Cash Flow Statements: Everything You Need To Know

Cash flow statements are one of the most important pieces of financial information for business owners–big or small. But many business owners don’t know what a cash flow statement is, or how to read one.

In this blog post, we’ll explain everything you need to know about cash flow statements, including what they are, how to read them, and why they’re important. Stay tuned! 

What is a Cash Flow Statement?

A complete set of financial statements for your business includes a balance sheet, an income statement, and a statement of cash flows. These three reports summarize the financial state of your business for a certain period of time.

Some businesses report cash flow quarterly and some yearly. If you have shareholders, a statement of cash flows is included in your annual report. 

The Cash Flow Statement is a snapshot of a business’s cash inflows and outflows. It has three parts: cash flow from operations, cash flow from financing, and cash flow from investments.

The statement shows the change in cash and cash equivalents from one period to another. For example, if the statement is prepared yearly, the change is the difference between January 1st and December 31st. 

The cash flow from operating activities is money spent on the business’s day-to-day operations. This could include purchasing inventory, selling goods or services, paying employees, keeping the lights on, etc.

This cash is generally steady and predictable. Operating cash flow can be calculated using one of two methods—indirect or direct, which we will talk about shortly.

Cash flow from investing activities is money spent on property, plant, and equipment. This might be the purchase or sale of these long-term assets. This cash is typically a one-time entry.

And finally, cash flow from financing activities is money earned or spent in relation to short or long-term loans or issuing or repurchasing of bonds or shares of stock. This category is also most often a one-time entry.

The Importance of Cash Flow

Cash flow is a critical indicator of the health of a business. These statements provide a glimpse of different areas of a business and are a valuable tool in determining a company’s worth. Cash flow will also illustrate how a company operates, as it can provide revenue and expenses. 

Cash flow is often used to compare one period to the next. A positive cash flow quarter over quarter or year over year indicates strong management decisions. Cash flow from investing and financing shows growth and prudent decisions.

Whether you hire an accountant or do the books yourself, you need to know how to prepare and read financial statements. It’s important to know where your money comes from and where it goes and be able to use it to make smarter business decisions.

Business owners use cash flow statements to attract investors to determine the correct time for a big decision, such as expanding a product line, acquiring new property, plant, or equipment, or hiring more staff. Presenting a solid cash flow will attract investors.

Investors use cash flow statements to determine whether a company can pay its short or long-term obligations and whether they would be an excellent addition to their portfolios. 

A cash flow statement also shows how liquid a company is, i.e., its ability to pay current debts. Liquidity is not to be confused with solvency, which is a company’s ability to pay ALL of its debts. The most liquid asset is cash, so the more positive your cash flow, the better your liquidity.

Generally accepted accounting principles require a complete set of financial statements when presenting financials to someone outside the company, i.e., investors or shareholders.

These include the balance sheet, income statement, statement of comprehensive income, statement of stockholder’s equity, statement of cash flows, and any notes related to these financial statements.

While your business may not have investors or shareholders currently, a history of these statements is helpful for your own use or if you decide to pursue a loan in the future.

How Cash Flow is Calculated

Cash flow is the difference between cash at the start of the accounting period to the end of the accounting period. 

Before we dive into the two methods of calculating cash flow, here are the basic steps to creating a cash flow statement.

  1. A cash flow statement starts with the balance of cash or cash equivalents on day one of the accounting period. 
  2. Cash flow is calculated for operating, investing, and financing activities.  
  3. Add or subtract the entire column
  4. What is left is the ending cash or cash equivalents.

Cash flow can be positive—having more inflows, or negative—having more outflows. While a positive cash flow is more desirable, it’s best to look at each section individually. A large purchase can throw numbers off.

There are two methods to determine cash flow from operating activities—the direct and indirect methods. These numbers will produce the same end result, but the methods of getting there vary.

Both methods are accepted by Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). The difference between the two is in the details provided.

Note that these two methods are used to calculate operating activities.

Cash Flow Statement Direct Method

Using the direct method for calculating cash flow is easier for someone reading the statement to understand, but takes more time to prepare as it involves looking at all cash collected during the course of doing business and subtracting all disbursements due to operations.

These transactions clearly depict what you spend your money on when it comes in and out of your accounts.

Cash Flow Statement Indirect Method

The indirect method is easier and faster to prepare. It’s tied to the numbers on the balance sheet. It starts with net income from the income statement and adjusts the number based on the accruals.

Net income is converted to cash flow by identifying non-cash expenses such as depreciation or amortization.

The indirect method uses an accrual accounting method, whereas the entries to the books are based on when a product is ordered, or an expense is invoiced, rather than when the money is actually paid or received.

The statement of cash flows covers items that are missing from the income statement, such as:

  • cash from sales (either after or before the sale),
  • cash paid for buildings and equipment that will be written off over the next several years,
  • cash received from bank loans,
  • cash received from the sale of assets,
  • cash payments to reduce a loan’s principal balance,
  • cash withdrawn by owners,
  • or cash paid to stockholders in the form of dividends.

