SFiXi™i&aY
CASH FLOW —THE OIL THAT

KEEPS THE SMAI L AND FAMIE.V
BUSINESS ORGANIZATION

RUNNING SMOOTHLY~

Andrew J.Polls
University of Southern Maine

ABSTRACT

The purpose of this paper is to emphasize the imponance of cash flow and the purposes of
uses of the Statement of Cash Flows. Two dt'forest methods of calculating cash flows from
operations are presented along wi th a discussion ofways to i nterpret cash flows and how to plan
for fiaure activity. The importance of cash flow should be clear to thefinancial manager whether
the business entity be a small family business or a major corporation. A shortage of cash flow
could result in the loss of valuable trade discounts or, in extreme circumstances, financial
embarrassment and bankruptcy. While a cash surplus does not necessarily translate into greater
returns to owners, it cenainly provides opportuni tiesfor prospective buyers who undersiand how
to utilize posiri ve cash flows. The caveat for interpreting cash flow is the same as thai used for
netincome: quality counts. This means that firms ttun depend heavily on depreciation to generate
cash flow are not looked on as favorably ai Jinns that have a preponderance of cash flow from
operations. Furthermore. cash flow should be analyzed to make cemain that the company is
invesdng properlyin order to maintain fiuure operanons. Managers who auempt toimprove cash

flow artificially by ignoring necessary invesunents in plant and equipment may not be familiar
wuh the concepts of cash flow.

INTRODUCTION

Before the business day is over, probably a dozen small companies inour nauon will declare
bankruptcy. Ibe Small Business Administration states that most businesses fail for lack of good
management (Small Business Administration, 1988). According to the Bank of America, the
history of small business failures reveals that many firms fail because of inadequate wodting
capital and poor cash flow management. Small business managers must always be concerned
with their company's day-to-day financial position, as well as its future growth and profitability.
It becomes ~to ensure that your company is using its assets and liabilities effectively, is
able to meet current obligations and botmw funds when ~,and is financially ptepued to
suppmt future operations.

oThis paper wai a runner up for The Distinguished Paper Award ar du. SBIDA National
Conference in San Diego. It was not mvriwed by the JSBSEditorial Advisory Board.

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A good starting point in an effort to enhance future operations would be in planning cash
flow —planning cash and planning profits period by period, performing cash flow analysis,
calculating cash flow from extended data, determining free cash flow and undedicated cash flow
and the cash conversion cycle. The purpose of this paper is to suggest some procedures a small
family business manager might follow in planning cash flow.

TIte income statement and the balance sheet, the general purpose and generally accepted
financial statements, do not answer all questions raised by users of financial statements. Such
questions include: How much cash was generated by the company's operations? How much was

spent for equipment and property, and where did the company get the cash for the expenditures?
How was the company able to make distributions to the owners when it incurred a net loss for the
year? The statement of cash flows answers those questions.

In November 1987, the Financial Accounting Standards Board issued Statement of
Financial Accounnng Standard No. 95, "Statement ofCash Flows (FASB, 1987)."The statement
is effective for annual financial statements for fiscal years ending after July 15, 1988. 'Ibus, the
statement of cash flows is now one of the major financial statements issued by a public company.
Unfortunately many small businesses do not prepare this statement and are content with the
conventional statements —the income statement and balance sheet.

The main purpose of a statement of cash flow is to report on the cash receipts and cash
disbursements of an entity for a period. Cash is broadly defined to include both cash and "cash
equivalents," such as commercial paper and money market funds. A secondary purpose is to
report on the entity's investing and financing activities for the period. To accomplish these
purposes, the statement of cash flows reports the effect on cash during a period of its operating
activities, investing activities, and financing activities. The effects of investing and financing
activities that do not affect cash are also shown. A reconciliation of net income and cash flows
from operating activities is also provided. Ifone could visualize the income statement as a motion
picture and the balance sheet as a still photo in black and white, the statement of cash flows
converts the balance sheet into a motion picture in technicolor.

'Ihe statement of cash flows summarizes the effects on each of the operating, financing, and
investing activities of a company for a period; it reports on past management decisions on such
mattets as expansion and the incurrence of debt. This information is available only in bits and
pieces from other financial statements. Because cash flows are vital to a company's financial
health, the statement of cash flows provides useful information to management and other
interested parties, especially creditors and investors.

