What Is The Purpose Of A Cash Flow Statement?

Financial statements provide valuable information about the financial health of a company. Knowing how to read and understand financial statements is the responsibility of every business owner and investor.

Most know about the balance sheet and income statement, but there is a third statement that is an excellent gauge of a company’s health and liquidity—the cash flow statement. 

So, what is the purpose of the cash flow statement?

The cash flow statement is one of the most useful pieces of information you can prepare, as it shows the cash coming in and going out of your company. This can give you a good idea of where you are doing well and where you could improve.

Without cash, a company ceases to exist. How cash flows throughout a company determines its success.

The cash flow statement serves many purposes. It tracks cash flow in three different areas: daily operational activities, investing, and financing.

These three areas offer numbers that investors study. They study the statement to determine whether the company has liquidity and is a good investment.

Even though the statement does not definitively show whether a company is making a profit, it does indicate profitability as it shows how well cash is managed.

What is a Cash Flow Statement?

To understand the inflows and outflows of a company’s financials, a company can prepare a cash flow statement. It provides a detailed picture of a business’ cash during a specific accounting period.

Even cash flow has a few different interpretations. There is free cash flow, which looks at the relationship between operating cash flow and working capital.

Then there is operating cash flow, which looks at the cash spent to make a product or service and the profit from the sale of that product or service. 

The cash flow statement is a more comprehensive look at cash from several different areas—operations plus investments and financing.

There are three main areas of the cash flow statement:

  1. Cash from Operating Activities is revenue and expenses incurred during regular business activities, or more specifically, the cash flow associated with producing goods or delivering services. These may include sales revenue, inventory, supplies, employee salaries, accounts payable, accounts receivable, interest payments and receipts, depreciation, and amortization.  
  2. Cash from Investing Activities is cash gained or spent on purchasing or selling assets, including plant, property, equipment, patents, trademarks, etc.
  3. Cash from Financing Activities is cash from debt or equity activities, such as selling stock or obtaining investment financing.

While cash flow statements are helpful for any business, cash flow statements are required for any company that sells and offers stock to the public.

It is reported on the 10-K form, an annual report provided to shareholders. It provides a comprehensive summary of finances for the year.

How to Interpret a Cash Flow Statement

A cash flow statement will give you insights into the company’s health. Suppose a company has strong management, a strong cash flow, exhibits low debt activities, and invests in its company regularly.

In that case, it will likely reflect a positive cash flow. If the company has trouble paying its invoices, this will also reflect on the statement.

Each of the sections of the cash flow statement tells a different story. Cash flow from operations indicates how much the company earns from sales and services and the cost of those services.

There are many things a company can do to affect this number, including cutting individual costs or finding a more cost-effective supplier.

Cash from investing is impacted by capital expenditures. Cash flow is reduced while purchasing new equipment, but that expense is ultimately performed for future growth. The sale of equipment or property boosts cash flow.

Cash from financing determines the dividends paid to shareholders. Investors look at this number to determine the company’s current debt and whether the company can handle more. This number also shows how the company raises cash for growth.

It’s important to understand that while an individual cash flow statement offers value, it’s beneficial to look at several statements over a longer period of time. Here’s why. Cash flow depends on when the transaction hits the books.

If a company receives many payments toward the end of the statement period but doesn’t pay its invoices until the next period, it might look like it has a lot of cash on hand.

In reality, it owes money that hasn’t yet been paid. If a company pays invoices late in the month, but their client is behind in payments, this results in a negative cash flow.

In each case, the company might show a profit on the income statement but skewed numbers on the cash flow statement.

Cash flow is a balancing act for the business owner – keep enough money coming in to pay the bills and keep creditors happy. It becomes a matter of cash flow management to keep these two in sync. 

As a business owner, you can significantly affect cash flow. For example, aligning your payment cycles with your billing cycles ensures sufficient revenues are available to pay bills during the accounting period.

A company that manages its cash well is more attractive to investors and causes less stress for its owners.

Positive Cash Flow

A company has a positive cash flow when more money is coming in than going out. It indicates that there is some cash for other purposes, including purchasing inventory, paying debts, and spending on business growth. 

One might assume the business is turning a profit if it has a positive cash flow, but that isn’t necessarily the case. Cash flow is based on money going in and out, while profit is the total after all invoices have been paid.

A high positive cash flow might mean that the company hasn’t paid some invoices or just received an influx of cash. Profit depends on where that cash is coming from.

