Where did all my cash go?
If I made that much profit, why doesn’t my bank balance look like that?
These are common questions to hear from business owners when they are looking through their income statement. It is a good and important question for business owners to ask, and is something that is important to understand, as having a good pulse on your cash flow is critical for successful business operations and growth. The quick response to this question (and, don’t worry, we’ll dive into it further if you read on), is that net income as presented on your income statement is not a direct reflection of your cash flow. The bridge between your net income (often referred to as your bottom line) and your bank balance is your cash flow statement.
Your net income reflects your revenues minus your expenses, but there are many transactions that flow through the income statement in ways that do not necessarily reflect the actual cash transactions, if any cash transactions at all, during the year. Some of these are “non-cash” transactions*, such as:
Depreciation of capital assets
Gains or losses on the sale of capital assets
Other transactions on the income statement that may not directly reflect cash transactions, depending on how you do your accounting, may include (though this is not a comprehensive list):
Sales to customers on credit, resulting in accounts receivable balances
Payments for insurance that may have been recognized as a prepaid expense
Purchase of inventory
Changes in your Work-In-Progress (WIP)
Purchase of any capital assets
Any large deposits made
Purchases made on credit, resulting in accounts payable balances
Receipt of or payment down on any loans
To better illustrate the dynamic these types of transactions have on net income and cash, let’s look at a hypothetical situation for Company ABC, listing different transaction types, the amount, and how these impact the bank/cash balance.
For Company ABC, the income statement might look like this:
Note: Example above does not include income tax.
At the same time, their cash balance (when looking at bank statements) may look like this:
Does this sound familiar? The cash balance is not what many might expect, given the results shown on the income statement. The assumption many might have, when looking at the income statement, is that if you start with a cash balance of $2,500, and have net income of $850, then you should have a closing cash balance of $3,350.
Here’s where we can see the impact of the types of transactions listed above on the actual cash balance, and how that relates to net income, using what is called a waterfall (or cascade) chart.
From this, we can see that net income was $850, and that through a series of transactions flowing through the income statement that may impact cash in a different way, the actual net cash transactions (or "change in cash") total $550. As a result, if you started with an opening cash balance of $2,500, you would end with the closing balance of $3,050, rather than $3,350.
As was illustrated in the waterfall chart above, the bridge that connects your income statement to your cash balance is what is called your Cash Flow Statement.
The Cash Flow Statement itself may then look something like this**:
Here you can see the reconciliation between your net income and your cash balance, which allows you to see how you arrived at your actual cash balance at the end of the year, from the net income presented on your income statement.
So, the next time you look at your bottom line while also looking at your bank balance, remember that the cash flow statement is what bridges the two. Knowing this, and understanding the drivers behind your cash flow statement, will help you better understand what it is that is impacting your cash flow.
As a closing comment, it’s not uncommon for business owners to make business decisions based on the cash balance in the bank. I hope you can now see that the current cash balance in the bank may not represent current ongoing operations, and that there are things, such as accounts payable balances, that may result in a higher temporary cash balance in the bank at any given time, which may be drawn down when such liabilities are resolved. When making larger business decisions, it is important to take this into consideration, as making larger decisions solely based on the cash balance in the bank at any given time may result in cash constraints down the road.
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*To be technically correct, these are actually connected to cash transactions, but there are timing differences in the cash transactions, in that what is represented on your income statement in one year may be connected to cash or non-cash transactions that occurred in prior years, and so the transaction amount itself does not equal the cash transaction amount in the same year.
**There are 2 different ways to prepare a cash flow statement, the Direct Method and the Indirect Method. The example above uses the Indirect Method, as it is the most common for businesses, and best illustrates the link between your net income and your cash balance. In the interest of not going too long in this post with something that likely has low relevance for most business owners, I haven’t used the Direct Method here.