This paper deals with the financial management of organizations whether they be the large
multi-national corporation or the smail independent family business. Financial management is
not confined to preparing financial statements, managing the petty cash, paying bills, collecting
debts, and handling relations with banks. Almost every action of the small business and every
decision made by its manager(s) or the individual enuepreneur has financial implications.

For the most part, small business owners are concerned with the future. They must
formulate decisions in terms of plans, with sufficient flexibility to adopt them to ever-changing
clfculrlstailces.

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As a small business grows in scale and complexity, so does the area of financial decision
making. The following is a list of what the author believes are the live most important
responsibilities of small business owners in this environment:

1. To ensure that the company always has enough cash to meet its legal obligations.

2. To arrange to obtain whatever funds are required lmm external sources at the right time,
in the right form, and on the best possible terms.

3. To use their knowledge and viewpoint to ensure that the company's assets and liabilities
- current and long-term —are utilized as effectively as possible.

4. To forecast and to plan for the financial requirements of future operations.

5. To perform afl the above functions and make afl decisions on the basis of one key
criterion: maximizing the long-term wealth of the company's owners ("Steps to
Starting a Business," 1986).

As the operations of a company go on day-by-day and month-by-month, they cause cash
to be received and cash to be disbursaL Moreover, these receipts and disbursements will not
always balance out to a steady, gradual increase in the company's cash, even if the company is
mahng steady profits. Large cash outflows will occur at times, such as when income taxes are
due or a major new capital investment must be paid for. Thus, over the short term, the cash
balances of any company fluctuate considerably.

There are two reasons for planning cash flow. The first reason is to ensure that short-term

sources of funds can be negotiated and arranged well in advance of having to use them. As the
cash flows fluctuate, there may be a time when cash balances fall below zem. These shortfafls
must be anticipated so that the liquidity of the business is not jeoaardizetL It is much easier to
negotiate a short-term knn in advance, thereby giving the indication of good management, than
it is to attempt to secure funds at the last moment in a crisis.

lbe second reason for planning cash flow is just as important if not more so than the first,
especially during high inflation periods. As a result of fluctuations, cash balances may be much
higher than immediate needs. Tbe idle cash must be invested in short-term money-market
instruments as soon as the cash becomes available, so as to preserve its purchasing power and
contribute to business profitability. Whether the business's cash budget indicates a shortfall or
a surplus, the manager of the firm must take appropriate action in a timely manner.

PLANNING FOR PROFITS AND CASH FLOW

Although there is a relationship between them, profits are not the same as cash flow. Profit
is an accounting concept designed to measure the overall performance of the company. It is
a somewhat nebulous concept, open to various measurement techniques and accounung prin-
ciples each of which produces somewhat different results, which are then open to different
interpfetatlolls.

In contrast, cash flows are not a measure of a company's performance. Take two extremes:
a new, profitable company, and an old, unprofitable company heading for bankruptcy and/or
receivership. The results in terms of cash flow are likely to be the same: declining cash balances.
A company can show a handsome profit and a net cash outflow in the same month, if it chooses

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to pay for new equipment in that month. It can equally show a substanual loss and an increased
cash balance in one month, if the results of increased borrowing or the proceeds from the sale of
other assets are received in tluu month.

However, the concept of cash is not nebulous. Either the company has a certain amount of
cash or it does not. And a lack of cash is critical. A company can sustain losses fora time without
suffering permanent damage, but a company that has no cash is insolvent and in imminent danger
of bankruptcy, no mauer what its profit picture may be. Thus, many financial transactions that
do not enter into the calculation of profit —such as buying new operating assets, getting additional
financing, and making distributions to owners —enter into cash flows. Similarly some
transactions that enter into the determination of profit —notably, the deduction of depreciation
expenses —do not enter into cash flows because they are non~h transactions with no effect on
cash balances.

PLANNING PERIODS

Cash flow planning consists of both short-and-long-term forecasts. The principal purpose
of a short-term forecast is to identify temporary cash shortages or surpluses and to deal with them.
The primary purpose of a long-tenn forecast is to establish lang-tenn goals and objectives and
provide a financial plan to meet the desired target.

