Cash flow

Profit isn't the same as cash

You sell 50 cups of lemonade at $1 each. But all your neighbors say, "I'll pay you Friday." Your notebook says you sold $50. Your jar is empty. If you need to buy lemons today, you can't.

Companies have the same problem. Cash flow tracks real money going into and out of the bank account.

Why profit and cash are different

• Customers pay later. The sale counts now, but the cash comes later.
• Wear and tear. An oven costs $10,000 and lasts 10 years. The income statement counts $1,000 a year as a cost. That's called depreciation. But the $10,000 of cash left the bank all at once, on the day the oven was bought.
• Big purchases. Buying ovens for a new shop is cash out today, but it doesn't show up as a cost all at once.

The three parts of the cash flow page

1. Cash from the business, or operating cash flow: the cash that comes from actually selling pizza.
2. Cash for investing: buying ovens, trucks and new shops. This is called capital spending.
3. Cash from financing: borrowing money, paying back loans, and paying dividends to owners.

Sunny Slice's cash year

• It started the year with $2.5 million in the bank. (That's the cash from the balance sheet.)
• Profit was $1.5 million. Part of the costs was $0.8 million of oven wear and tear, which is a cost on paper, but no cash left the bank for it this year. So cash from selling pizza was $2.3 million.
• It spent $1.3 million on new ovens and two new shops.
• It paid $0.6 million in dividends.
• It ended the year with $2.9 million.

Free cash flow

Cash from the business minus capital spending:

$2.3 million minus $1.3 million = $1.0 million.

That's free cash flow: money the company can hand to owners, use to pay down debt, or save. Sunny Slice paid $0.6 million of it as dividends and kept the rest. A dividend paid out of free cash flow is healthy. A dividend paid with borrowed money is a warning sign.

Warning signs

• Profit going up, cash going down, year after year. Maybe customers aren't paying. Maybe the numbers are being made to look nicer than they are.
• Free cash flow below zero for years, with no plan to fix it. Growing companies can spend more than they make for a while, but not forever.
• Paying dividends with borrowed money.

Some companies that later collapsed showed nice profits for years while their cash was quietly drying up. Checking the cash is how careful investors catch that.

Remember

• Profit is what the math says. Cash is what's in the bank.
• The cash flow page has three parts: the business, investing and financing.
• Free cash flow = cash from the business minus capital spending.
• Growing profit with shrinking cash is a warning sign.