A cash flow statement (CFS) is a financial statement that shows the inflow and outflow of cash in a company over a specified period. It provides valuable information about the liquidity, solvency, and overall financial health of a company.
Given that cash flow is the lifeblood of any business, understanding and interpreting a cash flow statement is crucial for making informed financial decisions.
In this guide, we will discuss the basics of a cash flow statement, provide examples, and explain how to read one.
What is a cash flow statement?
A cash flow statement provides a detailed breakdown of a company's cash inflow and outflow for a specific period, usually quarterly or annually. It is one of the three essential financial statements, along with the balance sheet and income statement.
Unlike the other two statements, which focus on profits and losses, the CFS shows how much actual cash a company generates from its operations, investing, and financing activities.
This is important because a company may report profits on its income statement but still face cash flow problems due to delayed payments, inventory issues, or other factors.
The three sections of a cash flow statement
A cash flow statement is divided into three main sections: operating activities, investing activities, and financing activities.
Operating Activities
The operating activities section includes cash transactions related to the company's primary business operations, such as sales and purchases. It shows how much cash is generated or used by the company's day-to-day operations.
Examples include collecting payments from customers, paying suppliers, and paying wages to employees.
Investing Activities
The investing activities section includes cash transactions related to the company's investments in assets such as property, equipment, or securities. It shows how much cash is used for acquiring or disposing of long-term assets.
Examples include buying new equipment, selling old equipment, and purchasing stocks or bonds.
Financing Activities
The financing activities section includes cash transactions related to the company's capital structure, such as issuing or repaying debt and paying dividends. It shows how much cash is received or used for financing the company.
Examples include taking out a loan, making interest payments, and distributing profits to shareholders in the form of dividends.
Examples of cash flow statement
To clarify the concept of a cash flow statement, here are two examples:
Cash Flow Statement Example 1:
XYZ Corp is a clothing manufacturer. Below is a simplified cash flow statement for the year ended December 31, 2020.
Cash Flow from Operating Activities
- Cash received from customers: $500,000
- Cash paid to suppliers: -$300,000
- Cash paid for wages and salaries: -$100,000
Net cash from operating activities: $100,000
Cash Flow from Investing Activities
- Purchase of equipment: -$50,000
Net cash used in investing activities - $50,000
Cash Flow from Financing Activities
- Issuance of common stock: $200,000
- Payment of dividends: - $20,000
Net cash from financing activities: $180,000
Total net cash flow: $230,000
In this example, XYZ Corp's operating activities generated $100,000 in cash while the company invested $50,000 in new equipment. The financing activities show a net increase of $180,000 due to the issuance of common stock. The company's total cash flow for the year was $230,000, which is a positive sign as it indicates that the company had enough cash to cover its expenses and invest in growth opportunities.
Cash Flow Statement Example 2:
ABC Inc. is a technology startup. Below is a simplified cash flow statement for the year ended December 31, 2021.
Cash Flow from Operating Activities
- Cash received from customers: $200,000
- Cash paid to suppliers: - $150,000
Net cash from operating activities: $50,000
Cash Flow from Investing Activities
- Purchase of property and equipment: - $100,000
Net cash used in investing activities: - $100,000
Cash Flow from Financing Activities
- Issuance of long-term debt: $50,000
- Repayment of short-term debt: -$20,000
Net cash from financing activities: $30,000
Total net cash flow: - $20,000
In this example, we see that ABC Inc. has a negative net cash flow of - $20,000 for the year. This indicates that the company uses more cash than it generates from its operations and investments.
The CFS shows that the company relied on financing activities, such as issuing debt, to fund its operations, as the cash revived from its operating activities was insufficient to cover its outlay for new equipment.
How is cash flow calculated?
Calculating cash flow statements can be done in two ways. There's the direct method, and then there's the indirect method. While the direct and indirect methods may serve the same ends, they're calculated in different ways, and it's important to understand the difference before undertaking this crucial part of financial analysis. Additionally, while they both follow generally accepted accounting principles, each of these ways to calculate cash flow is better suited to certain businesses than others. We'll run through how to decide which of the financing cash flows methods will be best for your business activities below.