Short-tenn forecasts are often prepared on a receipts minus disbursements basis, while
longer tenn forecasts are usuafly based on an adjusted net income approach. The short-term
forecast is focused on the timing of cash flows and on the availabiTity of cash to meet bills as they
come due. An insufficient level of cash on hand could cause the business to pass up valuable tmde
discounts. and, at the extreme, could cause the business to file for bankruptcy. Thus, the short-
term forecast concentrates on the actual receipt and disbursement of cash.

In times of high inflation, the necessity for actively managing the business's cash position
is obvious. Not only is it very expensive to bonow short-term funds, but there also may be periods
when no funds are available at any price. A business that has not secured a commitment in ad-
vance will be unable to meet its cash requirements. Excess cash must be invested as soon as it
becomes available, so as to avoid erosion in purchasing power. Making a cash budget also allows
the financial manager to see the impact of various decisions on speeding up or slowing down
cash flows.

Since cash flow planning is concerned with fluctuations in cash balances, the interval of
time used in planning is a more important consideration than the length of the whole planning
period. 'Ihe most common interval is one month. That is to say, a financial manager forecasts
cash inflows and outflows over one month and then cakulates beginning and end-of-month
balances. The procedure is repeated for the other eleven months of the year, if the overall planning
horixon is one year. Using one month as the time period has the advantage of coinciding with the
accounting period of most companies and probably also with their official period for collecting
receivables.

Many companies use a shorter interval of time, and some companies forecast by the day.
Why such a short interval? If the company forecasts by the month and shows adequate balances
at the end of each month, isn't it a waste of time to use a shorter interval? That this is not uue can
be shown by Tables I and 2.

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Table I

Cash Flow Plan For One itfonrh

Cash at start of month $20,000

Cash Inflows:
Collection of Accounts Receivable $35,000
Pmceah from sale of operating assets 10,000
Other collections - Miscellaneous revenues 3 000

Total cash inflows $48 000

Cash Outflows:
Selling expenses and wages $ 15,000
Purchases of inventory 20,000
Supplies 5,000
Rent 3,000
Taxes 4,000
Miscellaneous Expenses 1 000

Total cash outflows Q8 000

Cash at end of the month L20 000

It would appear from Table 1 that all is welL 'Ihe company's cash balance will stay steady
at $20,000. But will it'l Suppose we break down this forecast by the week, as is done in Table 2.

Table 2

The Same Cash Flow Plan By The Weeh

Week I Week 2 Week 3 Week 4

Cash at stan of week $20,000 ($2350) ($9300) ($2350)

Cash Inflows
Collection of Accounts Receivable 6,000 15,000 17,000 20,000
Pmceeds from sale of Operating Assets 12,000
Other collections: Misc. Revenue ~4000 ~5000

Total cash inflows $6 000 $ 15 000 $21 000 $37 000

Cash Outflows
Selling Expenses and Wages $6,000 $6,000 $6.000 $6,000
Purchases of Inventory 9300 5,000 4,000 5,000
Supplies 1350 1350 1350 1~
Rent 4,000
Taxes 5,000 7300
Miscellaneous Expenses 2 500 2 500 ~200 2 500

Total cash outflows $28 250 $22 250 ~13 750 $14 750

Cash at end of week ~250 ~900 ~250 $20 000

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Suppose a company uses a planning interval of one month. Its cash flow plan for one month
might look like that in Table I. As can be seen flom Table 2, although the month cash flow forecast
looks fine, the weekly forecmx shows that the company will be in considerable trouble before the
first week is over. Such a company would do well to choose a planning period not longer than
one week, and IgtggtjIIItglgglgf.

Usually, the size of cash inflows and outflows is much more predictable than their timing.
But when it is not, unexpectedly small

inflows

combine with unexpectedly large outflows could
create a serious cash shortage over a short time. This possibility must be avoided, either by
carrying large balances to provide a margin of safety or by maintaining a very short planning
interval and a continuous watch on how actual events are conforming to plan. Which alternative
is adopted will depend on the size of the balances needed and the management time available for
short-interval cash planning.

