The Indirect Cash Flow Method: How to Use It and Why It Matters

As with a lot of projections and financial analyses, there is more than one correct way to handle cash flow.

That’s true with financial statements, which offer financial history in well-defined terms, and it’s also true with projections, which go along with business planning.

This article looks at an alternative cash flow method, often called the indirect cash flow method, which projects cash flow by starting with net income and adding back depreciation and other noncash expenses, then accounting for the changes in assets and liabilities that aren’t recorded in the income statement.

This method is also called the sources and uses statement, or a sources and uses projection.

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How to use the indirect cash flow method

The indirect method starts with net income and then adjusts for all the sources and uses of cash that aren’t part of the income calculation. Results should be the same for either direct or indirect.

It’s important to be aware of both common methods because, unfortunately, some people who ought to know better don’t. People will look at one or the other and think that it’s wrong if it doesn’t match the method they know. It isn’t—at least not necessarily.

Notice also that the example here doesn’t match the standard one-column sources and uses statement you may have seen with accounting statements, because some concepts are sources in some months and uses in other months.

For example, in the row for inventory, the negative number shown in January is negative because buying inventory absorbed cash in that month. Then it’s positive from February through May, because in these months more inventory was sold, as cost of goods sold, than was purchased. It goes negative in June because in that month, again, more cash was used to buy inventory than the amount of inventory that was sold that month as cost of sales. In a lot of accounting sources and uses statements, laid out as single column, rows divide into either sources or uses, but not both.

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Why does this matter?

The most important takeaway from this article is that there is more than one valid way to calculate projected cash flow.

Unfortunately, some would-be experts don’t understand that and are too quick to say “you’ve done it wrong” when what they should be saying is “you’ve used that other method that isn’t my favorite.”

You, as a business owner, need to know that there are different ways to calculate cash flow—so you don’t get put off when somebody uses the other way.

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From Basic Numbers to Financial Projections

There are some good reasons that you might need formal financial projections. The best reason is planning cash flow better. I wrote about the cash flow traps in the previous chapter; being aware of them is better than not, but with standard financial projections, you can take your sales forecast, expense budgets, and starting position and with a few reasonable assumptions you can project your cash. That, however, takes standard financial projections. The cash flow is like the link between your income and your balances. See the illustration above.

You may run into the acronym GAAP, which stands for Generally Accepted Accounting Principles. Everything in this section is according to GAAP.

If you've done the basic numbers, you're already more than half the way there. You've already estimated your future sales, cost of sales, and operating expenses. You're very close to a standard pro forma income statement. Just add projections for interest and taxes, and you have that done.

From there you want to project your balances. What will happen with capital, assets, and liabilities? If you can set your starting balances to match your beginning-of-the-plan estimated guesses, then some rolling assumptions will take you right from there to cash.

In fact, my favorite way to make these estimates is to change and manage numbers in the cash flow and use those changes to automatically generate the balance sheet. I'll show you how to do that in detail in this section.

Income vs. Balance vs. Cash
An income statement (also called profit and loss) shows your business performance over a defined period of time (usually a month or a year). This is sales less costs less expenses, which equals profits. A balance sheet, on the other hand, shows your financial position at some moment (usually at the end of the month or the end of the year). This is assets, liabilities, and capital. Assets must always be equal to capital (also called equity) and liabilities.The cash flow reconciles the other two. Not all your money received nor all your spending show up in the Income Statement, and not all of it shows up in the Balance Sheet. The cash flow links the two. And, much more important, shows where the money comes from and where it goes.

In the meantime, though, there are some standard conventions for the way these various statements link together. This is true in GAAP, true in Excel, in Lotus 1-2-3 if you do it right, and automatically in Business Plan Pro.

  • Your sales forecast should show sales and cost of sales. The same numbers in the sales forecast are the ones you use in the profit and loss statement.
  • As with sales, you should normally have a separate personnel table, but the numbers showing in that table should be the same numbers that show up for personnel costs in your profit and loss table.
  • Your profit and loss table should show the same numbers as sales and personnel plan tables in the proper areas. It should also show interest expenses as a logical reflection of interest rates and balances of debt.
  • Your cash flow has to reflect your profit and loss, plus changes in balance sheet items and noncash expenses such as depreciation, which are on the profit and loss. The changes in the balance sheet are critical. For example, when you borrow money, it doesn't affect the profit or loss (except for interest expenses later on), but it makes a huge difference to your checking account balance.
  • The balance sheet has to reflect the profit and loss and the cash flow.
  • Your business ratios should calculate automatically, based on the numbers in sales, profit and loss, personnel, cash flow, and balance sheet.

