The general usage of financial statements by business owners goes something like this:
- P&L = always
- Balance sheet = sometimes
- Cash flow statement = never
Finance teaches us that the P&L measures profitability while the balance sheet is just a snapshot of what we own minus what we owe at a single point in time.
But there are a few secrets tucked inside the balance sheet…
Secret #1: you can find exactly where cash came from (sources) and went (uses) in your business simply by looking at your balance sheet.
The cash flow is in the balance sheet.
When it comes to reviewing cash flow, there are a few places we can go:
- Read the cash flow statement (underappreciated financial statement #3)
- Use a 13-week cash flow worksheet (a second set of books maintained directly from your bank detail)
- Check your bank balance periodically (limited usefulness)
- Look at your balance sheets
Let’s focus on #4 today: reading cash flow from your balance sheet.
First, what do I mean by “read cash flow from the balance sheet”?
A single balance sheet (today for example) has limited usefulness. It only tells us what we own (assets) and what we owe (liabilities) as of today. But when looking at 2 or more balance sheet dates, we quickly get a sense for the sources and uses of cash in the business.
Secret #2: the cash flow statement is created using the changes in each balance sheet account.
If receivables increase or decrease, that impacts your cash flow. When you buy a new piece of equipment, cash flow. When you purchase or sell inventory, cash flow. Spent money on the credit card? Cash flow.
Changes in the balance sheet = cash flow.
Why is this important?
A few reasons I find this concept useful.
It gives me a very quick read on cash trends without any extra work. I can easily pinpoint which areas of my business are creating problems. It reinforces the cash flow drivers in my business (i.e. when you see it in action, you’ll start paying closer attention to those key drivers).
But most importantly?
As long as you’re reconciling your bank accounts consistently, it will work regardless of how good your books are. (I can use this framework to help clients where bookkeeping is still a work in progress.)
How does it work?
- Pick the time period you want to review (3 months, 6 months, 1 year, multiple years, etc.)
- Download balance sheets for those dates (i.e. if you want to review calendar 2024, then you need a balance sheet for 1/1/24 and 12/31/24)
- Track the changes in each asset and liability account (i.e. if A/R was $100k on 1/1 and $250k on 12/31, then the change was +$150k)
- Review each “change” to analyze the sources and uses of cash flow in your business
This whole exercise might take only 10 minutes, it’s not complex. Once you’re done, you’ll likely have a few accounts with big swings up or down and maybe a few accounts with no change.
Secret #3: If assets increase, then cash decreases. If liabilities increase, then cash increases. Therefore, changes in asset accounts are inversed with cash flow (assets up, cash down).
What should you do from here (how do you use it)?
I find this to be a good “pulse check” on cash flow as opposed to an in-depth analysis; my preferred use case is monthly.. Maybe once each year I’ll do a more thorough review of these sources & uses.
When I get my financial statements, I always look at 6 consecutive months (columns) of the balance sheet. I’ll spot check the trends in asset and liability accounts and cross-reference it against my understanding of the business.
- If A/R keeps ticking higher each month but my sales aren’t growing, I’ll question what’s going on.
- Maybe A/P is steadily climbing (a source of cash) which could mean I’m taking too long to pay my suppliers.
Analyzing the “why” is our secret sauce…
Takeaway — Changes in balance sheet accounts represent cash flow swings. If asset accounts are up, then cash is decreasing (a use of cash). If liability accounts are up, then cash is increasing (a source of cash). These 3 sentences alone should change how you look at your balance sheet(s).
Homework — Get your beginning and ending balance sheet for 2024 and find the line items with 3 largest increases and 3 largest decreases during the year. What were they and why?
(As always, email us if you have questions or need help info@profitmastery.net)