How to Interpret a Cash Flow Statement

Cash flow statements can provide insights into the status of an organization. Keep in mind the stage of a business when looking at its cash flow.

A start-up might be investing heavily into new equipment or have a lot of promises for revenue, but its actual income might lag behind. A well-established company might be in the process of replacing outdated equipment, expanding into new territories, or holding steady.

By themselves, cash flow statements provide a small picture of a period of time. Examined over time, cash flow statements can show growth or decline.

Each section and number should be analyzed to determine where efficiencies, cuts, or growth can or should be implemented. For ideas on how to build profits and increase cash flow, check out this article.

Positive Cash Flow

A company strives to have positive cash flow. This means that more money flows into the business than flows out.

A positive cash flow means that the company can invest in people and equipment, pay its debt, and pay dividends to its shareholders. It affords flexibility and often means that investors look at the business with favor.

However, a positive or negative cash flow does not necessarily mean that the company is profitable. A positive cash flow does not translate to profit, and a negative cash flow does not translate to a lack of profit.

Negative Cash Flow

A negative cash flow means the company has more cash outflows than inflows. While a negative number might have bad connotations, it does not necessarily mean that the company is underperforming.

An investment in the business or a one-time transaction can cause a negative cash flow. It bears repeating that the statement of cash flows should be scrutinized and compared with past statements to get a clear picture of business health.

Example of a Cash Flow Statement

The first line of the cash flow statement is the amount of cash and cash equivalents at the beginning of the reporting period.

Once the three sections are complete, and an increase or decrease in cash and cash equivalents is determined, the last line of the statement is the amount of cash and cash equivalents at the end of the year. 

Here is a fictitious cash flow statement using the indirect method:

Cash Flow Statement

My Company

Year Ending December 31st, 2021

Cash Flow from Operations

Net Income                                                                                 $50,000

Additions to Cash

Depreciation                                                                               $10,000

Increase in Accounts Payable                                                  $10,000

Subtractions from Cash

Increase in Accounts Receivable                                           ($15,000)

Increase in Inventory                                                                ($10,000)

Net Cash from Operations                                                        $45,000

Cash Flow from Investing

Purchase of Equipment                                                             ($6,000)

Cash Flow from Financing

Notes Payable                                                                                $6,500

Cash Flow for Year ended December 31st, 2021            $45,500

Operating Cash Flow

The first section of the statement calculates cash flow from operating activities. Let’s break down what is included in this section. 

Net Income – This number comes from the income statement and is the total income, after expenses, for the period of time. In this case, January 1st through December 31st.

Depreciation is how accounting deducts the cost of a business asset over time. When a company purchases a large piece of equipment, they expect it to last for a certain period of time.

Over time, the asset will lose its value.

Meantime, the asset has value and can be claimed as such.

There are several ways of calculating depreciation, but essentially you take the purchase price minus the scrap value when you are done with the equipment and divide that by the number of years of the useful life of the equipment.

That number is included in financial statements. On the cash flow statement, depreciation is listed as income.

Accounts Payable is money we owe but hasn’t been taken out of the bank account. Since the money will come out of our cash, we subtract it from an income statement, but since the money hasn’t been taken out yet, we add it back into our cash flow statement.

Accounts Receivable is money we’ve billed to a client that they haven’t paid. We don’t have the cash in our accounts yet, so we deduct it from our operating cash flow.

Inventory is the raw materials that we’ve purchased to make our product. We’ve already spent cash on it, which is an asset to our business, but we can’t use it to pay bills, so we deduct it from our operating cash flow.

Net Cash Flow from Operations is the cash we’ve got on hand.

Using the direct method, you might have revenue from your product or service, administrative expenses, wages, interest, and income taxes. Depreciation and Amortization are still included.

Investing Cash Flow

Purchase of Equipment is an asset to your business, but it’s not cash anymore. As a result, it is deducted from your cash flow. The amount of depreciation is added to your cash flow over time, but this one-time purchase is deducted in this section.

If you bought a building or invested in a supplier, those items would also be included in this section.

Financing Cash Flow

Financing can be inflows or outflows as well. Inflows are when you receive money from an investor, obtain a loan, or use your line of credit. Outflows are when you pay off a loan or line of credit.

Notes payable are either increased (inflow) or decreased (outflow) depending on how it affects your cash on hand.

Cash Balance

After all of these calculations, what is left over is the amount of cash available at the end of the reporting period. This is your positive or negative cash flow. 

The Takeaway

Now that we’ve introduced you to the Statement of Cash Flows and given you some direction as to create one yourself, start gathering information and put one together. You’ll need it if you get to the point where you are taking out a loan or shopping for investors. 

Even if you don’t pursue those avenues, knowing your cash flow will enable you to make better decisions regarding the financial aspects of your business. Need more help? Check out our library of articles to help you keep more of what you make.

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