Editor's note: The following column is a part of larger "Understanding Financials" series written by Matt Lau, director of financial analysis for Regent Surgical Health. To re-read "Understanding Financials: Your Income Statement," click here. To re-read "Understanding Financials: Your Balance Sheet," click here.
In the "Understanding Financials: Your Income Statement" column, we learned that the accrual-basis method of accounting is based on the economic activity of the business, and that this preferred accounting method is used as the backbone for creating your income statements and balance sheets. However, it is also important to keep in mind that other time-tested principle ... Cash Is King. This is where the cash flow statement comes in handy.
The cash flow statement is the third of the financial statements which we as investors, managers, operators and employees should all understand. While the income statement tells us how our business is doing by showing the financial results over a period of time and the balance sheet shows us a snapshot of our business at one point in time, the cash flow statement shows us how the changes in the facility's balance sheet accounts and income affect cash over a period of time.
Cash flow statement basics
The cash flow statement includes only inflows and outflows of cash and cash equivalents (which are assets that are readily converted into cash ... such as money markets and short-term government bonds). Thus, this financial statement excludes transactions that do not directly affect cash receipts and cash payments (like the recording of depreciation or long-term fixed assets). The cash inflows and outflows are broken down into three categories — operating activities, investing activities, and financing activities.
Operating activities
Operating activities include the production, sales and delivery of services as well as collecting payments from payors and patients. Essentially, operating activities are what we do every day. We pay money for supplies, labor and the facility itself in order to provide high-quality surgical services. We collect money from payors for our services. Those are our operating activities.
There are two different methods of presenting the operating activities section of the cash flow statement: the direct method and the indirect method.
Direct method. The direct method essentially breaks the operating cash flows into major classes of cash receipts and cash payments. For example, the direct method will list cash receipts from payors, cash paid to suppliers and employees, and interest paid. This method actually results in a more easily understood report. Unfortunately, the indirect method is almost universally used.
Indirect method. The indirect method uses the facility's net income (taken from the income statement) as the starting point, then subtracts out all non-cash transactions and finally makes additional adjustments based on movements in balance sheet account balances which occurred as a result of cash transactions. Essentially, what those "balance sheet" adjustments mean is that an increase in an asset account is subtracted from net income and an increase in a liability account is added back to net income (and vice versa).
Let's think about that for a second. Suppose the balance of our accounts receivable account was $500,000 at the beginning of the year. At the end of the year, the balance of our A/R account was $750,000. Thus, our A/R balance increased by $250,000 during the course of the year. But what does that mean in terms of cash? Well, since the A/R balance increased, it basically means that we billed $250,000 more than we collected during the year. However, the income statement (and more specifically the net income number) only includes the amount we billed. So, in order to adjust the net income to properly reflect the movements in cash, we have to reduce net income by the $250,000 increase in A/R.
Investing activities
Most often, investing activities are the purchase or sale of assets, such as equipment, land or a building. Investing activities can include other transactions (such as loans made to suppliers, loans received from customers, and payments related to mergers and acquisitions), but you will mainly see the purchase and sale of assets in this section of your facility's cash flow statement.
Financing activities
Financing activities include the inflows and outflows of cash to the company's owners as well as the company's lenders. Thus, for owners, this section will include investments received by the business as well as the distributions paid to company owners. For lenders, this section will include proceeds from raising debt and repayment of debt principal. (Note that the interest portion of debt repayment is included in the operating activities section.)
Cash flow statement analysis
So, what type of information can we learn about our facilities from the cash flow statement? First, really focus on the operating activities section. It provides information on our company's solvency. Then, take a look at the net cash flows from operating activities. If that number is consistently positive, then our normal day-to-day operations are self-sustaining. We are creating more than enough positive cash flow to pay our bills and then some. However, if the cash flows from operating activities are consistently negative, we could very well have a problem. Eventually, the business will run out of cash if we don't figure out a way to change what is going on.
The operating activities section of the cash flow statement also provides us with additional information for evaluating changes in assets and liabilities. In the example we used above, the balance of our A/R account increased by $250,000 in one year. That could be a good thing, meaning that business has grown and our case volumes have increased. However, it could also be a bad thing, as in the case where payors just aren't paying us as quickly as they had in the past. The cash flow statement can bring these changes to our attention and alert us to potential problems.
In addition to the information we can learn from the operating activities section, the investing section of the cash flow statement can help us evaluate the investments and financing decisions we have made for the business. The investing section will show us how much we have spent investing in new equipment and expansion. The financing section will show how much of our cash we have to pay to our debt lenders, and how much cash we can distribute to the owners. This information gives us a more complete picture of the business as a whole and an idea of where it is headed in the future.
Knowing the components of the cash flow statement and what signs to look for can help us determine the financial strength and short-term well-being of our business. While the income statement and balance sheet provide us with an economic picture of our business, the cash flow statement shows us how much cash we have and how much cash our business generates. The information contained in the cash flow statement can provide a clearer picture of the liquidity of a business, and in some cases can act as a red flag for potential problems in the future. Ultimately, a healthy cash flow statement can help the business attract new creditors, prospective employees and potential investors to help the business grow and thrive.
Learn more about Regent Surgical Health. Contact Matt Lau at mlau@regentsurgicalhealth.com or (708) 498-4473.
Read more from the leadership team of Regent Surgical Health:
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- Practical Guidance on 3 Top Revenue Cycle Challenges — OON Payors, Denials and Collections
- Regent Surgical Health Opens New Alaska Surgery Center in Anchorage