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How to Manage Operating Cash Flows

In a small, one-owner/one-manager business, one person has to manage both profit and cash flow from profit. In larger businesses, managers who have profit responsibility may or may not have cash flow responsibility.

The profit manager may ignore the cash flow aspects of his sales and expense activities. The responsibility for controlling cash flow falls on some other manager. Of course, someone should manage the cash flows of sales and expenses.

The net cash flow during the period from carrying on profit-making operations depends on the changes in the operating assets and liabilities directly connected with sales revenue and expenses. Changes in these accounts during the year determine the cash flow from operating activities. In other words, changes in these accounts boost or crimp cash flow.

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Profit is the starting point for determining cash flow from operating activities. Alternatively, a business may use the direct method for determining and reporting cash flow from operating activities.

The cash flow from profit is determined as follows:

  1. Start with the accounting profit number, usually labeled net income.

  2. Add depreciation expense (and amortization expense, if any) because there is no cash outlay for the expense during the period.

  3. Deduct increases or add decreases in operating assets because

    An increase requires additional cash outlay to build up the asset.

    A decrease means amount invested in the asset is reduced and thus provides cash.

  4. Add increases or deduct decreases in operating liabilities because

    An increase means less cash is paid out than the expense.

    A decrease means more cash is paid out to reduce the liability.

You may ask: What about changes during the year in those balance sheet accounts that are not highlighted? Well, these changes are reported either in the cash flow from investing activities or the cash flow from financing activities sections of the statement of cash flows. So, all balance sheet account changes during the year end up in the statement of cash flows.

The manager should closely monitor the changes in operating assets and liabilities. A good general rule is that each operating asset and liability should change about the same percent as the percent change in the sales activity of the business.

If sales revenue increases, say, 10 percent, then operating assets and liabilities should increase about 10 percent. The percents of increases in the operating assets and liabilities (in particular, accounts receivable, inventory, accounts payable, and accrued expenses payable) should be emphasized in the cash flow report to the manager. The manager should not have to take out his calculator and do these calculations.

Controlling cash flow from profit (operating activities) means controlling changes in the operating assets and liabilities of making sales and incurring expenses: There’s no getting around this fact of business life. There’s no doubt that cash flow is king. You can be making good profit, but if you don’t turn the profit into cash flow quickly, you are headed for big trouble.

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