In a previous article I talked about business numbers and the critical difference between cash and profits. This article looks at how to plan for cash in a business plan, understanding the critical elements that affect cash flow. You don’t want to be one of those businesses that goes broke even while producing profits.

Basic cash planning example
Lets start with a simple example. Illustration 1 looks at the business from the point of view of money coming in and money flowing out. Sales and profits are out of the picture, (although sales influences money in and costs and expenses influence money out).

In this very simple model, your sources of money are cash sales, payments from receivables, new loan money, and new investment. Your expenditures include buying widgets in cash, paying interest, paying bills as they come due (i.e. paying accounts payable), and paying off loans.

Illustration 1: Basic cash plan

Even at this basic level, you can see the potential complications and the need for linking the numbers up with a computer. Your estimated receipts from accounts receivable must have a logical relationship to sales and the balance of accounts receivable. Likewise, your payments of accounts payable have to relate to the balances of payables and the costs and expenses that created the payables. Vital as this is to business survival, it is not nearly as intuitive as the sales forecast, personnel plan, or income statement. The mathematics and the financials are more complex.

A more realistic example
The cash plan can get complicated quickly when you deal with a more realistic business example. In the following illustrations, were going to look at the cash planning for a start-up company.

Beginning assumptions
With Illustrations 2 and 3 we set the starting points, which are the projected income…

Illustration 2: Income statement

…and the starting balance.

Illustration 3: Starting balance

We see a simple example of business income, which we’ll use as a first step for planning cash. Sales hit a peak in May. The example already divides sales between cash sales and sales on credit. We also have a simplified version of wages and operating expenses so that we can focus on the cash plan instead of the income statement.

Cash flow breakdown
In the following sections, I will explain the Cash Flow table, row by row, and how the numbers in your Cash Flow have a direct impact on the Balance Sheet, to help you better understand the direct link of one table to another, and how changes in one table directly affect the other.

For the purpose of discussion, we have divided a standard Cash Flow table into separate sections, Sources of Cash and Uses of Cash.

Sources of cash
Illustration 4 lists possible cash sources for our sample company. Most of these have balance sheet impact, and several come from the income statement. For now, we’ll focus just on the cash flow. After dealing with cash we’ll also look briefly at the specific cash flow implications on the balance sheet.

Illustration 4: Sources of cash

  1. The first row, Cash Sales, is a simple estimate. It should link with your sales forecast and income statement to avoid inconsistencies. Cash sales plus sales on credit equal total sales. Normally, credit card sales are grouped into cash sales because the business gets the money in a day or two. Cash in this case means cash, check, and credit card, everything except the real sales on credit, which are sales made on terms.
  2. The second row, From Receivables, is an estimate of the dollar amount received from customers as payments of accounts receivable.
  3. The third row, From Sale of Inventory, shows special sales of inventory sold outside of the normal business. For example, sometimes a manufacturer sells excess inventory of materials or components, outside of its usual and regular sales channels. This shouldn’t include the normal sales of normal inventory, which go on the income statement as sales.
  4. The fourth and fifth rows are From Sale of Other Current Assets and From Sale of Capital Assets. Selling current or long-term assets is another possible way to generate cash.
  5. The next three rows are where you estimate amounts of money coming into the company as new borrowed money. The difference between each of the three is a matter of type of borrowing and terms. The row named From New Current Debt is for money you get by borrowing through normal lending institutions, as standard loans, with interest payments. The row named From New Other Current Liabilities is for items like accrued taxes and accrued salaries and wages, money owed that will have to be paid, but isn’t formally borrowed. Normally there are no interest expenses associated with this row. The row named From New Long-term Debt is for new money borrowed on longer terms.
  6. The last row in Sources of Cash, New Capital, is for new money coming into the company as investment.

Uses of cash
Illustration 5 is an example of uses of cash for our sample company.

Illustration 5: Uses of cash

  1. The first and most obvious use of cash is to Pay Accounts Payable. The accounts payable balance is money you owe. Every month, you pay off most of this.
  2. The row named Payroll etc. is for wages and salaries and other compensation-related payments you make every month to your employees and the government. These obligations don’t go into accounts payable. Instead, you pay them every month.
  3. The row named Immediate Expenses is for other expenses, aside from the wages and such in the row right above it, that you pay as incurred. They never go into payables to wait their turn.
  4. The Immediate Cost of Sales row is very similar to the one above it, the difference being that these are costs of sales, instead of expenses, that are paid as incurred.
  5. The next row, Interest Payments, assumes that interest is paid as incurred instead of waiting in payables to be paid later. Therefore, interest payments decrease cash. The amounts have to match the income statement.
  6. The next two rows, Principal Payments Current Debt and Principal Payments Long-term Debt, are for principal payments of debt. When you pay off your loans, you lose cash. In the example, there is a regular payoff of long-term debt, and a single payoff of part of the current debt.
  7. In the second row from the bottom, you record new Inventory in Cash. You’ll have to know how much new inventory you’ll be buying, so the portion of it paid in the same month is part of calculating new payables.
  8. Finally, in the last row, purchases of New Capital Assets reduce cash and change the balance sheet amount for the related assets.

