A wise banker once said, "Profits don't pay loans back – cash does." While that comment is somewhat cryptic, it does make a point. Namely, that profits result from an accounting formula that often includes accruals, depreciation, and other items that do not change a company's cash position. On the other hand, cash flow is truly what a company has available on any given day or month to meet its obligations.


So, how does one measure business cash flow, and to what purpose? The traditional formula for the measurement of a company's cash flow is as follows:

Cash Flow = Net Income + Depreciation + Amortization Expense + Interest Expense – Owner Distributions

The result is what banks call either operating cash flow or repayment capacity. This metric aims to isolate how much cash the business generates on an annual, quarterly, or monthly basis to pay debt payments owed.

A business owner's two common considerations when looking at cash flow are interest payments and owner withdrawals. How are interest payments treated in computing cash flow? Interest payments are added back even though they are a true cash expense because they are also included in the debt payments: not adding them back would double count them. Owner withdrawals are taken out of net income because they are a true cash expense that generally does not show up on an income statement. The bank's objective is to evaluate how the business can handle its obligations at the entity level and not at a global level that includes owner personal incomes. Of course, owner withdrawals can be discretionary and is one way an owner adds or subtracts from the business repayment capacity.

However, measuring a company's ability to repay debt is not the only reason a business owner would need to get a handle on its monthly or quarterly cash flow. Bank loan payments are not the sole recurring obligation that a business has to meet. Biweekly payroll, inventory purchases, and capital expenditures are just a few other examples of obligations that a business needs to fund with cash. Understanding how changes in a company's balance sheet affect its cash position are extremely important for any entrepreneur. For instance, knowing that an increase in inventory levels is a cash use and a reduction in average receivable levels is a cash source, it can go a long way in providing a business owner with a sense of its operating cycle and how cash plays such an important part.

Navigating through the challenges of operating a business is always a challenge. But knowing your cash position and being able to project cash flows for the next 3-4 months certainly helps the average business owner sleep at night knowing they will meet their recurring obligations if necessary. The more capacity a business has to cover their debt with cash flow, the more they understand that "cash is king." This capacity also places them in a more advantageous position to be approved for a business loan. If you are a business owner and have questions about a business loan, give us a call and connect with one of our local community bankers.

Written by David Brown, Senior Commercial Lender