Facts About Financial Projections

Normal people hate financial projections because of their off-putting formats and buzzwords. Really, it's just a matter of making good estimated guesses about what you're going to be selling, what it'll cost and what your expenses will be.

Let's go over a few simple points that generate a lot of unnecessary errors in business plans. These are simple facts -- accounting conventions, in some cases -- that answer a lot of entrepreneurs' frequently asked questions. Don't let your business plan look bad because of easy-to-fix errors.

Before I start, take a breath. Don't glaze over when you see financial terms. They aren't that hard, and they are that important. Stick with me.

1. Tax law allows businesses to establish so-called fiscal years instead of calendar years for tax purposes. For example, your fiscal year might go from February through January, or October through September. Use "FY" (as in "FY07") to specify the year in your plan. The year is always the calendar year in which a plan ends, not the year it starts.

2. Understand sales on credit and accounts receivable. When your business sells anything to another business, you usually have to deliver an invoice and wait to get paid. That's called sales on credit, which has nothing to do with credit cards, but plenty to do with B2B sales. When you make the sale and deliver the invoice, the invoice amount increases sales and accounts receivable. When that money gets paid, it decreases accounts receivable and increases cash.

3. Separate costs from expenses. Costs are normally the cost of sales, sometimes called cost of goods sold and direct costs. Costs are the money you spend on whatever you're selling, like what a bookstore pays to buy books. Expenses are regular running expenses like rent and payroll -- expenses you'd have whether or not you had any sales.

4. Don't call your investment venture capital unless it comes from one of the few hundred actual VC firms. If you're getting venture capital, you'll know it. If not, just call it investment.

5. Don't confuse assets with expenses. New entrepreneurs think their companies look better if they have a lot of assets. One common example is wanting to take money spent on programmers and pretend that paying a programmer is buying an asset. Take my word for it: You don't really want that. It's better to expense those development expenses. That lowers your tax bill and makes your balance sheet look better, because you don't have fake assets.

6. The two main accounting standards are either cash basis or accrual; accrual is better because it gives you more accurate cash projections. It seems counterintuitive, but cash basis isn't as good for predicting cash. The difference is timing. In accrual, the sale happens when you deliver the goods or perform the service. In cash basis, the sale happens when you get the money. In accrual, you owe the money when you receive the good or service, regardless of when you pay. In cash basis, you don't show what you owe until you pay it. I strongly recommend accrual because it's much more realistic. Real businesses don't pay upfront; they pay later.

7. Pro forma is just a dressed up way to say projected or forecast. It's one of those potentially daunting buzzwords that really isn't that complicated. The pro forma income statement, for example, is the same as the projected profit and loss or the profit and loss forecast.

Adapted from an column, May 2007.

Projections: How Many Months? How Many Years?

For any normal planning purposes, for any normal company, you should have at least 12 months detailed month by month for business plan forecasts. That would be for sales forecast, cost of sales, your burn rate, and eventually the complete financial forecast, if you're going to do it. Then have another two years beyond that, for three years total, as annual projections.

That doesn't mean you don't think in longer terms. Think about what you want for your business for 5, 10, 20 years. I'm all in favor of that. But I don't think you should plan in the detail of financial forecasts, for very long time periods. The larger numbers -- sales, for example, involve so much uncertainty that you don't get your time's worth back by trying to project more detail. At least not in normal cases. If you're farming lumber from tree farms, maybe.

Be forewarned. You'll run into experts who will say you need more than 24 months by month, or more than five years in detail. They will be very sure of themselves. Sometimes what they mean when they say that is that they know more than you do, so they want you to suffer more. Or they want you to pay them to do the financials instead. Or they don't like you or your business plan and they're embarrassed to tell you that. So instead, they say you need to forecast in more detail. If they are investors, what they mean is that they don't want to invest and they don't want to tell you why. If they are loan managers, they don't want to make the loan. And they don't want to tell you the real reason.

My advice to you, when that comes up, is that unless you are a special case (if you are, you know who you are), look for another expert.

The Three Main Statements

I've taken you this far with just the basic business numbers. To be fair, that's far enough. It certainly gives you some numbers to get a hold on and to manage, review, correct, and revise.

