Don’t Count Your Eggs without a Positive Cash Flow

Normally, when money (cash) changes hands at the time of a sale, this is considered a business transaction that has taken place. You’d add this transaction on your monthly financial statement as a part of the revenue for that month. You’d deduct the operating expenses incurred in that same month to determine the net profit. However, this can be muddled if the transaction has occurred on paper in the form of a contract, but the goods and services haven’t been rendered.

In addition to knowing how to account for sales on a Financial Statement, it’s also imperative to understand how account receivables are not the same as cash flow. They are clearly included as assets on the Financial Statement, but a company can get into financial trouble if it’s cash flow is too low.

A simple example of this business scenario can be demonstrated in how my parents bought groceries when I was a child. The owners of a small general store in my hometown had developed a high level of trust in their customers. I remember going to the register with my mother and she’d say, “Can you put this on my account?”

Normally, our family purchases were small at the general store including milk, bread, and of course fresh eggs! However, my parents would pay the store owners, Jack and Jill (yes their real names) by writing a check at the end of the month for the balance due. Jack and Jill would deposit the check, and the money wouldn’t actually appear in their business account until the following month.

I imagine Jack and Jill had a positive cash flow. This gave them the flexibility to set-up some of their account receivables on a credit basis; however, with a limited cash flow this would not have been possible. The merchandise they most likely purchased on credit was no longer part of the company’s assets, since it had left the shelves on the day my parents had shopped in the store.

Jack and Jill were literally counting their eggs as sold, but the money wasn’t reflected as revenue in their account for that month; hence, their eggs were not hatched! I’m sure they chose to allow customers to purchase on an informal credit basis as a form of customer service, and as a way to increase sales.

To complicate things even further, we might ask, had Jack and Jill already paid for the inventory they sold? How was this being reported on their monthly income statement?

What’s an acceptable way to track expenses and revenue on a Financial Statement? Let’s consider that products and services are ordered, but the actual transaction of goods and money hasn’t yet taken place in order to determine how the financials are represented in accounting.

With larger companies handling multiple orders per day in thousands of dollars, “expenses do not get recorded when they are committed.” (Sicilano, 2003, Page 54) An accounting transaction is recorded only when the supplier has shipped the product, and the product has been received by the customer.

However, if the company pays for the order net 30-days of an invoice after receipt of goods, then this money is not part of the company’s current cash flow. A company can operate on credit themselves, but when it comes to paying for other expenses, like payroll, then limited cash flow can impact the future success of the company.

Let’s presume that Jack and Jill had 20 families owing $100 dollars for groceries, but the revenue would not be credited to their bank account until the following month. Let’s also assume some families pay their bills late, or some may have a financial hardship and suddenly can’t pay their bills at all. Without a cash flow for operational expenses for their business, Jack and Jill might not have enough money in their account for employee payroll in the current month. Even if they only had five part-time employees making $500 per month; without a cash flow there wouldn’t be any reserve to cover payroll checks.

Many companies operate on an accrual basis, which means “financial transactions are recorded when they actually happen, even if the payment is made later.” (Sicilano, 2003, page 75) However, in order for a business to count its eggs before they are hatched, it’s critical the company has enough cash flow to pay the monthly operating expenses. Even if they have a cash flow, they really shouldn’t count a percentage of eggs unhatched. The odds are high that some won’t hatch! Many financial advisors will agree, “the best metric to understand your short-term and long-term survival is by looking at your business cash flow.” (Wood, 2019)

When analyzing the financial position of a company, it’s important to take a look at whether the cash flow has been steadily increasing over time. A company should not have too much of its assets tied up in account receivables not yet paid without a cushion. Inventory sitting on the shelf, loans issued to employees and stockholders, and invoices not yet paid are all categorized under business assets on a Profit and Loss statement. However, a positive cash flow is one of the biggest predictors of fiscal health, and should be the basis for strategic investment decisions.

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REFERENCES

Siciliano, Gene, (2003) Finance for Non-Financial Managers, , New York, New York, McGraw-Hill.
Siciliano, Gene, (2003) Finance for Non-Financial Managers, , New York, New York, McGraw-Hill.
Wood, Merideth, (2019, July 22) Get Your Business Cash Flow Positive ASAP: The Total Guide, https://www.fundera.com/blog/cash-flow-positive

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