Accounting Concepts: Understanding Working Capital, Cash Flow, and Assets

If your cash outflow is greater than your cash inflow, then obviously, your company is going to run out of money. When the cash inflow is significantly less than the cash outflow for a long period of time, the term to describe such a company is bleeding, or more formally known as negative cash flow.

Working Capital Defined:

In a nutshell, working capital refers to the sum total of all assets minus the sum total of all liabilities. This is a very important term to remember, and you will be tested on it.

Working capital: A company's sum of all current assets minus a company's sum of all current liabilities equals its working capital.

Essentially, what are we calling "working capital"? It is the owners' equity, part of the fundamental accounting equation, except that it is the cash flow retained within a company. You will hear accountants use this word a lot when referring to the health of a company. For example, accountants will use working capital to describe the leverage the company has to conduct short-term business, as well as long-term projects. The working capital of a company is directly related to the cash flow of a company.

Fixed Assets:

Fixed assets are long-term operating assets such as buildings, machinery, vehicles, computers, and office equipment. Fixed assets are assets that a company owns and does not rent or lease. If a company owns a building, that asset is fixed and it is in fact an asset (it is of value and can be sold). This is much different from when a company rents or leases the building, in which case that building is a liability; the company does not own the building and the building has no value that the company itself can get cash for.


It is time that we take a small detour and discuss a fairly important concept that can influence cash flow, and that is depreciation. You have probably heard this term used in everyday life, such as a depreciation of your car or your house. In the accounting world, we refer to depreciation as an expense, otherwise known as depreciation expense.

Depreciation expense: Spreading out the cost of a fixed asset over a period of time instead of charging the entire cost at a single point of time (a day or year).

Why do you think this would be beneficial for a business to do? If your company is going to purchase a building for $1 million, a building the company will be using for at least 10 years before selling it, it does not make much sense to reflect that cost in one accounting period because the totality of owning and using that building will reap benefits far greater than that single year or accounting period. For this reason, companies may choose, and rightfully so, to spread this one-time cost or expense over a longer period of time. The company may decide to expense this $1 million in their accounting cycle for 10 accounting periods (10 years) at $100,000 / year, which is 1/10th the cost of the building. Unpaid Expenses:

Another variable that factors into a company's cash flow is its unpaid expenses. We learned something about unpaid expenses previously when we discussed how accounts payable works in the accounting cycle and balancing the accounting equation. Very often a company will pay its expenses after a period of time that it already has enjoyed the product or service. All unpaid expenses are liabilities, of course, as liabilities are items you must pay off in a given amount of time. There are three types of unpaid expenses, listed in the box below.

Accounts Payable (AP): These are items that a business purchases on credit. The company will receive goods or services with an invoice to be paid in a certain amount of time.

Accrued Expenses: This is a little less straightforward than AP expenses, in that it is an estimate of what needs to be paid off by a certain amount of time. These liabilities would include unpaid vacation time, unpaid bonuses, the cost of future maintenance to honor customer warranties, etc.

Income Taxes: These are any unpaid taxes for income that a business owes to the Internal Revenue Service. Sometimes the tax bill is paid over the remainder of the year instead of all at once, depending on a company's cash flow.

It is important to note that unpaid expenses have a positive effect on cash flow. If a company has not paid a bill but has documented that it must pay a bill (AP), then cash held within the company is more than if the company had paid off these expenses. The company is accounting for these expenses but has not paid in cash for these expenses. A credit in AP, accrued expenses, or income tax means more cash flow within the company. You need to look at the negative and positive numbers in these accounts to get an accurate picture of a company's cash flow. In other words, a liability does not necessarily equal a cash deficit at any given point of time. Prepaid Expenses:

You guessed it. Prepaid expenses are the reverse of unpaid expenses. They are expenses that you already have paid for. An example might be if you hire a consulting firm to maintain your computer network. You pay the firm in advance for the year 2011, say, $25,000, and the check is cut in December 2010. Every month you would deduct or transfer a fraction of the cost of the $25,000 (25,000 / 12 months = 2,083.33) against your assets account from the prepaid expenses account, which is an account listed under assets. Prepaid expenses have a negative impact on cash flow in that cash is deducted to pay the prepaid expense before you are using the service or product provided.