It's likely that at some point you'll want to go further, into the straight financial projections that are part of a complete formal business plan.

The good news is that with what we did with the basic numbers, you're already a long way there.

The bad news is that here again the details and specific meanings of financial terms matter. You can't just guess. So I warned you earlier about the importance of timing with sales, costs, and expenses. This is very true with standard financials. Also, it starts to matter what goes where. It can be confusing and annoying. For example, interest expense goes into the income statement but principal repayment goes into the cash flow, which then affects the balance, but never appears anywhere in income. That means a standard debt payment that includes both interest and principal repayment has to be divided up into both parts. Interest is an expense on the profit and loss. Debt payment reduces debt on the balance sheet.

Elsewhere in this book I discuss the huge difference between planning and accounting. With the three main financial statements, specifically, financial analysts use the term pro forma to describe projected statements and predictions. An income statement, for example, is about past results. A pro forma income statement is a projected income statement.

The Income Statement

The income statement is also called profit and loss. People often refer to the bottom line as profits, the bottom line of the income statement. It has a very standard form. It shows sales first, then cost of sales (or COGS, or cost of goods sold, or direct costs, which is essentially the same thing). Then it subtracts costs from sales to calculate gross margin (which is defined as sales less cost of sales). Then it shows operating expenses, usually (but not always) subtracting operating expenses from gross margin to show EBIT (earnings before interest and taxes). Then it subtracts interest and taxes to show profit.

Sales – Cost of Sales = Gross Margin

Gross margin – Expenses = Profits

Notice that the income statement involves only four of the seven fundamental financial terms. While an income statement will have some influence on assets, liabilities, and capital, it includes only sales, costs, expenses, and profit.

A Word about Words: Profit, Income, and so on
Some say income statement, some say profit & loss, or profit or loss. That's the same thing. Accountants and financial analysts use those titles interchangeably. I use income and income statement, but you can read profit & loss if you like.

The income statement is about the flow of transactions over some specified period of time, like a month, a quarter, a year, or several years.

If you've done the basic numbers I recommended in the previous chapter -- sales and cost of sales in the sales forecast, and expenses (including payroll) -- then you've got the bulk of the income statement done. Take the sales and cost of sales from that table, and the expenses from that table, and If you have interest expenses, and taxes, add them in. And that's about what it takes.

The Balance Sheet

The most important thing about a balance sheet is that it includes a lot of spending and money management that isn't included in the income statement. It's most of the reason that profits are not cash, and that cash flow isn't intuitive. It's all very much related to the cash traps.

The balance sheet shows a business's financial position, which includes assets, liabilities, and capital, on a specified date. It will always show assets on the left side or on the top, with liabilities and capital on the right side or the bottom.

Balance sheets must always obey the following formula:

Assets = Liabilities + Capital

Unless that simple equation is true, the balance sheet doesn't balance and the numbers are not right. You can use that to help make estimated guesses, and pull things together for projected cash flow.

The Cash Flow Statement

The cash flow statement is the most important and the least intuitive of the three. In mathematical and financial detail it reconciles the income statement with the balance sheet, but that detail is hard to see and follow. What is most important is tracking the money. By cash we mean liquidity, as in the balance in checking and related savings accounts, not strictly bills and coins. And tracking that cash is the most important thing a business plan does. The underlying truth is:

Ending Cash = Starting Cash + Money Received – Money Spent

What's particularly important in planning is that neither the income statement alone nor the balance sheet alone is sufficient to plan and manage cash. I discuss the cash flow in much greater detail in the section Planning the Cash Flow.

Standard Tables and Charts

So those three main tables are just about essential for a complete business plan: you have to project income, balance, and cash flow. Cash flow is the single most important numerical analysis in a plan, and should never be missing. Most plans will also have a sales forecast, and profit and loss statements. I believe they should also have separate personnel listings, a projected balance sheet, projected business ratios, and market analysis. There are others that are common, but not necessarily required (depending on the situation and exact context of the plan). Those might include the following:

