- In Biz Concepts
“Cash flow is fundamental – it’s the heartbeat.”
A former business partner said that to me one time while we were on a train in Northern Italy.
We had just met with a businessman who was struggling to stay afloat financially. We were trying to help him arrange bank financing for an infrastructure project, and his lack of cash flow was making it difficult.
“Cash flow is the heartbeat, and this guy is on life support,” he said.
My colleague was a smart, astute finance guy. MBA-trained. He worked in investment banking for a while, and for a big four accounting firm. Super sharp guy. Great with numbers.
He and I worked side by side on deals for about 5 years. We used to joke that he gave me my MBA and I gave him his law degree. That was pretty much true. I usually led the deal structuring and due diligence on all of our transactions, and he was the finance guru who focused on the modeling and commercial aspects. We absorbed each others’ knowledge by osmosis. Ours was a very complimentary professional collaboration.
Cash flow is the heartbeat.
It’s one of those foundational statements that’s hard to forget – a truism.
A heartbeat is fundamental. Always on, cranking away in the background. It’s always there, until it’s gone. On or off. Dead or alive.
Cash flow – or more specifically the need for cash flow – is the same. It operates like a heartbeat. It’s the lifeblood for a company that allows everything else to function. When it’s cranking, you’re alive. Bills get paid. You make payroll. When it stops, you’re dead. Everything stops. This goes for businesses as well as one’s personal finances.
But where does cash flow come from? What is cash flow, actually?
Answering these questions requires a look at the financial statements: the income statement (aka profit & loss), the balance sheet, and the cash flow statement (CFS).
If you need a quick primer on financial statements, I suggest reading these resources which I’ve found useful for a basic understanding:
Quick Overview: Investopedia – Financial Statements: List of Types and How to Read Them
Deeper Dive: Book – The Portable MBA in Finance and Accounting
The CFS is often the last one named in the sequence of financial statements, and therefore most people think of it as the least important. Often, when I ask someone for a copy of their financial statements, they’ll only send their income statement and balance sheet and leave the CFS off completely.
Most people look at the income statement first – showing money coming in, money going out, and whatever is left over is profit. Simple enough. Then people look at the balance sheet – a ledger of assets and liabilities. It gives us an idea of the value of a business – represented by the equity portion. Most people have heard of a balance sheet and pretend to know how to read one.
Which leaves us with the cash flow statement. It’s the least understood, yet arguably the most important.
Why? Because it measures cash flow – the heartbeat. It’s the heartbeat monitor.
The cash flow statement is broken down into three sections:
- Cash from operating activities,
- Cash from investing activities, and
- Cash from financing activities.
Let’s go through each one and think about the concepts, not just for a business’ finances but also for one’s personal finances.
| Cash from Operating Activities | |
| For a business: This section is a distillation of the income statement, showing whether the company is generating a profit or a loss. If there’s profit, the company generates positive cash flow for a given period of time. If there’s a loss, the cash flow is negative. | For one’s personal finances: This section shows you the answer to the question, as if you were asking yourself: “do I spend more or less than I earn?” It shows how much income someone earns, and how well they budget their expenses within their income’s parameters. |
| Cash from Investing Activities | |
| For a business: This section is usually a cash outflow, showing when a company makes investments by buying assets with their extra cash. And then, occasionally, there’s a reversal and the cash flows back in when the asset is divested. | For one’s personal finances: This section covers situations where someone makes investments and ties up their cash, and then reaps the return when the investment is sold and converted back to cash. |
| Cash from Financing Activities | |
| For a business: This section shows how much the company borrows. Or, how much cash a company takes in when they sell part of the equity of the company (i.e. selling shares to raise money). These situations create cash inflows. And then, when the company pays back the principal on the loan, or buys back stock, there’s a cash outflow. This section is really important since it shows how much cash a company needs to meet its cash needs for operating expenses when the company is operating at a loss. | For one’s personal finances: This section shows how much a person borrows to maintain their lifestyle outside of what can be covered by their income. Could be a bank loan, or credit cards, or other types of debt. This section is really important since it shows how much credit a person uses to meet their personal cash needs on an ongoing basis. |
What we are talking about here is financial health – whether for a company or a person.
If you look at cash from operating activities, it tells you how well the heart is beating on its own without any support.
If cash from operating activities is negative, that usually means that there is cash coming in from financing activities – often in the form of debt borrowing. This is like a pacemaker needed to maintain the heartbeat.
Requiring a lot of cash from financing activities is like having clogged arteries, adding strain to the cardiovascular system. This is because taking on debt starts to add pressure on cash from operating activities, since interest payments are accounted for in that section and therefore put a drag on operational cash flow.
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I learned a lot of these concepts from my former business partner, often by remembering the truisms he said from time to time like on the train that evening in Italy.
“Cash flow is the heartbeat,” he said. Such a simple way to put it.