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Cash is king

There is a catchy saying among finance and accounting pros: Profit is a vanity, cash a sanity! There is much truth in this, as Profit and Loss statements contain many accounting assumptions that can easily turn a negative result into a positive one, giving the reader a false sense of security. With the cash - flow statement things are far more difficult to diguise

The basics of the cash flow statements

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The cash flow statement allows anyone to get a glimpse of the inner workings of a company's bank account. Think about it from a more personal perspective; it is almost as if you would keep a detailed log of everything that has moved your bank account in one or the other direction, neatly itemized into categories (as is the case for the balance sheet). For example, you have various kitchen equipment worth 3.500GBP. Next month the value has increased to 4.000GBP, which means you must have spent money on something worth 500GBP. The cash flow statement works similarly; it analyses the movement of money in the Profit and Loss Statement and the balance sheet to demonstrate how and where money was spent. 

And like the Balance sheet, it helps the reader by categorizing the inflows and outflows into three different categories that we will explore in short before summarizing everything with a practical example. 

Cash from Operating Activities:

Quite simply: this category summarizes the cash in- and outflows from the core activities/operations of the business. It includes the money received from customers or the money paid to suppliers or staff members.

Cash from or used for Investing Activities:

In this category, jolly beancounters summarize the cash paid for everything that the company will hold as an asset from which it hopes to receive benefits in the future. The most straightforward thing that comes to mind are machines or other types of equipment that will generate income for the company in the future; in the case of the Jolly Brew Ltd., it is the brewing kit. Further investments of financial nature are certain types of financial securities like other company shares. For example, the Jolly Brew Ltd. could decide to purchase shares of Heineken. The future benefit from this acquisition would be, for example, an appreciation of the shares of Heineken or some dividend income.

Cash from Financing activities:

Financing in this category refers to borrowing money or paying it back to whoever has lent it to the company. As you can recall, the Jolly Brew Ltd has borrowed some money from friends and family and a bank, both of which would show up in this category. If the business goes well for the Jolly Brew Ltd., it could also pay out some dividends; again, this would show in this category.

Now it is time for a practical example!

Below you will find the essential building blocks for a cash flow statement, Building Block 1: The Profit and Loss statement, and Building Block 2: the balance sheet. Both blocks are necessary to construct a statement that shows how cash has flown through the arteries of the Jolly Brew Ltd.  

Building Block 1: The P&L

A little recap:

Ultimately everything comes down to cash, but the way to portray a business's performance is far more elaborate than just reading your bank statement and putting everything into understandable categories. Don't get me wrong; this is a valuable and legitimate way to construct a cash-flow plan. In fact, a board member of my previous employer once told me that you only really understand and get a feel for a company once you fully understand what goes in and out of the company's bank account eacry month. True! but as explained in early sections, we need to get a nuanced understanding of a company's performance in reasonable time intervals, such as a month, a quarter, or a year, as this will allow us to anticipate trends and act on them! So, above, you have the P&L statement for the first quarter! This building block alone cannot determine how much cash was earned because it is riddled with estimates, assumptions, and non-cash expenses such as depreciation! Remember, depreciation is simply a charge to account for the usage over the useful life of a piece of equipment. We have not spent 900GBP each quarter, but the P&L is all about performance, so it is only fair to state that an expense occurs when a machine is being used. The only thing we can reasonably say is that we made a profit of 375GBP, which is increasing the value of our operation! Ok, if the P&L is of no use, maybe the Balance sheet will be? 

Building Block 2 

Above, you see the balance sheet, which is a snapshot of what you own and owe at any given time. You notice that at the start, the owner's personal savings was the only thing the Jolly Brew Ltd. had to show for itself. 

Let's quickly remember that accountants have one basic magic formula they use countless times again and again! 


   Assets - Liabilities = Equity

You see that everything always needs to balance!

Like on a scale!

Therefore quite logically, the 20.000 cash paid in by the owner also shows up on

the equity side of the equation. Equity is what the owners have invested in the

company. This is determined by subtracting all the liabilities from the assets. Equity is also a type of valuation. It would be the minimum price tag you put up for your company. You would essentially sell your portion of the company to a potential buyer. Many assets financed via external credit would not lead to a higher valuation just because you have more assets on the books. Credit is only an illusion of wealth that needs to be factored into every valuation, as it belongs to someone else. Imagine the following example: A colleague at work brags about his new BMW; people might think he is the big cheese and super-loaded. But let's assume the BMW is worth 30.000GBP and he only has 3.000 left to pay off in car finance. It means that he almost outright owns the BMW and that it adds 27.000GBP to his personal wealth. Should the car finance, however, amount to 30.000GBP, this adds nothing to his personal wealth because the bank owns the BMW! He drives around not only on borrowed money but also when the finance is that excessive on borrowed time. His personal illusion or dream of wealth can develop into a real-life nightmare when things go against him, and he should not be able to fulfill all the obligations linked to the car finance. In essence, individuals and companies always need to be sensible about how much they borrow!

