Revenue is Vanity, Profit is Sanity, but Cash is King

In a previous life, when I owned a company that implemented accounting software, I noticed something often happened when we ran the first set of financial statements.

The owner of the business would usually reach for the profit and loss statement, while the accountant wanted the balance sheet.

It was interesting to observe these two different perspectives. The owner wanted to know the bottom line, and how sales were trending; the accountant was more interested in the current financial snapshot of the business, such as cash availability, outstanding accounts receivables, debt to equity ratio, etc.

Today, working closely with growth-oriented companies, I have become acutely aware how these two reports, if simply analyzed on their own, can potentially provide a false sense of optimism.

Without having an accurate assessment of cash flow, which can’t be determined from reading these reports, even a highly-profitable, growing business could be headed for disaster without its management being aware of it.

I want to emphasis this point. A highly profitable company with double-digit, year-over-year growth can run out of cash if cash flow isn’t intentionally managed. Without a purposeful focus on measuring and growing cash, as well as profit, high-growth companies risk running short of it. Hence the saying, “Revenue is vanity, profit is sanity, but cash is king.”

Cash flow is an expression used in every business, almost every day. “Our cash flow is good.” “Cash flow is tight.” “We need to improve our cash flow.” Most businesspeople use the term to vaguely describe the general availability of cash in their business. However, to a financial analyst, it’s far from vague. It has a specific value. It is a ratio that describes management competence. A competence you must possess if you’re going to be an effective leader of your organization.

There are only two uses for cash in any business: to invest in growth; or to fund management-sanctioned waste.

Ratios relating to cash-flow analysis quickly illustrate which of these is predominate in a business. If you’re considering asking your bank for a loan, seeking investors, or selling your business, analysts will want to know the ratios for your business. Even if none of these scenarios apply to you, you should learn to understand at least some of these ratios so you can effectively analyze and manage your cash flow.

I’m going to assume you’re not a finance person. If you are, this article will be akin to preaching to the choir. I’m also assuming you’re either not receiving cash flow reports today, or if you are, you’re not analyzing them to the extent you should.

This article isn’t going to get into the nitty gritty of creating or analyzing cash flow reports. What I hope to accomplish by writing it is encourage you to work with your accountant to understand cash flow analysis, and shift your focus from strictly bottom line and revenue, to include cash-flow management as a top priority.

So then, what is cash flow?

Cash flow is the change in cash and debt balances over a given period.

How do you calculate cash flow?

The cash flow statement reports on cash generated and used over a given time by stating the difference in the amount of cash available at the beginning of a period (opening balance) and the amount at the end of that period (closing balance). It’s called positive if the closing balance is higher than the opening balance, otherwise it’s called negative.

To calculate your operating cash flow, add net income, depreciation, and amortization together with income from other sources or charges, then subtract the net increase in working capital (current assets minus current liabilities).

What is the difference between cash flow and cash position?

Although closely related, cash flow refers to the net change resulting over time from inflows and outflows of cash, where cash position refers specifically to your company’s relative cash position at a given point in time.

What is good cash flow?

A healthy business should generate positive net cash flow from operating activities, and should be able to grow it over time. Positive cash flow is achieved through careful cash management, but does not necessarily equate to profitability.

What does it mean to have negative cash flow?

Conversely, negative cash flow does not necessarily mean your business is running at a loss. It may be due to a mismatch of expenditure and income; in other words, a timing issue. A chronic mismatch however, may indicate ineffective credit management, leakage of funds through fraud, or actual losses due to expenses being higher than revenue.

What are cash flow ratios?

Ratios provide easy-to-understand measurements that illustrate how solvent, liquid, and viable a company is. There are many cash flow ratios, each used to assess the health of a business by analyzing its cash flow relative to various factors. You and your accountant can determine which ratios make the most sense to monitor depending on the circumstances of your business. Select perhaps three to five and review them monthly, along with your other financial reports, to have a keener understanding of the status of your cash flow and whether you may be heading for trouble.

The only indisputable facts in any set of financial reports are the numbers that relate to cash. Profit can be manipulated to provide a specific outcome and certain valuations can be amended that influence your balance sheet. Only your cash and debt balances are factual. Consequently, these are the numbers your bank or investors will look at to determine the real performance of your business. You should too.