Cash Flow: A Closer Look

Cash flow can mean many different things to many people, but in the world of accounting, there is little open to interpretation. Cash flow is the flow of actual cash that the company has to use to do financial transactions.

Let us take an example of cash flow:

Suppose your company purchased 100 acres in Ohio for $50,000 in 1985. Now, in 2011, the value of that land is $800,000. According to your income statement, you could report that as an asset, or essentially, you made $750,000 profit. However, that is not cash. That is what we call paper profit or paper value . Your company may own $800,000 worth of land, but that does not mean your company has $800,000 cash to spend. "Cash flow" does not equal profit. This is key to understanding how a business operates on capital.

In general, there are two types of cash flow described in a business: positive cash flow and negative cash flow.

Positive Cash Flow: positive cash flow means that the cash coming into a business is greater than the cash going out of a business. This is the primary goal of all companies.

Negative Cash Flow: negative cash flow is the opposite of positive cash flow; the cash leaving the company is greater than cash being received into the company.

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To fully understand an income statement generated by your company, you should ask the accounting division these three questions about how the income statement relates to cash flow:

- How is the company handling its current cash flow? Is it in a bank account generating interest, in bonds, the stock market, etc.?

- What percentage of the net income the company reported for an accounting period is actual cash flow, or cash on hand? How much of the profit is paper value?

- What is the average percentage of cash that exists in net income for a typical income statement (say, for the last five accounting periods)?

Cash Flow Statement:

According to Generally Accepted Accounting Principles (GAAP), there are three major financial statements that a company needs to report to the public: 1. Balance Sheet, 2. Income Statement, and 3. Cash Flow Statement. We already learned that a balance sheet summarizes a company's assets, liabilities, and owners' equity. The income statement shows revenue and expenses, summarizing the final profit of a company for a specific accounting period. The cash flow statement is exactly as its name describes. It is a report that shows the cash a business received during an accounting period, and what the company did with that cash.

There are three basic components to a cash flow statement: operations, investments, and financing. They are summarized here:

- Cash Flow from Operations: This cash flow is generated from normal business operations that make a profit and turn that profit into a cash flow.

- Cash Flow from Investment: This cash flow is from any cash generated from holding long-term investments or assets needed to run a business. This includes the selling of any long-term assets (such as selling that $800,000 worth of land in the above example). It also would include the interest made in the accounting period for an endowment. For example, if a company relies on the interest of its $5 million endowment, the cash generated from this is considered cash flow from an investment.

- Cash Flow from Financing: Cash flow from financing includes any capital or distribution of profit to the owners of the company.

The final line or figure in a cash flow statement will yield the company's net increase or decrease of cash, which is a number derived from each of the three components listed above.

In order for a business enterprise to remain viable in the marketplace, it needs to ensure the availability of a certain amount of available working capital. Without such an available reserve, the business can actually cease to exist on account of inabilities to properly serve customers, acquire necessary supplies, and/or produce essential products.

Furthermore, in the event an emergency situation should occur, a business needs to have accessible funds for damage control purposes.

In theory, a business realizes it ought to operate in the black with excesses of funds; in reality, however, these ideals are not always possible because of economic conditions and other mitigating factors. Even during times when a company's profitability is up, it may not have sufficient cash flow to sustain normal operations.

Cash Flow: Overview

Many small business owners fail to realize that the key to success is proper planning. In order to remain a viable, marketable entity, businesses of all sizes and types need to have a strategy for potential future situations and be able to react quickly to volatile market changes.