Direct method
The direct method essentially involves tracking all incoming and outgoing money from the business. It's called direct because of this seeming simplicity; using this method, a cash flow statement shows every cash transaction during an accounting period. It doesn't take into account non cash expenses such as depreciation or other non cash transactions. Instead, it focuses on actual cash flow.
Items included in the direct method include:
- Interest paid
- Cash payments from customers
- Capital expenditures
- Money paid to suppliers and other cash outflows.
It focuses on cash generated, rather than sales generated. You can use this method to calculate cash flows for your financial statements, but it's less popular than the indirect method, in large part because you'll need to have all of your cash receipts to hand and it can be time-consuming. However, it's generally easier for non-experts to understand a statement of cash flows calculated using this method.
Indirect method
The indirect method is considered more straightforward than the direct method. This method involves taking the company's net income from an accounting period, and then subtracting changes in working capital and non-cash items. Items considered not cash include depreciation, deferred taxes, and other other factors that don't influence net cash flows. Working capital adjustments refer to the difference between liabilities and current assets, and can include accounts payable, inventory, expenses, and accounts receivable.
Direct cash flow v indirect cash flow statements
As we've seen, there are key differences between the direct method and indirect method. Both of them meet international financial reporting standards, but the indirect method is much more common. The direct method, while easy to understand, can be difficult to put together for companies that have a large number of transactions. The indirect method, on the other hand, is easier to put together, though generally only if the company already has a handle on their financial statements.
Deciding which one is right for calculating cash flow for your business will depend on a couple of key details, including:
Company size
Choosing the calculation method for your financial statements will largely depend on the size of your business. Small businesses that have a small number of transactions and fixed asset values will likely benefit from using the direct approach for calculating their operating cash flows. Companies that have a lot of daily transactions will almost certainly find that their indirect method is better for calculating cash flow, based on the effort required to prepare financial statements when a large number of transactions are involved.
Time and resources available
For businesses in-between small and large, it's best to consider how much time and resources can be allocated to putting together cash flow statements. Cash flow statements put together using the direct approach are generally easier to understand and make it easier to interpret cash outflow, inflow, and predict future cash flows. For this reason, if it's an option, then it can be valuable to create a financial statement using this method. But in some cases, this won’t be feasible. If the business lacks time and software, then using the indirect approach for creating your statement of cash flows will be your best option.
How to read a cash flow statement
Reading a cash flow statement may seem overwhelming at first, but it is relatively straightforward once you understand the basics. Here is a step-by-step guide on how to read a cash flow statement:
- Start with the first section, "Cash Flow from Operating Activities." This shows the company's cash inflows and outflows from day-to-day operations.
- Next, move on to the "Cash Flow from Investing Activities" section. This shows any cash used for investing in long-term assets or received from selling them.
- Lastly, look at the "Cash Flow from Financing Activities" section. This shows any cash used for financing the company's operations or received from investors or creditors.
- Pay attention to the "Net increase/decrease in cash" line at the bottom of the statement. This shows whether the company had a net positive or negative change in its cash balance for the period.
- Compare the cash flow statement with the company's income statement and balance sheet to get a complete picture of its financial health.
It's important to differentiate between positive and negative cash flows. Positive cash flow indicates that the company's operations are generating enough cash to support its expenses and potential growth opportunities. On the other hand, negative cash flow may indicate financial struggles or investments in long-term projects.
Why are cash flow statements important?
Greater detail about spending
Cash flow statements offer a greater level of insight about how and where a company is spending its money. Profit and loss statements only tell part of the story, since they don't include certain payments that influence cash flows, such as loan payments. With a clearer picture, businesses can make strategic decisions that lead to positive cash flow and secure the future of the company.
Planning advantages
An issue with cash flows can put significant strain on a business. Having a balance sheet that outlines net income with outgoings and accounts receivable additions can give business leaders insight into operating cash flows. With an accurate statement of cash flows, managers can keep track of spending and make short-term and long-term plans for the well-being of the business.