From the point of view of avoiding insolvency, the size of cash balances in relation to cash
flow has a bearing on the planning interval. Ifcash balances are large, temporary variations within
a long planning interval such as a month are unlikely to place them in jeopmdy. But if the company
is operating on inadequate balances, a strong net cash outflow over only a few days may bring
balances down to dangerously low levels. In such circumstances a short planning interval is

ecessary for survival, even if it could not be economicafly justifled on any other grounds. For
this reason, a company that normally uses a planning interval of one month may switch to weekly
planning when its cash bahnces are dangerously low.

DEVELOPING THE PLAN

Once the planning horizon and planning interval have been determined, the actual planning
can begin. The first step is to forecast expected cash receipts during each planning interval. Sales
receipts are nonnafly based on the sales forecast and experience of the pauern of receivables
coflecdtxts. Other receipts, such as those from the sale of operating assets, and invesunent
income, can also be predicuxl with a fair degree of accuracy. Receipts higher than the forecasts
may result in cash that might otherwise have been invested profitably; but receipts lower than
expected may expose the company to ifliquidity, which is far more serious.

The next step is to forecast cash disbursements. Here planners again lean on experience of
what cash outlays are normally needed to maintain a given level of sales, but they also need the
help of others in the organization. For example, if the purchasing department believes that prices
may soon be going up and plans to pick up several months'orth of inventory soon, the planner
must know about ik If a major advertising campaign is being planned the financial manager must
be made aware of its planned cost and timing. Every manager with the authority to commit large
sums of money must be fully aware of the responsibility to keep the financial manager informed
of future plans. Table 3 shows estimated cash outflows included in the cash flow forecast.

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Table 3

Cash Flow Forecast By Afonrh

Jan. Feb. Mar. Apr. May June

Cash at first of month $ 19,680 ($ 10,020) ($1,820) $ 13,180 $22,230 $ 13,670

Cash Inflows
Sales receipts 55,000 57,000 69,000 61,000 64,000 65,000
Insurance Claim 7,000
Misc. Revenue 4 000 3 500

Total Cash Inflows $59 000 $57 000 $~69 000 $~$4 500 $71,000 $~65 000

Cash Outflows
Labor payroll 23,000 23300 24,000 24500 31,000 25300
Salaries 4JI00 4,800 4,800 5,600 5,600 5,600
Inventory 31,000 15300 18350 11,650 28,760 15,625
Supplies 2,400 1,800 2,000 2,000 2,000 2,000
Insurance 750
Icase Payments 1,000 1,000 1300 1,000 1,000 1300
Advertising Exp. 500 500 1300 500 500 500
Misc. Expense 1,000 1400 1~ 1~ 1~ 1%0
Loan Payments 18,000
Income Taxes 7,000 9,000
Professional Fee 500 4,000
New Equipment ~500

TOTAL CASH OUTFLOWS $88 700 $48 800 $54 000 $55 450 $79 560 $51 625

Cash at end of month ~$ 10 020 ~$ 1 820 $ 13 180 $22 230 $ 13 670 $27 045

Once cash inflows and disbursements have been forecast, the planner can forecast cash
balances at the end of each planning unit. 'Ibe results of this appear as the top and bottom lines
of Table 3.

At this point, the planner has a cash flow forecast, nota plan. Planning is the mental process
of visualizing a set of events that one is determined to make happen in the future, not just a
summary of what one expects to happen. But it is at this stage that planning can begin.

Some of the cash balances at the end of each planning interval may be higher than needed;
others may be too low or even negative. Planners first determine how to invest any excess cash
in order to earn the maximum mturn on it, depending on its amount and the length of time for which
it will be available. Next, they decide how to cover temporary shortages of cash exposed by the
forecast. Other means are delaying purchases or payments until a later period, deciding to reduce
or eliminate certain expenditures, selling short-term investments or other assets, accelerating
collections, and so on. Table 4 shows the results of this kind of planning based on the cash flow
forecast in Table 3.