  • Startup costs, and startup funding. We've already talked about startup costs, but most business plans for startups also need to show where the money to pay for startup costs is coming from. That's a combination of investment and borrowed money. Your balances have to balance, and they don't balance without startup funding. Sometimes the startup funding will produce a useful business chart, a bar chart showing investment vs. borrowed money.
  • Past Performance. When a plan is doing a complete financial forecast for an existing company, past performance is required to set the starting balances for the future. The last balance of the past is the first balance of the future. In practice, people often have to project a few months forward to estimate what the final balance will be on the day the new plan starts. For example, if you're doing a plan for next year starting in January, and it's only October, then you have to guess what happens to balances between October and December.
  • Break-even analysis. A break-even analysis is a standard routine that compares sales to fixed and variable costs to determine how much sales will it take to cover costs. It can be an annoying analysis sometimes, because it requires averaging variable costs and unit prices over an entire business, but it can still be useful as a first look at the risks related to fixed and variable costs.
  • Market analysis. The market analysis is usually an important core component of the market information, supporting information that is required when you're working on a plan for outsiders. Investors, bankers, professors of business, consultants, and others like to see proof of market. The market analysis table shows what data you have, usually a market growth projection, in general by segment. It's really a good idea to break the market into useful subsets, called segments. Market analysis can produce some good-looking charts too, like pie charts breaking the market into segments, and bar charts showing market growth as projected into the future.
  • Ratios analysis. When you're projecting your income and balances, you can then use math and formulas to project standard business ratios. There are a couple dozen standard ratios that accountants and analysts often like to see. These are things like return on investment, profits to sales, inventory turnover, collection days, and so on.
  • Use of funds. For plans intended to go to either investors or lenders, use of funds is a list showing how the money coming in will be spent. Use this to convince investors that you will put their money to good use.

You should also use business charts, like bar charts and pie charts, to illustrate your projected numbers as much as possible. Graphics illustrate numbers very well. They are easier than numbers alone to see and understand.

Fixed and Variable Costs and Burn Rate.

As you consider your projected income statement, I hope you see three of your spending budgets there -- the cost of sales, the payroll, and the expenses. These also contain your fixed vs. variable costs, and your burn rate, which we went over in the Chapter 4. Those are good numbers to keep in mind.

Why do fixed costs matter? They add to the risk. You have to pay them, whether you're making money or not. Some companies reduce risk by trying to make as much as possible into variable costs, depending on sales, instead of fixed costs. For example, to make programming expenses variable instead of fixed costs, contract the work by milestone, or pay less fixed compensation and more royalty on sales.

The burn rate is the same thing. It's a sense of risk. If you know you need $10,000 every month to cover your burn rate, then when you watch your sales you have an instant sense of where they have to get.

Seven Simple Words You Should Know

You don't have to be an accountant or an MBA to do a business plan, but you will be better off with a basic understanding of some essential financial terms. Otherwise, you're doomed to either having somebody else develop and explain your numbers, or having your numbers be incorrect. This is a good point to note the advantage of teams in business: if you have somebody on your team who knows fundamental financial estimating, then you don't have to do it yourself.

It isn't that hard, and it's worth knowing. If you are going to plan your business, you will want to plan your numbers. So there are some terms to learn. I'm not going to get into formal business or legal definitions, and I will use examples.

  1. Assets. Cash, accounts receivable, inventory, land, buildings, vehicles, furniture, and other things the company owns are assets. Assets can usually be sold to somebody else. One definition is "anything with monetary value that a business owns."
  2. Liabilities. Debts, notes payable, accounts payable, amounts of money owed to be paid back.
  3. Capital (also called equity). Ownership, stock, investment, retained earnings. Actually there's an iron-clad and never-broken rule of accounting: Assets = Liabilities + Capital. That means you can subtract liabilities from assets to calculate capital.
  4. Sales. Exchanging goods or services for money. Most people understand sales already. Technically, the sale happens when the goods or services are delivered, whether or not there is immediate payment.
  5. Cost of sales (also called cost of goods sold, direct costs, and unit costs). The raw materials and assembly costs, the cost of finished goods that are then resold, the direct cost of delivering the service. This is what the bookstore paid for the book you buy, it's the gasoline and maintenance costs of a taxi ride, it's the cost of printing and binding and royalties when a publisher sells a book to a store for resale.
  6. Expenses (usually called operating expenses). Office rent, administrative and marketing and development payroll, telephone bills, Internet access, all those things a business pays for but doesn't resell. Taxes and interest are also expenses.
  7. Profits (also called Income). Sales minus cost of sales minus expenses.

Focusing on the Income Statement

The Income Statement is probably the most standard of all financial statements. It comes with standard math too.

Sales - Cost of Sales = Gross Margin.

