(22) Understanding Financial Statement: Types of Cash

Understanding these cash types can help you, the business owner, avoid many pitfalls that sink so many businesses. Remember, the number one reason businesses fail is not because they are unprofitable; it’s because they run out of cash!

Three types of cash


Since cash is so vital to the health of a business, is all cash created equal? The answer is NO! There are three sources of cash for your business:

  1. Operating Cash - cash generated by the operation of your business showing how well management converts profits into cash
  2. Financing Cash - cash input from shareholders or borrowed/repaid to lenders
  3. Investing Cash - cash outgo or income from buying or selling assets

If cash is king, operating cash is supreme emperor. It is only through a positive generation of operating cash that you have a sustainable business model. If you can’t convert profits into operating cash, you will eventually fail.

Ways to increase operating cash include increasing margins and stretching payables aging, as well as decreasing inventory and shortening receivables aging.

Here are some ways to view the three types of cash:

Investment cash needs – Operating cash flow (OCF) = Financing cash flow (FCF)
OCF – Investing cash flow (ICF) = Free cash flow


Here are 4 tests for analyzing Operating cash flow.

  1. Is OCF positive? If not you’re in trouble.
  2. Is OCF greater than Net Income? If not, it means Net Income is not turning into cash but instead is being tied up in Receivables and/or Inventory. In a well run business, OCF should be greater than Net Income due to depreciation, which is a non cash expense.
  3. Is OCF greater than Fixed Asset Investment (ICF)? If not, it usually means you have to borrow to buy Fixed Assets. OCF is insufficient to fund growth. Capital intensive businesses usually fall into this predicament. Financing needed = OCF – ICF.
  4. Is OCF heading in the same direction as Net Income? If profits are trending up but OCF is trending down, you have a problem. Many times this is how fraud or embezzlement is detected.
To summarize my previous four articles - owning a business is a process of using the assets of the business to generate sales, control expenses to generate profits, and efficiently convert profits into cash. CASH IS KING!

The balance sheet illustrates what a company owns and what it owes. It is a snapshot in time. The BS always has a single specific date. Every transaction within the business affects the BS. It shows if the company is solvent, if there is enough liquidity or cash to cover short-term obligations, the distribution of your assets (cash, receivables, inventory, PPE), how much the company owes, and any claims by others on company assets.

The income statement (also known as Statement of Earnings, Profit and Loss (P&L), or Statement of Operations) illustrates the Promise part of the transaction. It is like a movie showing what has happened over a specific period of time. It is the theoretical representation of what happened if everything goes according to plan. However, it doesn’t tell you when or even if the settlement actually occurs. It shows how effective the owners are at controlling their expenses in the effort to turn sales into profit.

Finally, the cash flow statement shows the real money – like the old Wendy’s commercial: “Where’s the beef?”. It represents the Settlement part of the transaction. Similar to the income statement, it is like a movie showing what happened to your cash over a specific period of time. The cash flow statement illustrates how effective you are at turning profits into cash.

NET INCOME IS AN OPINION…..CASH IS A FACT!

In any business, management makes decisions. These decisions are converted into activities, which are reflected in the financials. With the analytical skills and all three financials you can trace back through the numbers, uncover the activities, and determine the decisions made by management. Imagine how mastering this capability will enhance your success as a business owner and business buyer!



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