Year end is a common time for all businesses to assess their profit for the previous year. Unfortunately, for some businesses, this is the only time they analyze their financial results. A business’ annual profit has tax ramifications for that business (C-corp) or the business owners (S-corp, LLC, Sole proprietorship), so individuals are interested to know the profit or loss and how it will affect their tax situation.
The question I hear most often from clients at this time of year is “where is the cash?” The question usually arises when the business has a profit of a certain amount, but the cash (checking) account has not increased by a similar amount. The simple assumption is made that if the business made a profit of $10,000 then the cash should be $10,000 higher.
The Cash Flow Statement is the easiest tool to answer this question, but most small business do not produce (or have their bookeepers or accountants produce) a cash flow statement. Cash flow statements are a very useful tool for business owners and managers, but cash flow statements are also harder to understand than Profit and Loss Statements or Balance Sheets.
Whether or not you use or understand cash flow statements, the same information can be obtained by examining a comparative balance sheet. A comparative balance sheet (see PDF example Comp Bal Sheet) is a balance sheet for one time period compared to another time period. All accounting software packages allow you to produce these statements. At year end, create a balance sheet for the year just completed and add to it the balance sheet for the previous year. If your accounting software allows it (QuickBooks and Peachtree do) have the system calculate the change from the previous year to this year. Everything on this statement will answer your cash questions.
The first two items to review are the “net income (loss)” and the cash (checking) account. Net income (loss) should be shown in the Equity/Capital/Shareholder’s Equity section of the balance sheet. The net income for the current year will be shown in the current year column. Ignore the “change” column for net income. A net profit for the year will be shown as a positive number, and a net loss will be shown as a negative. Compare this number to the change from one year to the next in cash. The change column on the remaining items on the balance sheet will illustrate the differences between the net income (loss) and the increase or decrease in cash.
- Depreciation/Amortization – The change column for the accumulated depreciation and/or amortization accounts is important to notice. Depreciation and amortization are “non-cash” expenses. So these items reduce profit but do not reduce cash.
- Creation or use of cash – The remaining change column items should be reviewed to determine if they are a creation of cash or a use of cash.
- Increase in an Asset – any increase in an asset from one year to the next is a use of cash
- Example- If in 2009 inventory was $12,000, and it was $20,000 at the end of 2010. This is a use of $8,000 in cash.
- An increase in the amount of inventory does not affect profit, so it helps explain a difference between the change in cash and net income.
- Decrease in an Asset – any decrease in an asset is a creation of cash
- Example- accounts receivable (accrual accounting only) in 2009 is $50,000 and in 2010 is $40,000. This is a $10,000 creation of cash.
- The net income number “assumes” you were paid only for the amount of sales you recorded, but the change in cash includes payments for sales recorded in prior years.
- Increase in a Liability or Equity- any increase is a creation of cash
- Example – 2009 Bank line of credit is $40,000 and 2010 is $65,000. You have created cash of $25,000 by additional borrowings
- Decrease in a Liability or Equity- any decrease is a use of cash
- Example – 2009 Notes payable-company auto is $24,500 and 2010 is $19,750. You were making cash payments on the loan for the company car. Each payment included interest (would be included in the net income number) and principal (not included in net income number). You have used cash to pay down debt.
- Increase in an Asset – any increase in an asset from one year to the next is a use of cash
The cash flow statement illustrates these changes in a certain format. The most commonly used cash flow statement is the indirect method. This method starts with net income (loss) and ends reconciling to the change in cash. The changes to the balance sheet accounts are grouped into one of three categories by business function. Changes in accounts like AR, inventory, accounts payable or sales tax payable deal with the day-to-day operations of the business and are included in the Operating Activities section. Changes to the accounts in the fixed assets and equipment accounts are included in the Investing activities section of the cash flow statement. Notes payable and borrowing changes are in the Financing Activities section. The net cash change from net income (loss) is totaled with the amount of change from each of these three types of activities to reconcile cash at the beginning of the year to the year-end balance.
The cash flow statement or a comparative balance sheet is a great place to answer the question “where is the cash?”