Gross Margin
I didn't talk much about gross margins when we discussed the sales forecast and the cost of sales, but the gross margin is a useful basis for comparison. Generally, industries have some kind of standard gross margin. Retail sporting goods do about 34 percent on average, and grocery stores about 20 percent. You own results will always be different from the standard, so just understand why you're different, and don't worry about it too much.

Gross Margin - Operating Expenses = EBIT

EBIT is also called gross profit in some circles, but that same term is sometimes applied to the gross margin, so I like EBIT better.

EBIT - Interest - Taxes = Net Profit.

The numbers are usually presented in that order. For financial statements the presentation can become very complex, as various items get broken down into rows and rows of detail, but for planning purposes, you want to keep it simple if you can.

The following illustration shows a simple income statement. This example doesn't divide operating expenses into categories. The format and math starts with sales at the top.

Standard Income Statement
This is a partial graphic, showing only three months of a 12-month table.

I hope you notice that you've already gathered most of this data as part of your flesh and bones of the plan. You've already done the sales forecast, cost of sales, payroll, and expenses. If you've followed the standard financial definitions, as I hope you did (otherwise I'll have to say I told you so), then creating the income statement is a matter of pulling the information together into a single table. Then add estimates of interest expense, and taxes.

Keep you assumptions simple. Remember our principle about planning and accounting. Don't try to calculate interest based on a complex series of debt instruments, just average your interest over the projected debt. Don't try to do graduated tax rates; just use an average tax percentage for a profitable company.

Keep Your Balance Sheet Simple

A business's balance sheet shows the financial picture at some specific time, like at the end of the last day of the month or the end of the last day of the year. The financial picture is a matter of assets, liabilities, and capital. Through the magic of double-entry bookkeeping, your financial transactions are recorded in a way that ensures the balance sheet will indeed balance if the entries are correct.

The Law of Balance
Assets are always equal to the sum of capital and liabilities. Your books have to show that.

So let's make sure first that you know what's what. Some definitions are in order. These are three terms you should know in order to create a blanace sheet:

  • Assets. Cash, accounts receivable, inventory, land, buildings, vehicles, furniture, and other things the company owns are assets. Assets can usually be sold to somebody else. One definition is "anything with monetary value that a business owns."
  • Liabilities. Debts, notes payable, accounts payable, amounts of money owed to be paid back.
  • Capital (also called equity). Ownership, stock, investment, retained earnings. Actually there's an iron-clad and never-broken rule of accounting: Assets = Liabilities + Capital. That means you can subtract liabilities from assets to calculate capital.
Estimating the Balance
If you do it right, once you set your starting balances, you can use your cash flow assumptions to calculate the rest of the balance sheet.The idea is that you have educated guesses already for sales, costs, and expenses. You can use assumptions for sales on credit and payment days and collection days and inventory management to calculate these balances. Then use assumptions for debt and new investment to keep the cash flow accurate. The balance comes automatically.Read on, I'll show you that in the rest of this section.

This is planning, not accounting. That's one of the primary principles of the plan-as-you-go business plan. To make a powerful and useful cash flow projection you need to summarize and aggregate the rows of the balance sheet. Resist the temptation to break it down into detail the way you would with a tax report after the fact. This is a tool to help you forecast your cash.

Sample Balance Sheet
Keep your balance sheet simple because you need to link it to your cash flow assumptions.

Starting Your Balances

To do your financial projections well, you need to start the balance sheet and then adjust it according to assumptions in the cash flow. How you start your balance sheet depends on what numbers you have.

If you're an existing or ongoing company, startup costs and startup funding are irrelevant. Use an estimated ending balance to set up the beginning balance of the planning period. I say estimated, in this case, because usually you're doing your business plan to start a new period in a few months, such as working in October for a plan starting the following January. So you don't actually have the ending balance for the year that's going to end in December; but you do have pretty good numbers to estimate.

I usually recommend a past performance table showing three years of data, even though you actually use just that last year, which normally includes some estimates of ending balances and full-year data. Here's an example.

If you're planning a new company, just starting, then you set your starting balances using the estimated starting costs you did for basic business numbers. Your startup costs include assets and expenses. The expenses affect your capital, because they add up to a loss at startup (don't be disappointed, that's the way almost all startups begin. That loss means you're keeping track of expenses so you can deduct them from taxable income later, when you make a profit).