Calculating the cash balance
When you’re done with both sections, add the new sources of cash and subtract the uses of cash, and you have an estimated ending Cash Balance for each month, as shown in Illustration 6.

Illustration 6: Cash balance

Even with this detailed list, we’ve still missed some other items that might reduce cash. There is nothing in this sample table for purchase of current assets. There is nothing showing for owner’s draw or dividends. There is no row for interest income, or miscellaneous income. This is just a simple example intended to point out the relationships between the different tables, and the dependencies involved in calculating a real cash flow.

Links with balance sheet
I can’t talk about cash without relating the cash flow to the balance sheet. The three most important financial statements in a plan, income statement, cash flow, and balance sheet, are linked to each other.

Illustration 7 shows the sample balance sheet linked to the cash flow in the previous illustration. Most of the rows on this balance sheet are directly affected by the cash flow, and need to change every time the cash changes. To close the circle, let’s look in detail at the balance sheet.

Illustration 7: Related balance sheet

  1. The Cash Balance row is the balance in your checkbook. You calculate this with the cash flow.
  2. Accounts Receivable is the money owed to you by customers for sales already made. The balance increases with sales on credit, and decreases with payments of accounts receivable. For any month, the ending balance is the sum of the previous ending balance, plus new sales on credit, minus payments received.
  3. Calculate the Inventory balance as the previous balance minus direct cost of sales plus new inventory purchases.
  4. Calculate Other Current Assets as the previous balance plus new assets purchased (from the uses of cash) minus disposal of assets (from sources of cash).
  5. Capital Assets are long-term assets, usually plant and equipment. This month’s balance is equal to last month’s balance plus new assets purchased, minus disposal of assets.
  6. Accumulated depreciation decreases the value of the capital assets. This month’s balance is last month’s balance plus new depreciation, from the income statement.
  7. Accounts Payable will be last month’s balance plus additions (a subset of costs and expenses) minus payments of payables. New payables will include new inventory not paid for when purchased, plus indirect costs of sales not paid as incurred, operating expenses not paid as incurred, and similar items.
  8. Current Notes (short-term) will be equal to last month’s balance plus new borrowing minus principal payments. Interest payments are not included, because they go into the income statement and don’t affect the balance. Principal payments and new borrowing should come from the cash flow.
  9. Other Current Liabilities are things like accrued taxes and accrued salary, liabilities you know you have but haven’t paid.
  10. Long-term Liabilities (debt) increases when you borrow and decreases with payment of principal. The balance is going to be last month’s balance plus new borrowing as a source of cash, minus principal payments as a use of cash. In the sample case, the March balance shows a $100 increase for a new loan, minus a $3 decrease for payment of principal, so that the $376 at the end of March is exactly $97 more than the $279 at the end of February.
  11. Paid-in Capital is money invested. The balance should be last month’s balance plus new investment from sources of cash, minus dividends from uses of cash.
  12. Retained Earnings is the accumulated earnings reinvested in the company, not taken out as dividends. Normally this changes once a year when the annual statements are prepared.
  13. Earnings are the accumulated earnings since the end of the last year. This month’s balance should be equal to last month’s balance plus this month’s earnings. At the end of the year, with an annual adjustment, earnings still left in the business become retained earnings.

Understanding cash flow
Your cash plan is the most critical financial element of your business projections. If it is going to be useful at all, a business plan helps you develop a realistic cash estimate, based on the underlying relationships we explored in the previous chapter. Whenever you change an assumption in sales forecast, personnel plan, profit and loss, or balance sheet, it affects your cash flow.

The examples here describe the way cash flow works. Profits are very important to cash; the more profits, the better the cash, because profits are sales (that generate cash) minus costs and expenses (that cost cash). What is less obvious is the impact of balance sheet items:

  • An increase in assets decreases your cash. A decrease in assets increases cash.
  • An increase in liabilities increases cash. A decrease in liabilities decreases cash.

These two principals lead eventually to the impact of receivables, inventory, and payables. As you look at your assumptions for the cash flow, keep in mind that every extra dollar of receivables or inventory as assets is a dollar that you don’t have in your cash balance. Every dollar in payables is a dollar that you have in cash, too. Although this simple cash model doesn’t show the critical impact as clearly as our examples in the previous chapter, the mathematics and financial principles are the same.

The cash plan is vital, the most critical financial analysis in the business plan. It has to manage the difference between cash and profits. The cash flow stands between income statement and balance sheet, and brings the two together.

Tim BerryTim Berry

Tim Berry is the founder and chairman of Palo Alto Software and Follow him on Twitter @Timberry.