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Typically when thinking of cash flow, an owner or manager is contemplating how to best meet the company’s current obligations as they fall due — in addition to funding the future growth of the company. This article is the first in a series of articles that will explain how best to maximize cash flow and profits in your business.

Throughout the series we will examine conventional ways of managing business, and the impact they have on creating more cash and profits. We will then review other possible techniques that stem from theory of constraints, lean manufacturing and other best practices to measure how they affect cash flow.

In order to properly measure and demonstrate the results of these different operating strategies we need to be clear on certain key definitions to gauge the best course of actions. (See Key Definition side bar)

To provide an example of Cash Flow from Operations (see sidebar definition, Cash Flow from Operations), let’s assume the following financial information about ABC Company.

ABC Company has:
• Net income of $200,000
• Depreciation expense of $25,000 (included in net income)
• Accounts receivable grew by $35,000
• Accounts payable grew by $50,000

Cash Flow from Operations is calculated as:
Notice that increasing accounts receivable is recorded as a use of cash, and increasing accounts payable has just the opposite effect as a source of cash.

DIFFERENCE BETWEEN CASH FLOW AND PROFIT

The main difference between net profit and cash flow is the timing of recognizing revenue and expenses vs. the actual inflow and or outflow of cash. Net profit is calculated using accrual accounting. Accrual accounting recognizes revenues and expenses not based on inflows and outflows of cash, but rather when the transactions take place.

For example, under accrual accounting sale revenue is recorded at the time when title for the product passes to the customer from the seller. The cash, however, is not received until the customer pays the invoice 30 days later.

Raw materials are purchased in order to manufacture a finished product which his then sold to the customer. Although a payment for the raw materials might have been made to the vendor for the raw materials, the raw materials, labor and overhead used to make the product are not expensed (through cost of goods sold) until the finished product is sold to the customer. The timing difference from recording the expense vs. the payment made to the vendor depends on how long it takes to make and sell the finished good.