You know that assets have to equal capital and liabilities. You've got assets defined in the startup table, so what's left is to show where the capital and liabilities are. These are, between them, what you've used to pay for those expenses and assets. Here's an example:

Planning the Cash Flow

I worry most about cash flow because it's so insidious. Like the old saying about rivers, still waters run deep. Cash is frequently hardest to manage when businesses are growing. It is the least intuitive of the financial projections, but the most important. I hope you've read through the cash flow traps portion of Chapter 4. I was trying to scare you. It's good for you.

We got through the basic business numbers with that discussion of cash traps instead of the full detail of the cash flow. That might be enough for the early plan, but eventually you're going to want to build a real cash plan, using real numbers, and real financial math.

Experts can be annoying. There are several ways to do a cash flow plan. Sometimes it seems like as soon as you use one method, somebody who is supposed to know tells you you've done it wrong. Often that means she doesn't know enough to realize that there is more than one way to do it.

Let's start simple here, with a basic direct cash flow plan.

A Simple Basic Cash Flow Plan
There's nothing particularly fancy about this plan, or the table, or the math. You just need to keep track of money coming in, and money going out. This means paying bills as they come due (i.e., paying accounts payable), and paying off loans.

Even at this basic level, you can see the potential complications and the need for linking up the numbers using 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 financial projections are more complex.

A More Realistic Example

So that last one was a simple case, but let's take a more common case. It doesn't have to get that complicated -- remember this is planning, not accounting -- but I do want to deal with some of the more important issues. So let's create another case.

I can't explain cash flow without income and balance. Remember, I did say that the cash flow was what brings the two together. So let me show you some samples. Here's the hypothetical income statement:


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Notice that in this case you can see how we've divided sales into cash sales, in the top row, and sales on credit, in the second row, and that those two rows sum to total sales. Normally we wouldn't show that division in an income statement. I do it like this for this example, because it helps me show you what's going on.

Now let's look at the balance sheet. This is the starting balance for the sample case. In your own plan, you set up starting balances as part of your startup funding, or as the ending balance of your last plan. For now, here's the example.


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I'm going to use these two samples to show you how cash flow brings them together.

Breaking Down the Detail Cash Flow

So let's look then at a cash flow projection that unites these two other statements. In this case we're going to do a direct cash flow, but remember there's also an indirect cash flow method, and there are experts who insist on one or the other, even though you can really do it either way.

So please follow along with me as I go through the cash flow by sections. We start at the top with things that bring in money, meaning cash received. That includes both cash from sales, and cash from other things like borrowing and new investment. You see the example here:


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Cash sales is pretty obvious. It's the same number that was on the income statement. Remember, that's not really just coins and bills, that's also payments by check, and by credit card. In business planning, cash means money in the bank.

Cash from receivables can be confusing at first, but what we see is the way receivables hit your cash flow. When you compare this table with that income statement we just looked at, notice what happens to cash from receivables. The $230 we get as cash from receivables in March is just about the same $228 you made in sales on credit in January. I hope you're guessing that this is because we're estimating 60 days on average waiting for our money. Difference between $228 and $230 is the difference between 60 days and two months. That's a very slight difference.

Cash From Receivables

So let's look more closely at that second row, and how it's calculated. The numbers here are in the background. They don't show up on a standard cash flow statement, but they are critical calculations.

Remember: if you get paid immediately by your customers, by cash or credit card, you don't have to worry as much about this. If, however, you're selling to businesses, then this is really important. Unless you're really unusual, with business-to-business sales, you deliver invoices to your business customers and you then have to wait for them to pay you. You get into a balance situation, in which they don't want to tip the balance by waiting too long, and you don't want to tip the balance by insisting too hard. It's quite common.

Those Critical Assumptions
  1. Accountants normally figure collection days after the fact, using your sales on credit and average balances. With algebra, you can calculate in reverse. For example, if I know I'm selling $35,000 per month on credit, and I have 60 days of collection days, then my balance should be about $70,000.
  2. Not all of your sales are on credit. Some customers, even business customers, will pay cash. You might have a mix of consumers who pay cash and businesses that wait to pay. So you have an assumption of percent of sales on credit.

You deal with this with assumptions. In the illustration here you'll see an assumption for estimated collection period in days, meaning how many days, on average, you wait to get paid. You also have assumptions for sales on credit as a percent of total sales.

