Cash flow is the lifeline for all businesses and, not surprisingly, is a top concern for many business owners. They rely heavily on cash flow statements and the expertise of their accountant to make informed strategic business decisions. Therefore, cash flow statements must be accurate.
Cash flow statements are one of the three fundamental financial statements used, alongside income statements and balance sheets. However, one could argue that the cash flow statement is the most critical as it summarizes the amount of cash flowing in and out of an organization. Inaccuracies can result in misinformed decision making, which can be devastating to a business.
Accounting professionals must have the right tools and resources in place to not only avoid cash flow mistakes but also help maximize cash flow for clients.
So, what are common mistakes in the cash flow statement and how can you help clients improve cash flow management? This article will look to answer these questions, and more.
What is in a cash flow statement?
A cash flow statement shows the actual flow of a company’s cash, which makes it especially helpful in determining a company’s short-term viability. This differs from the income statement, which shows accruals of income and expenses based on GAAP accounting. Furthermore, the cash flow statement does not include non-cash items like depreciation.
What are the main types of cash flows?
The cash flow statement is divided into three core segments: cash from operating activities, cash from investing activities, and cash from financing activities.
The cash flow statement provides business owners, as well as investors, a better understanding of how the company generates cash and meets its financial obligations. As noted above, to paint this financial picture, the cash flow statement is segmented into the following three sections:
- Cash from operating activities: This is the cash a company generates from its day-to-day operations. Many publicly traded companies will present this section by adjusting net income to net out non-cash activities, such as depreciation, amortization, and adjustments for accounts payable and receivable, among other items.
- Cash from investing activities: Essentially, any item that is classified on the balance sheet as a long-term asset could fall under investing activity. So, this section could represent cash used to buy property, plants, equipment, and other productive assets. It could also represent cash used for investing in assets, as well as proceeds from the sale of equipment or other long-term assets.
- Cash from financial activities: This section is cash that is received or paid out from borrowing and issuing funds, such as amounts raised in a debt offering or loan proceeds. It may also include dividends paid.
The net cash from all three of these sections is then added up to determine the net increase or decrease in cash during the period.
To illustrate this point, consider the following example from the Harvard Business School:
Your client started the year with approximately $10.75 billion in cash and equivalents.
On the cash flow statement, cash flow is broken out into cash flow from operating activities, investing activities, and financing activities. The client brought in $53.66 billion through their regular operating activities. Meanwhile, they spent approximately $33.77 billion in investment activities, and a further $16.3 billion in financing activities, for a total cash outflow of $50.1 billion.
The result: The client ended the year with a positive cash flow of $3.5 billion, and total cash of $14.26 billion.
Common cash flow issues
When analyzing a company’s cash flow statement, there are some common cash flow issues that may arise.
- Expenses: If a company has too much money going out each month to cover expenses or is unexpectedly hit with a hefty expense (i.e., equipment that needs to be repaired), that can quickly pose a cash flow issue. To help avoid a cash flow crunch, business owners should have an efficient plan in place to track expenses on a monthly basis and project future expenses for the months ahead.
- Overlooking recurring charges: Overlooking recurring and seemingly insignificant charges can quickly add up and result in cash flow issues if not taken into account. For example, monitor sign-ups for online services that have smaller, automatic monthly charges. Additionally, keep an eye on cash expenses like buying bagels for the team on the way into the office.
- No projection plan: It is advisable that every company maintain a six-month cash flow projection with expected revenue and expenses, while also adjusting for any seasonal peaks and valleys.
- Unclear payment terms: To help avoid delays in receivables, businesses should establish consistent policies and procedures to ensure that their customers pay in a timely manner. This means clarifying payment terms and expectations on every invoice, such as “payment due upon receipt” or “payment due within 30 days.”
- No collection plan: When slow-paying customers turn into delinquent customers, businesses should have a standard collection plan in place to collect unpaid bills. This involves setting times to send invoices and to follow up on unpaid invoices. If a customer is significantly late in paying a bill, such as several months late, businesses should consider using a collection agency or third-party collections service.
How do you find mistakes in a cash flow statement?
When it comes to preparing cash flow statements, there are several common errors that can take place. Knowing what to look for can help identify mistakes in a cash flow statement. These include the following:
- Misclassifications: As noted earlier, the cash flow statement is broken down into three categories: operating, investing, or financing activities. Misclassifying cash flow is a common error. There are a few tips to keep in mind to identifying improper categorization:
- Investing activities are generally related to changes in long-term assets.
- Financing activities are usually related to changes in long-term liabilities and/or equity.
- Operating activities are typically related to the income statement and changes in current assets and current liabilities.
- Non-cash transactions: Non-cash transactions are often missed and improperly included in the statement of cash flows as if cash changed hands. For example, when purchasing a new vehicle through the issuance of a note payable, there is a tendency to show the gross purchase price and the new note balance in full within the investing and financing areas, respectively. However, there was actually no cash that changed hands. It was simply the signing of a piece of paper.
- Omitted non-cash transactions: Failure to disclose non-cash transactions need to be corrected. The form of presentation can vary, be it in a narrative at the bottom of the cash flow statement or tabular. If there are several and/or complex non-cash transactions, a separate footnote might make sense.
- Interest and taxes: The amount of interest and income taxes paid are often overlooked when using the indirect method of reporting the statement of cash flows. It is common to not only miss these disclosures but also improperly report them even when included. Note that accrual balances need to be adjusted to cash basis for proper reporting.
What to do when you have a cash flow problem
As a trusted advisor, accountants are ideally positioned to help clients find solutions to cash flow problems. Below are several ways you can help:
- Review and, as needed, adjust a company’s product or service pricing.
- Review a company’s customer contracts and, if possible, suggest they renegotiate existing contracts to secure more favorable payment terms so they can get paid faster.
- Reevaluate their accounts payable and, if necessary, encourage clients to negotiate payment terms with vendors.
- Review a client’s accounts receivable process. If necessary, help them standardize billing processes, create protocols to send bills for services at the same time, and send invoices using the same method (i.e., email, etc.).
- Reevaluate their spending costs. Are there expenses and costs that can be eliminated or reduced?
How to improve cash flow management
To help clients take preventative action, there are several red flags accountants should keep on their radar.
For starters, keep watch for negative cash flow, or negative cash from operations. This could indicate the company is relying on financing or asset sales to fund its operations, which is not a sustainable position in the long run.
Another red flag to have on your radar is an operating cash flow ratio (operating cash flow/current liabilities) of less than 1.0. This could mean that the company is not generating sufficient cash to pay its bills.
Remain aware of large changes in cash flow from period to period and how they compare with changes to the income statement. Are net earnings holding steady but cash flow from operations is declining? If so, this could be a warning sign of problems ahead.
Accounting professionals can prevent mistakes in cash flow statements by automating the process with a robust accounting solution such as Accounting CS Payroll, which has powerful cash management features to help optimize client cash flow.
To learn more about current challenges accountants face, read “Top accounting issues in 2023.”