Apologies for the quick recap. Back to the cash flow statement!

We have determined that we need the two building blocks to understand how cash has moved through the company. Now it is time to draft the cash flow statement. 

1. We start by taking the net profit figure from the income statement. It is after all the income we get on paper for any given period. It contains a lot of estimates and assumptions, which we need to weed out to get to our real cash gain or loss for the month. 

2. We, therefore, take depreciation which is a non-cash expense (meaning it is not really money spent on anything), and add it back to the profit figure. This figure, while not cash in its purest form, is an excellent approximation.

3. To further sharpen the picture, we have to turn to the balance sheet next and start looking for changes in all of the various accounts from one period to the next. 

You might throw in: Why all the hassle? We know that cash has increased from 20.000 to 60.275GBP! Yes, I agree, but we need to see how this has happened; that is why we go through the hassle of dissecting the P&L and Balance sheet to find out where we made and lost money. 

The first part of the cash flow statement is the "CASH from OPERATING ACTIVITIES." This, in my opinion, is the most crucial part because it tells us whether we can earn some cold hard cash from our primary business operations. The calculation is quite simple: look at the balance sheet accounts associated with your business's day-to-day operations and determine whether there was an increase or decrease between any given period!

In our case, I am starting with the accounts receivables, where all the invoices not yet paid by our customers show up. In our case, the movement from the start of 2022 to the end of Q1-2022 was 25.000GBP, explained by the fact that we only invoiced our German customer for the beer deliveries at the end of Q1-2022. 

But I have a question for you now:


Question: Is an increase in accounts receivables from one period to the next a good or bad thing? (You can probably guess...)

Answer: It is a bad thing! Imagine this keeps growing and growing as one after another period passes; this would be a total disaster as it means that customers are not paying for the stuff we sold and shipped them.

We move on and do precisely the same for inventory; look at the movement between periods. We can see that inventory has increased, which again had negative consequences for our operating cash flow as we needed to fork out money to purchase ingredients, etc...

Basically, when accounts in the asset section increase, it means that cash was spent to acquire these assets. The opposite is true for the liability accounts. Take accounts payable, for example. In this account, we record all the invoices from suppliers. What does it mean when this account increases from one period to the next? Well, it means that we record more and more supplier invoices and make no genuine efforts to reduce the ever-growing balance by paying some of these invoices. And this is good for the cash flow! By the way, don't see this as an incentive not to pay your suppliers but feel encouraged to seek better payment terms.

4. The next building block is the "CASH from INVESTING ACTIVITIES." For most companies, this section will show what amount of cash was spent to acquire capital goods such as computers, machines, and anything big and shiny, not just your odd pencil or stapler. 


In the snapshot above, you will notice that we purchased the brewing kit. An asset increase from one period to the next has a negative cash impact as money was spent to acquire the asset. In my balance sheet, I was kind enough to show price paid for the asset and the depreciation (value lost over the period) of the same asset. Not all balance sheets will do you the same favor. Therefore when you only see the net value (in our case, 17.100GBP), you have to add back the depreciation in the cash flow from investing activities calculation. For this, you take the total depreciation shown in the P&L and add it to the movement between the two balance sheet accounts (as shown above).

5. Last but not least, we take the final part of the cash flow statement, which is the cash from financing activities. Like ordinary people, sometimes companies need cash to finance more significant projects, such as purchasing machinery or other equipment. Sometimes finance needs to be raised to keep the business running during difficult times. This section of the cash flow statement shows how much the company is borrowing or paying back. 


The Jolly Brew Ltd. raised 74.000GBP, which increases its liabilities and positively impacts the cash flow. It is double-edged sword. When finance is raised, you need to dig deeper to understand why it was raised. When you pay down some credit lines, this will show up as a negative figure in this section.

Now we have managed to calculate the figures for each of the sections! The final task is to add all the subtotals together to get the change in cash from one period to the next! By adding it all up, you can see that we get a net change of 40.275GBP.

Wrapping it up:

The entanglement of the cash-flow statement with other financial statements demonstrates underlines its beauty. While the balance sheet constitutes a snapshot of a company's wealth at any given point, such as the 31st of December, this information alone is not helpful to a reader if used without the help of the other statements. Even in combination with the P&L and the balance sheet is not quite as robust of an analytics tool. A company could, for example, record sales in the past year and record high current assets such as a inventory and receivables! But on the surface, all these healthy indicators don't mean anything if the operating cash flow is negative! The operating cash flow allows anyone a look under the bonnet, which is essential to understand what is going on with a company's engine. 

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Company valuation is far more complex than determining a company's book value by netting off assets and liabilities. When you buy a company, you essentially buy a future income stream. You, therefore, need to consider a whole host of factors, such as a company's market position, its technology and management team, etc... You also have to perform a basic health check by understanding its financial position—all significant parts of an attempt to value a company correctly. 

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