So that all boils down to a row in the illustration here, cash from receivables. That's the amount that gets into your cash. You can see how this is different from sales. You can also see the flow between last month's ending balance, this month's sales on credit, and this month's ending balance.


The collection days estimator sets the amounts received. (Amounts shown in thousands. Numbers may be affected by rounding.)

Just in case you have any doubt about how that works, take a look at the following illustration with the same numbers except for the change in your estimated collection days. What happens is that the more the estimated collection days, the more of your assets are in receivables, which means, ultimately, less cash. We stated that in cash flow traps: every additional dollar in receivables is a dollar less in cash.

This simple change turns acceptable cash flow into cash problems.

Additional Cash Received

All those other rows on the money coming in are about other ways that you might get money into your company from something other than sales. The illustration shows these category rows and you can see that new borrowing, new investment, and even sales taxes collected are other ways you get money.

Money off the income statement

What all these other elements have in common is that they are ways your company gets money that doesn't show up in the income statement.

I don't want to get into accounting jargon. The rest of these rows will look fairly simple to you if you've dealt with accounting and financial statements at all, and could be daunting if you haven't.

Tip: Calculating balances

Please notice that this table links to your balance sheet. In this example we're adding $100 to new long-term liabilities, which goes to the balance sheet. We're also adding $25 to the investment, which goes to the balance sheet in additional paid-in capital.

Other income is there because some companies have income from special operations, like interest income, that they don't put on their income statement. That's very rare.

Sales tax is there because you collect tax for the government, and you have to pay it, but it isn't really sales or income. You're a tax collector. So you need to keep track of what you collect.

The rest is new debt, money from sale of assets, or new investment. I should add that I use new other liabilities to keep track of debt that doesn't have an interest rate, such as loans from founders or from your rich relatives.

The total gives you all the money coming into the company. That's the happy first half of the cash flow. Now we need to look at what we're spending.

Estimating Expenditures

What I'm showing here in the illustration might look like it's a self-contained table, but it's really just the bottom half. This is where the money goes (or technically, where you plan to send it). The top half, on the previous pages, was where the money was coming from.

It starts with money you spend on operations. That's what you spend in cash, and what you spend to pay bills. These, between them, are the universe of things that happened on the income statement. The split between cash and payment of bills can be confusing, but we have to keep track of that to do a real cash flow.


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The Other Side of Sales on Credit
This paying the bills portion of the cash flow is where you get the other side, the good side, of sales on credit. This is where you are a business, so you get to wait a while before you pay the bills. The calculations are a lot like the ones for accounts receivable, based on the days of waiting, and the bills coming in. By the way, between what you pay in cash and what you pay as paying bills, you have to include all the payments on the income statement. That means all the costs, all the expenses, plus interest, and taxes, all go through the filter of either cash spending or bill payment. That includes inventory too.We'll look in detail at calculating these payments shortly.

And, just to make that even more fun, bill payment has to include payment for inventory, which is particularly tricky because inventory isn't directly on the cash flow. As we discussed in cash traps, inventory is money spent on assets first, and those assets become cost of goods sold when they are in fact sold. We'll look at that in a few pages, so bear with me.

Much like with the money received and accounts receivable, the first two rows of this table show money spent in cash and bill payments. Money spent in cash is frequently payroll, for example, for which you pay people directly, not after a few weeks. Sometimes there are other cash payments, such as petty cash.

The second obvious use of cash is bill payment. This accounts payable balance is money you owe. Every month, you pay off most of this, depending on how quickly you pay. As with receivables, there are some calculations in the background, like those shown in the illustration below:

In the example here, the calculations start with the ending balance of accounts payable from the previous month, then add new obligations, then subtract obligations paid directly in cash, as well as this month's bill payments, to calculate this month's ending balance. This month's bill payments depend on the assumption of waiting 30 days, on average, before paying bills.

Additional Expenditures

So aside from the cash payments and bill payments, the spending section of the cash flow table has a list of some other ways that companies spend their money -- ways that aren't on the income statement, which is why they have to get into the cash flow and affect the balance sheet.

The list is similar to the list we have of non-income-statement money received. Just as you can receive money from other income like interest or such, you can also pay money that way. Then there are taxes, like sales taxes, which have to be paid to the government. You collected them from customers, but you have to pay them as well.