Within the business model, it is important to have a "cash flow plan." In order to arrive at such a proactive itinerary, business owners need to understand that the operating cycle is the same as the system through which cash flows. This cycle begins when the inventory is purchased and goes through to the point when money is collected within the accounts receivable department. Essentially, the cycle/cash flow measures the process by which assets are converted into cash.

The important element for a business to consider is the specific time frame for its operating cycle. For example, if the operating cycle from the purchase of supplies to the collection of receivables encompasses a period of 90 days, this then becomes the amount of time a business owner is prepared to finance.

Because entities that provide capital to businesses do so at a specific interest rate, business owners need to add these additional costs into their overall financing budget. While it may seem obvious, the longer a business's operating cycle, the higher the financing costs are going to be.

Cash Flow Statement: Definition

The cash flow statement is used to present a summary of both a business's cash inflows, or funding, and outflows, or expenditures, over a specified period of time.

Note: While we have already learned that accounting periods can vary based upon the preference and/or nature of the business in question, the general time frame is that of one year divided into 12 periods. Where accounting practices are concerned, the tendency is for businesses to utilize start and end dates different from those of the typical calendar year and to implement the concept of quarters.

Primarily, the cash flow statement can be used in one of two ways:

  • As a long-range projection or forecast of future operations; this is referred to as "pro forma" or planning analysis.
  • As a historical (post-facto) record containing accurate financial data.

The ideal is for a manager to utilize both procedures, as well as develop a yearly projection accompanied by a real-time record of each month's financial transactions.

Basically, the cash flow statement offers a projection of the amount and timing sequence in which cash is anticipated to flow in and out of the business within the forthcoming accounting period.

The projection equips a business or lender with estimates of how much cash will be available and when. In addition, it provides the business with a tool for identifying the approximate amounts and dates at which funds are likely to be needed. Plus, it also provides the lender with a sense of the business's debt repayment capacity.

In this vein, the cash flow statement helps ascertain both the amount of debt borrowers are able to incur, in addition to the time in which they are likely to be able to repay the principal amount based upon the size of the installment payments.

Cash Flow Analysis

For this reason, it is important for business owners to carefully assess the operating cycle and, as a result, come up with the minimum cash amount they need in order to cover their financing needs without overstretching their potential budgetary limits.

The assessment of the operating cycle is also known as "cash flow analysis" because it is intended to identify the amount of funds a company's daily operations generate, thereby showing whether this amount is sufficient to cover financial obligations.

The cash flow analysis is also a good way of seeing the relationship that exists between major outflows of cash going toward financial obligations and major inflows of cash coming from sales.

As an outgrowth of conducting a cash flow analysis, a business should be able to detect whether its combined inflows and outflows yield a positive cash flow or a negative deficit. Further, the analysis is capable of showing notable changes that occur over time.

For instance, if more sales occur after the beginning of the year, yet more money goes out during the holidays, then this may be an area in which planning can prove highly useful.

Gaining perspective over the ins and outs of the operating cash flow allows a business owner to develop more effective strategies for retaining funds versus expanding operations.

The bare minimum amount of cash a business should have on hand is enough to cover the cash obligations for the upcoming month. A business owner may wish to expand this amount because it does not offer much of a safety net in the event of a major incident or a lull in sales.

For those business owners willing to take the time to create a monthly cash-flow projection, this effort can go a long way in helping them to both identify and possibly eliminate deficiencies and/or surpluses in cash, as well as providing them with a tool by which they can compare sales figures to past months.

The drawback, of course, when implementing a new system of any kind is that when problems are found to exist, they need to be addressed and ideally corrected to prevent their recurrence. This is especially true in the case of cash-flow deficiencies. Once business leaders detect deficiencies, they need to adjust their financial plans in an effort to free up additional supplies of cash.

Conversely, should the cash flow analysis find there are excess amounts of cash, then this may mean the company is engaging in excessive borrowing or has extra funds that could be better put to use in investments.

As a whole, the overall objective in performing a cash flow analysis is for the business owner to ultimately develop a plan that consistently yields a well-balanced cash flow.