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One accounting number you MUST understand

As a CPA, several people have asked me, “What is the most important metric to tell how I’m doing in my business?” It’s actually a really important question. I’ve found that far too often, business owners don’t exactly know how their business is performing, or even how to figure it out. Sure, they usually have some idea, but far too often, it’s not more specific than “pretty good” or “not so bad.” You owe it to yourself to know where your business stands at all times. I do not understand how owners can make good business decisions or plan for the future of the company without that knowledge.

I’ve heard many different answers from people to the question. Net income, sales, expenses, equity, and a couple others usually come up. But I would strongly argue that cashflow is by far the most important, specifically cashflow from operations. We’ve all heard the saying that “Cash is King.” Well… the saying is right. I’ve seen businesses that were profitable on paper, but that have run out of cash and had to shut down. The phenomenon is pretty simple to explain. An quick example would be:

Assume a business is on the accrual method of accounting. That means when the business makes a sale, it typically records it as income. If credit terms have been extended to the customer, say “Net 15” or “Net 30”, then no cash is collected when the sale is made, the customer has 30 days to pay. If the company has to pay its vendor for the merchandise in 5 days, but the customer pays for the goods in 15 days, then there is a negative cashflow cycle. In 5 days, the company will technically be bankrupt without outside capital. (Even if you don’t extend credit terms to your clients, anything that can create a lag in collecting cold hard cash (possibly credit card sales or bad debts) can create the same effect.)

The opposite is also possible. I see this with rental real estate frequently. It’s possible that a property’s rent will be enough to pay for all of the on going expenses to run and maintain the property, even with some left over. So the owner can service the mortgage, pay property taxes, a property manager, and all the other expenses that go along with owning property and have some left over. However, due to depreciation, a non-cash expense, the income statement would show a loss. If the property owner was not a savvy investor, then it would appear that their rental business is performing poorly, but by analyzing Cashflow from Operations, he would see that his bank account will be going up every month. It’s possible that the owner could use a loan or contribute his own money to cover the gap. That’s why we need to specifically pay attention to Cashflow from Operations. This does not include cash from loans, owner contributions, sales of long-term assets (equipment, buildings, land, etc.). It is simply the cash that the normal activities of the business produces. If this number ever turns negative, watch out!!!

A caveat: if you are in the start-up phase, or trying to prove a concept’s viability, then sales, burn rate, or some other measure might have more meaning. But for typical, fully operational businesses, Cashflow from Operations is King.

So you say, well that’s all great and wonderful, but how do I calculate Cashflow from Operations? Well, unfortunately that gets complicated very quickly. If you are using accounting software, like Quickbooks, to track your income and expenses, a Statement of Cashflows is included. Sometimes it works perfectly. Sometimes I have found that it doesn’t automatically calculate cashflow correctly or in a way that is meaningful, especially if Quickbooks wasn’t setup correctly to begin with. This is where working with a CPA can pay huge dividends. I don’t want this to turn into a solicitation, but there are many areas of business where business owners need some outside expertise and this is one of them. Understanding how cash flows in and out of your business is too important to hope the software did it right or to just assume you understand without digging into the numbers.

What other metrics do you track that your business couldn’t live without? Share your thoughts below.