Cash Flow vs. Earnings…What’s the Difference? (Part 2 of 2)

This is Part 2 of a two-part series on Cash Flow vs. Earnings.  Part II focuses on the impact on cash of the business operations, driven by operating expenses from the income statement, and changes in related accounts from the balance sheet.

The table below shows how operating expenses are transferred directly from the income statement to the Operating Activities table in the UCA Cash Flow statement.  Changes in balance sheet accounts (such as Other Receivables, Accruals, etc.) are calculated and input in this section as well.  As described earlier, decreases in asset accounts and increases in liability accounts are considered sources of cash (input as a positive number), while increases in asset accounts and decreases in liability accounts are considered uses of cash (input as a negative number).

Operating Activities
General and Administrative Expenses Personnel/Salary Expense Lease/Rent Expense	Directly from income statement, a use of cash
(+/-) change in Other Receivables during the period	( + ) decrease in other receivables, is a source of cash ( - ) increase in other receivables, is a use of cash
(+/-) change in Accruals during the period	( + ) increase in accruals, is a source of cash ( - ) decrease in accruals is a use of cash
Cash Paid for Operating Costs	Total of the above accounts
Net Cash After Operations (cash available to service debt)	Cash from Trading Activities Less: Cash from Operating Costs

Net Cash After Operations (NCAO) in the above table is a good measure of whether the business is generating positive cash flow.  If NCAO is negative, it is typically because the business operation is not profitable, growth has outpaced the business’ ability to generate cash, or the business is simply spending or investing cash faster than it is generating or collecting cash.  An operating or working capital line of credit may fill this gap in cash flow, but many UCA models do not consider a line of credit or other types of debt as part of the trading or operating cycle of the business.  And if the business is regularly borrowing to support cash shortfalls in operations, it may not be sustainable over time.  The impact and appropriate use of debt is reflected later in the analysis (see below).

Debt Service
Interest Expense Withdrawals   Current Portion of Long-Term Debt (CMLTD)	Directly from income statement Owner Withdrawals/Dist’ns, Sub-S tax payments, Adj to retained earnings, etc. Note: This does not use the change in CMLTD; typically, the prior period CMLTD is used which represents the principal due during the current period.
Cash Required for Debt Service	Total of the above accounts
Cash After Debt Amortization	Net Cash After Operations Less:  Cash Required for Debt Service

If Cash After Debt Amortization is negative, it is an indication the business did not generate sufficient cash flow during the period to service its debt.  A typical measure of strong cash flow is the ratio of NCAO to Cash Required for Debt Service.  A ratio exceeding 1.25 is typically considered acceptable, with higher a ratio in excess of 1:50 considered strong.  Ratios of less than 1.0 are considered deficient, and typically require additional analysis to identify the factors creating the cash flow deficiency.  Consistency of these ratios and improving trends across fiscal periods are also good indicators of the reliability of the cash flow.