Insights to working capital
It's imperative that executives have a clear understanding of the company's working capital; in other words, how much free cash they have available to make improvements to the business. Income statements can only tell you how much -- with a statement of cash flows, executives can have a clear understanding of operating cash flow and make an informed decision on whether to allocate cash to improve the business. If cash flows are positive, then the statement of cash flows can be used as justification for expansion. On the other hand, if cash flows are experiencing trouble, then cutting costs to preserve operating cash flow may be required.
Investor purposes
Equity financing can be a highly effective way to generate capital. A statement of cash flows can be used to show potential investors that the business is in good health and that there's a high possibility that they will receive dividend payments. All investors will want to see cash generated, income statements, net income, and other key indicators of financial health, all of which are included in the statement.
Traditional funding
Looking to get a loan from the bank? Traditional lenders look beyond the income statement and net income figure when deciding whether to provide funding. Consistently having healthy cash flow indicates that the business is functioning well and is more likely to meet the loan's repayment demands.
Greater control over finances
Businesses can quickly find themselves in trouble if they don't have a clear overview of their financial standing. Cash flow statements provide businesses with a high level of insight into their financial health, outlining outgoings, incomings, and much money that allow stakeholders to make well-informed strategic decisions.
Practical tips for cash flow analysis
When analyzing a company's cash flow statement, here are some practical tips to keep in mind:
- Compare the current period's cash flow statement to previous periods to identify any significant changes or trends.
- Pay attention to the "Cash Flow from Operating Activities" section as it gives insight into the company's core business operations.
- Look for any red flags, such as consistently negative cash flow from operating activities.
- Use a cash flow forecast to estimate future cash flows and potential challenges.
- Consider the company's industry and economic conditions when interpreting the cash flow statement.
- Assess liquidity by comparing the company's cash inflows and outflows to its current liabilities. A healthy company should have enough cash to cover its short-term debts.
Regular cash flow analysis is crucial for businesses to understand their financial health and make informed decisions. By learning how to read and analyze a cash flow statement, you can better evaluate a company's performance and make strategic investment decisions.
A vital insight into business operations
Understanding a company's cash flow statement is essential for investors, creditors, and potential partners. It provides valuable insights into a company's financial health and reveals how it manages its cash resources.
Moreover, analyzing the statement can help identify potential risks and opportunities for growth. By regularly reviewing the cash flow statement, businesses can make informed decisions to improve their operations and ultimately increase their success.
So, it's crucial to have a good grasp of how to read and analyze a cash flow statement for any business or investment endeavor. For more tips and strategies on how to manage your finances and grow your business, visit the Chaser blog.
Cash Flow Statements FAQ:
What is a cash flow statement?
A cash flow statement is an important financial document produced internally by businesses. It tracks all the company's incomings and outgoings during a specific timeframe. The statement includes calculations of all the company's inflowing and outflowing cash. It's an essential document that can provide significant insights into the overall financial health of the business.
Why is a statement of cash flow important?
They're important because they allow businesses to manage their liquidity. Running into liquidity issues is one of the most common causes of business closure. Having a statement that provides insight into outgoings and incomings ensures that businesses can meet their short-term expenses, including payments to suppliers, employees, and other operating costs. You can consider the statements as indicators of a company's financial health.
How do cash flow statements benefit businesses?
An income statement is useful for determining sales, but it doesn't tell the whole picture. By analyzing incomings and outgoings, businesses can determine how much money they have available to invest to improve their operations. On the other hand, if there are issues, then it's a warning sign that cash spending must be reduced. Ultimately, it's used as a signal of how the company is performing. It can also be used to attract investors or secure a loan from a bank.
Is a cash flow document the same as an income Statement?
An income statement is important, but it serves a different purpose. An income statement focuses on profitability, whereas a flow document focuses on how much cash is readily available. Additionally, an income statement includes all sales, regardless of whether the money has been received.
