Calculating Cash Flow

Cash is the lifeblood of business and understanding how the statement of cash flows works is essential for every aspiring Richard Branson or Mark Zuckerman. Putting together your cash flow statement can be tricky for the newbie but is actually very easily mastered with this simple hack.

The Indirect Method

The Philosophy of the indirect method is that cash flows should be in essence driven by profits so, to calculate the indirect method of cash flows, you start with your profits and then make adjustments for everything that are not profits until you get to your change in cash flows. When you think about it, this is very intellectually satisfying. After all, our main obsession is with profits, and rightly so. However, profits don't keep the employees coming back and the lights on, cash does. So by closely examining all the uses of cash we can see where our cash is going and locate any potential problems; which makes the indirect method of calculating cash flows a fast, efficient, and very powerful weapon in your arsenal of business management for maximum profits!

The Hack

Debits equal Credits and the balance sheet must balance, or assets = liabilities plus equity, got that? That's all the accounting you need to know for this exercise. Now take this a step further. Download your comparative balance sheet into Excel, you know, it's the assets = liabilities plus equity page. Comparative means that we show two periods, usually year ends, side by side. Now, in the immediate column to the right make a total subtracting the current periods assets from the prior periods and copy it all the way down, except in the totals cells. Now move down to the liabilities and equity section and do the opposite, subtracting the prior period from the current period. We do the opposite because credits (liabilities and equity) have the opposite value (-) from assets (+), but that's really not important at the moment. Now sum the new column that represents the change in the balance sheet. If you did the exercise right then the sum should be zero. If you're not getting zero that means that you forgot to reverse the formula for the liabilities and equity section or you included subtotal rows in your new column. Pretty frickin' cool, huh? But that's not the coolest part. Now redo your sum to exclude the difference in cash, usually the first line. The sum of all the other changes must be exactly opposite any single change, or in other words the sum of every other change equals the change in cash flows times negative one!! Flippin' mindblowin' stuff! And the basis of the Indirect Statement of Cash Flows.

Putting This Into the Statement of Cash Flows

You're 80% of the way there and, if you are only doing this to understand your business and not to make a real, bona fide, according-to-GAAP cash flow statement then skip over the rest of this post and head to the next. The next step is to turn this information into the required format to have an official looking statement. Well, if you take a look at my sample Cash Flows Statement you will see that the first line is net income, and what is net income but part of the change in retained earnings? If you read my earlier post on retained earnings you will remember that the change in retained earnings is comprised of net income plus capital contributions less distributions. So your net income, the first line on your statement, less your distributions or plus your contributions in the investing section will equal your number for the change in retained earnings on the balance sheet you worked on in the paragraph above. And so it is down the line, every line on your cash flow statement must either alone or in aggregate with another line equal a line in the change column that you just calculated on your balance sheet. This is brilliant stuff kids and I wish my accounting professor would have explained to me this way. Actually, maybe he did but I sat next to this really cute mamacita that day; I could be a moron like that.

The Challenges

The next big challenge on your statement of cash flows will be the change in fixed assets, which will be a component of plus depreciation expense less any new assets purchased plus any assets sold plus or minus the gain or plus the loss on that sale. The key is, when you add up those factors they must equal that line for the change in fixed assets. If not you're forgetting one component so review the equation in the first sentence of this paragraph and figure it out.

After fixed assets the next most complicated line is the change in notes payable or debt. The formula is that new monies borrowed minus debt payments plus interest expense will equal your change in debt. This is important because all three components will go on a different line on your statement of cash flows, but their sum must equal the change that you calculated on your balance sheet or you're doing it wrong and you need to review.

Other than that everything else pretty much matches line for line between your balance sheet calculation and the statement of cash flows. Just plug in the numbers and voila! your change in cash flows will equal the amount that you calculated on line one of your balance sheet! If for some reason it doesn't just go back over and make sure that you can reconcile each line for the changes that you calculated on your balance sheet to the cash flows statement. If you can't you must be missing a line.

Finished, Miller Time!

When you're done patting yourself on the back for a job well done then it is time to get down to the really important business, what all this madness means to you and your business and how the statement of cash flows can help you run your business better. Alas, that is the source of another article as I'm tired and turning in for the night; so stay posted!