Negative Cash Flow

Negative cash flow means that cash outflows are higher than cash inflows. It could indicate a positive, such as the company just invested in new equipment or purchased inventory.

It could mean that there are clients that haven’t paid their invoices. It could also mean that sales are down, and the company is running out of cash and equity to keep it afloat. 

It could also mean that the company makes enough revenue to cover costs, but there is a mismatch in the timing of funds. In any case, the business owner should study where this shortfall lies that determine ways to even out the cash flow.

What is the Purpose Of the Cash Flow Statement?

The cash flow statement provides valuable information for business owners and investors. Each line item provides insights into where the cash came from and where it is going.

Each change in cash should be studied and understood to determine where the numbers come from and how they relate to the rest of the statement.

Information About Non-Cash Investing and Financing Activities

While operating cash flow is extremely important, it’s only one-third of the cash flow statement. The second and third sections provide information about investing and financing activities.

Even small businesses have some sort of investment—often from the owner’s pockets. Perhaps they may take out a line of credit or a business loan. Maybe they even borrowed money from family or friends.

As a business grows, the financing might come from outside investors or shareholders, and the investments might be in the form of property, plant, and equipment.

Whatever forms the investments and financing take, tracking each source and how they grow and deplete over time is vital.

Financial Condition Of the Firm

While a positive or negative cash flow tells part of the story, a company’s financial condition is much more complex. Each activity tells a story.

If cash received is low, one might wonder if sales are down or if clients aren’t paying their invoices on time. If cash payments to vendors are high, perhaps the business is stocking up on inventory, or maybe there was a price hike, and they need to search for a new supplier.

If employee salaries seem high, look to see if they just hired a new team member and their role in the firm’s growth. If salaries are lower, check to see if the company just downsized and how that will affect the company’s production.

Look at investing activities and see if the company bought or sold large equipment or land. If financing levels are high, check and see if the company received an influx of cash from an investor or if their interest payments on an existing loan are out of the ordinary.

Provides a View of Management Strategy

The statement of cash flows provides insight into a firm’s management strategy. If the firm has a positive cash flow, but it’s due to the sale of property or equipment or the downsizing of staff, you should investigate whether the company is changing directions or selling assets to stay afloat.

On the other hand, strong revenues, intelligent acquisitions, and prudent investing are all signs that the company is moving in a positive direction.

While the statement will clue you into interesting numbers, it’s essential to understand their meaning. As you can see, one number can mean one thing or the opposite, and due diligence is the best way to understand why.

A cash flow statement can also be used to plan for the future. If a company has several months’ worth of positive cash flow, the owner can consider expansion, restructuring of debt, or other investments.

Legal Requirements

The cash flow statement must be prepared using proper accounting standards. Looking closely at the cash flow statement, an investor can spot red flags that indicate something is amiss. 

Methods Used to Produce a Statement Of Cash Flow

There are two methods for reporting numbers—direct and indirect methods. The difference between the two is how cash is handled and when it is reported.

Indirect Cash Flow Method

The indirect cash flow method is based on the accrual accounting method. Revenues are recorded as earned, and expenses are recorded as they are incurred.

Using this method, you don’t necessarily have cash on hand or have paid cash out when you record information in your books. For example, if you perform a service for a client and then send them an invoice, this is recorded as cash in the indirect method.

You may not receive the cash for 30 or 60 days—at that point, you would do nothing to the books, as you’ve already recognized the revenue.

To prepare the cash flow statement using the indirect method, start with net income from the Income Statement, then add back in non-cash expenses such as depreciation and amortization.

Direct Cash Flow Method

The direct cash flow method records items when they are paid—either to you or ones that you’ve paid to your suppliers. Money is recorded when it comes in or leaves your bank account.

In the above scenario, you’ve performed work for your client and sent them an invoice. However, you will not recognize the payment on your cash flow statement until you receive a check and put it in the bank.

To prepare the cash flow statement using the direct method, add all cash collected from operating activities and subtract all expenses from operating activities.

The Bottom Line

All small or large businesses need to understand where they are financially.

The balance sheet, income statement, and cash flow statement are all tools for making better decisions.

Knowing how to read these statements and understand what investors are looking for is crucial as your business grows.

The more you know, the better equipped you are to make changes to adapt to the changing environment.

Here at Wealth Factory, we are dedicated to providing you with the most up-to-date and accurate information to help you keep more of your money.

For more topics related to finance and wealth, check out our library of articles.

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