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Table 4

Cash Flow Plan

Jan. Feb. Mar. Apr. May June

Cash at first of month $ 19,680 $9380 $7380 $7480 $ 11,630 $8,070

Cash Inflows
Sides Receipts $55,000 $57,000 $69,000 $61,000 $64,000 $65,000
Insurance claim 7,000
Misc. Income 4,000 3300
Shon-tenn Bank Loan 19,400

Total cash inflows $78,400 $57,000 $69,000 $64,500 $71,000 $65,000

Cash Outflows
Salaries $27.800 $28,300 $28,800 $30,100 $36,600 $30,800
Inventory 31,000 15300 18250 11,650 26,760 17,625
Payments for supplies 2,400 1,800 2,000 2,000 2,000 2,000
Insurance 750
Lease payments 1,000 1,000 1300 1,000 1,000 1500
Adverusing 500 500 1400 500 500 500
Misc. expenses 1,000 1300 1300 1~ 1300 1~
Loan payments 18,000 10,000 10,000
Income taxes 7,000 9,000
Professional fees 500 1,000 3,000
Equipment 5300
Short-term investment 5,000 5,000 ~5000

Outflows $88,700 $58,800 $69,000 $60,450 $74,560 $61,625

Cash at end of month $ 9380 $ 7380 $ 7380 $ 11,630 $ 8,070 $11,445

TIte financial manager has decided to finance the forecasted cash shortage in January by a
$20,000 short-tenn bank kran with a yearly interest rate of 18 percent, which will be paid olf in
two equal installments in February and March. flhe $ 19,400 actually received from the bank
represents the loan less interest deducted in advance. This is known as the proceeds from a
discounted loan). By March, the company has spare cash, which it can invest in short-term,
interest yielding securities —$5,000 in each of the three months of March, April, and June.

However, this would have caused cash to drop to a low in May: $3,070 by the end of the
montix Instead of investing in April and borrowing again from the bank, the planner has decided
that payment of some May bills can be deferred until June: $3,000 in professional fees and $2,000
for inventory. Thus, once the financial manager has determined how to invest excess cash and
how to cover cash shortages, he or she incorporates the results of these decisions into the cash flow
forecast, which now becomes a plan.

The accuracy of the forecasts that are used in preparing the cash flow plan is of critical
imponance in having the plan be a useful tooL The less reliable the forecasts or the more uncertain
the financial manager is about the unexpected events they may affect the cash flows, the larger

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the cash balances, lines of credit, or a combination of both that are required. If the planner does
not have much confidence in the forecasts, the resulting plan will be of little value to the
organization.

PLANNING AND CASH FLOW ANALYSIS

Tbe financial manager should recognize that much of the desired infomution is difficult to
forecast, since many of the receipts and disbursement dates are not always available. This will
surely complicate cash flow planning. The traditional receipts and disbursements approach does
not lend itself easily to in erpretarions of cash flow. For example, the answers to such questions
as how much the firm shouM set aside for investments in fixed assets or how the firm should fund
future growth are not apparent from such an analysis.

Although net cash flow can be calculated by subtracting cash disbursements from cash
receipts, the financial manager should note that cash flow from operations is often calculated by
taking net income and adding expenses that do not affect cash such as depreciation, amortization,
and deferred taxes. Historically, financial managers used net income plus depreciation as a pmxy
for cash flow. Today, most accountants and financial managers recognize cash flow as being the
former amount (net income plus expenses not decreasing cash) plus increases (minus decreases)
in spontaneous liabilities minus increases (plus decreases) in spontaneous assets. Spontaneous
assets and liabilities are those accounts which move directly with a change in sales. For example,
accounts receivable and invenuuies would be representative of spontaneous assets, while
accounts payable and accruals would be indicative of spontaneous liabilities.

'Ibis calculation of cash flows is referred to as an indirect approach, since the actual cash
receipts and disbursements are not used, but rather are estimated from all the accounts affecting
cash flows. For example, all of the sources and uses of funds that affect cash flows from operations
are included in the indirect cash flow calculation. The indirect approach is frequently used for
forecasting long-term cash flows (more than one year), since projections of net income may
receive greater attention than the actual timing of receipts and disbursements. The indirect
approach may also facilitate more reliable long-term planning.

Many financial analysts and managers are becoming increasingly interested in the concept
of cash flow. Careful management of available cash resources is critically important to maintain
a company's competiuveness.

REFERENCES

FASB (1987)."Student of Cash Flows," Siaiemenr ofFinancial Accounting Srandards No. 95,
Stamford, Conn.

Small Business Administration (August, 1988). SBA: What u is...WIuu ir docs, Publication
OPI-6, Washington, D. Cz Oflice of Public Information.

"Steps to Starting a Business," (1986).Small Business Repurrer 10, 1986 3.

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