Understanding Your Cash Flow

Running out of cash is every startup’s nightmare. The most serious scenario is obviously burning through your runway, but temporary cash crunches can happen too. Few things are worse than sitting down to pay a large bill, and realizing you don’t have the cash on hand that you thought you did. 

While cash crises can happen in any economy, the risk is especially acute in a downturn, when your startup’s income may vary much more than previously projected. In the current environment, it’s more important than ever to understand your current cash status, and where it’s likely to go next.

To do that, you need two things: accurate financial statements, and knowledge on how to use those statements to get the information you need. Getting accurate financial statements is fairly straightforward: you need to have accurate books (and if you currently don’t, Pilot can help). As for knowing how to use them, that’s what we’re here to talk about.

The Income Statement: The Trends

First, let’s take a step back. Your company probably tracks its finances using accrual accounting (and if it doesn’t, you should change that immediately). In the accrual method, you record income and expenses when a service is delivered, rather than when the money is actually transferred. For example, a business might make a sale with net-60 terms, and get paid on day 58. In their records, the transaction is added as income the day the deal is signed. However, the company won’t actually have the money in the bank until nearly two months later.

Accrual accounting offers a lot of benefits, one of which is visibility into the health of your business through your income statement (also called a profit and loss statement). Your income statement tells you where and when you’re bringing in money over a period of time, and where and when you’re committed to spending it. You can see how many sales you’re making, how often, and for what amounts, which might be less obvious if you were just looking at cash deposits. You also see what purchases your business has made, so there are no surprises when a bill comes due.

However, the income statement doesn’t tell you how much money you have at a particular point in time. It shows that you made $5000 in income from a sale last week, but not when the money will be received, or how much cash you currently have in the bank. And if you simply assume that $5000 is in your cash account, you may make spending decisions that lead to a cash crunch if it turns out that income is still an IOU.

This is where the cash flow statement comes in.

The Cash Flow Statement: What’s in the Bank

The cash flow statement shows you how much cash you had at the beginning of a certain period (which might be monthly, quarterly, yearly, etc), and how much you had at the end. The amount you finished with, i.e. the bottom line, is what you actually have in the bank. Just looking at the bottom line, however, doesn’t tell you the whole story. You need to carefully examine the numbers that go into it.

A cash flow statement has three sections: investing activities, financing activities, and operations activities. 

Cash flow from investing activities is related to investments your company makes, usually spending money on growth (it’s also sometimes called the capital expenditures section). It’s important to remember that this is not money that others are investing in your company – that’s the next section.

Cash flow from financing activities is money invested in your company by others. If you raise a capital round, for example, or take out a bank loan, that money is recorded here. While the financing section will likely reflect your largest influxes of cash, it will also likely be relatively rare. After all, you don’t exactly raise venture funds every other month.

Cash flow from operating activities is the money your company makes (or doesn’t) in the course of its normal business. This is the money coming in from sales, minus the money required to keep everything running. From the perspective of managing your business and understanding your day-to-day cash position, operations income is the big one to watch.

For most startups, operations income is a negative cash flow. You spend more money than you take in, and thus you have a burn rate and a runway, instead of a self-sustaining profitable business. Keeping an eye on this part of your cash flow statement lets you track just how much you’re burning – and whether it matches up with your expectations. If the cash numbers are significantly off from your expected burn, you’ll want to investigate why.

With the cash flow statement, you know how much money you have – but not how much you’re going to have.  For that, we head to the balance sheet.

The Balance Sheet: Where You’re Headed

Going back to our earlier example sale: say you made that $5000 sale, which is recorded as income for this month, and say you have net-30 payment terms. That $5000 isn’t currently reflected in your cash flow statement, because you don’t have the money yet. On your balance sheet, however, it’s listed as an asset in your accounts receivable. You know to expect it in your bank account within the next 30 days (unless your customers don’t pay – but that’s a different problem).

Say you also made a software purchase this month for $2000, again with net-30 payment terms. You haven’t paid yet, so that money is still present in your bank account, but your balance sheet shows that you’ve made the purchase. You know that even though you technically still have that cash, it’s going to be paid out in the next 30 days – so if you’re considering making another purchase, you shouldn’t include that $2000 in your calculations of available funds. 

Using the three financial statements together, you can keep track of both your actual cash and your projected changes, and avoid setting yourself up for any accidental overdrafts. Now more than ever, it’s important to have accurate, up-to-date books, and know how to leverage them to guide your business forward.