accrual method, the sale will appear on the income statement in June but not in the cash flow statement until August, so that your reported revenue and inflows of cash will be different. If you are keeping your accounting records on a cash basis, you would not show the sale on the income statement until you received payment and revenue and cash inflows would match. Learn more about how to manage cash flow for businesses only at LSBF.