Debt repayment can be important because it's easy to forget. The interest portion of your payments belongs in the income statement because interest reduces taxable income. It's deductible. Principal repayment, however, doesn't show up on the income statement and isn't deductible. But it does reduce your cash, so you have to plan for it. Also, it reduces the debt balance, so this calculation affects your balance sheet.

In the third row from the bottom, you record the purchase of new other current assets. You'll have to know how much you purchase in new assets in order to estimate your balance sheet. While in real life these might also be recorded as accounts payable and paid a few weeks later, we make them explicit here as if they were paid immediately in cash. That makes for better cash planning.

Logically, this next row is one for purchases of new long-term assets. These also reduce cash.

The last row in spending tracks dividends. Dividends are the distribution of profits to owners and investors. They reduce cash but don't appear anywhere else.

Planning Cash for Inventory

As we saw in the graphics in the cash flow traps, inventory (sometimes called stock) can have a major impact on cash flow. So we have to plan for it.

And If You Don't Manage Inventory?
Then you don't have to worry. Go on. This is one cash trap that won't catch you.

The illustration here shows one way -- and there are others -- to plan for inventory. You have an idea how much inventory (by value, dollar amount) you would use to match your sales forecast. Then you assume how much inventory (in months) you need to keep on hand, and what the minimum purchase is. You can then calculate the details, as shown.

Inventory goes into the books as an asset when it's purchased. It leaves the company as cost of goods sold when it's sold. The cost of inventory shows up in the cash flow when it's paid for, regardless of when it's sold, usually as cash spending or bill payments.

Inventory gets into your cash flow when you pay for it. In the example here, the beginning inventory balance supplies the amounts required until the third month, when additional inventory is purchased. That purchase goes into accounts payable, and is paid as part of the normal flow of bill payments. Inventory purchase is the bulk of the $346,000 new obligations in March shown in the spending details sample on the previous page.

Calculating the Cash Balance

So now you've done both halves of the equation, money coming in and money going back out, so you can put those two halves together to calculate the cash flow, and the cash balance.

Cash flow is the change in the cash balance from month to month. You get that by adding money received and subtracting money spent.

Cash balance is the amount of money on hand. You get that by taking the previous month's cash balance and adding this month's cash flow to it -- which means subtracting if the cash flow is negative.

Having a negative cash flow every so often, for a month, isn't a big problem. You should never have a negative cash balance. That's the same as bouncing checks.

Business Ratios

By the time you have your financial forecast complete, you have numbers available to do some standard business ratios. I can't say that I'm a big fan of ratios, but they can look good in a full and formal business plan, even though they are projected ratios. Here's an example.

The real use of ratios, in my opinion, is watching them as they change over time. In the best of the plan-as-you-go business planning idea, you have some key ratios that are important to you. They are in your objectives and you review them in meetings.

Notice in this case that I've also added a reference to standard business ratios. This is a good touch in a business plan. They come from available industry data, which I discuss in the next section. Don't expect your company projections to ever be an exact match. Be prepared to explain why they are different. And they are always different.

Break-Even Analysis

The break-even analysis is not my favorite analysis for a business plan. It has lots of problems. First, people often confuse it with payback period, meaning when do you break even on the money spent with money returned to you from a business, as it grows. That's not break-even. Second, it depends on being able to deal with estimated average numbers that are hard to do. Businesses rarely produce an average revenue per unit, or an average variable cost per revenue unit, or average fixed costs.

Still, it is useful if you take it with a grain of salt. It can help you see the implications of fixed vs. variable costs, and it can give you a basic idea of how much you need to sell to cover costs. If you don't expect it to be too exact and you don't put too much stock in it, then it can make sense and be useful.

I have an example here. The standard break-even financial formulas are:

The units break-even point is:

Fixed Cost ÷ Unit Price - Unit Variable Costs

The sales break-even point is: The sales break-even point is:

Fixed Cost ÷ (1-(Unit variable Costs/Unit Price))

This section of the model calculates technical break-even points, based on the assumptions for unit prices, variable costs, and fixed costs.

The break-even analysis depends on assumptions for fixed costs, unit price, and unit variable costs. These are rarely exact assumptions. This is not a true picture of fixed costs by any means, but is quite useful for determining a break-even point.

People often represent break-even a line chart, showing the break-even point as the point at which the line crosses zero as sales increase. The example here shows a break-even analysis that compares unit sales to profits, and assumes:

Fixed costs of $94,035

Average per-unit revenue of $325

Average per-unit variable cost of $248