To keep your business running, you’d better have enough cash on hand to pay for your daily expenses. Similarly, before you pursue any form of growth—new equipment, products, markets—you need to know that you can fund that endeavor. But with money streaming into and out of your business, how can you be certain where you stand fiscally?
Financial reports offer you the insight required to make smart financial decisions for your day-to-day operations and your future. In this article, we’ll take a closer look at one of these documents: the cash flow statement. We’ll dig into what it is, how it’s created, and how you can use one to effectively manage your business.
What is a cash flow statement?
As the name would suggest, a cash flow statement is a document that reports on the cash flow—the incoming and outgoing money—of an organization during a particular time frame, known as the accounting period. These records offer concrete insight into the short- and long-term financial health of a business by tracking its performance along operational, investment, and financing activities.
Why are cash flow statements important?
These records are especially useful in diagnosing monetary issues, such as payment processing bottlenecks, overspending, and potential financial shortfalls. In addition, cash flow statements can be used to create financial forecasts, making them crucial for any budgeting and planning efforts—particularly when determining if growth can be funded with excess capital or if financing will be needed. And if financing is, in fact, needed, these records will also help to establish the health and creditworthiness of the business to outside investors.
In many cases, the creation of cash flow statements is mandated by law. For instance, if a business is publicly traded within the United States, that organization must file regular records—cash flow statements among them—with the U.S. Securities and Exchange Commission (SEC). And these filings need to align with established Generally Accepted Accounting Principles (GAAP) reporting taxonomies.
The structure of a cash flow statement
After listing the total cash available at the beginning of the report, cash flow statements are typically divided into three sections—operations, investing, and financing—ending with a summary that identifies the net cash flow for the given accounting period.
Operations
This section outlines the incoming and outgoing funds tied to the core business functions of the company. As such, you’ll list out revenue generated from sales alongside expenses tied to daily functions, such as payments made for raw materials, payroll, warehousing, interest, and taxes.
It’s important to note that this section may also feature details tied to non-cash accounts, like accounts receivable (A/R), accounts payable (A/P), depreciation, and amortization.
Investing
The investing section focuses on cash flows tied to your property, plants, and equipment (PPE). Whenever you sell existing assets, you’ll record that income here. Similarly, when you purchase PPE using cash rather than debt, you’ll also make an entry. Unless there is a major downsizing in fixed assets, this section will typically appear as a negative total.
Financing
The final section captures the circulation of income between the business and its owners and creditors, clarifying whether the organization is functioning via equity or debt financing. So, these entries will align with issuing stocks or bonds, engaging in buybacks, and repaying loans or dividends.
Direct vs. indirect calculations for cash flow statements
When assembling a cash flow statement, there are two primary approaches used to identify and track revenue and expenses within the operations section: the direct method and the indirect method. The strategy you employ will depend on your broader accounting practices.
Direct method
You’ll want to use this method if you track your financials using a cash accounting approach, meaning that you recognize revenue only when a payment is received and recognize expenses only when they have been paid. As such, this approach will focus primarily on recording those transactions that directly affect your cash pool.
To find your operational cash flow, you’ll follow a rather straightforward procedure, starting with your opening cash position and subsequently adding all of the funds collected from your various business activities and subtracting all cash disbursements.
Indirect method
By contrast, the indirect method is aligned with the accrual accounting strategy. For accrual accounting, you recognize revenue when it is earned and expenses when they are incurred. Since these totals will be different from your cash accounts, you’ll need to adjust your entries within the operations section, first listing the net income figure recorded on your separate income statement for the same accounting period. You’ll then need to adjust this amount, removing any accruals—essentially stripping out the non-cash details (e.g., amortization, depreciation) that you commonly record in your income and expenses.
How to read a cash flow statement
Fortunately, the layout for cash flow statements is very straightforward and relies on simple computation to provide you with a net cash flow that clarifies the fiscal health of your business. When that number or any subtotal is a positive figure, this means you have a positive cash flow—you’ve gained more cash than you’ve lost. Conversely, a negative number indicates a negative cash flow—you’ve spent more than you’ve brought in.
Within your operations category, you’ll almost always want to see a positive cash flow. This suggests that your core business is profitable and presumably will survive for the foreseeable future. Admittedly, these figures will occasionally dip into the negative, but if they remain there for an extended period or are consistently low, you may need to rein in spending or reexamine the efficiency of your collections efforts.
Conversely, your investing section should typically produce a negative cash flow, but ideally a small one. If a business is in a growth period, the net cost of this section will obviously spike, but stakeholders tend to remain unconcerned with these temporary increases. However, when they become excessive or prolonged, it may suggest an overly aggressive or poorly thought-out investment strategy.
For the financing portion, a positive cash flow likely suggests an influx of capital, such as additional funds from an investor or the receipt of a business loan. Meanwhile, a negative subtotal means that the company is paying off any incurred debts, providing dividends to investors, or engaging in a stock buyback.
Example of a cash flow statement
Rather than remaining in the abstract, let’s take a closer look at exactly what a cash flow statement shows us. Consider this sample record:
Demonstrandum Inc. |
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Cash Flows Statement |
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Beginning Cash and Cash Equivalents | $ 30,000.00 | ||||||
Operations Activities | |||||||
Net income | $ 25,000.00 | ||||||
Adjustments to reconcile net income to cash | |||||||
Depreciation and amortization | $ 7,000.00 | ||||||
Changes in operating assets and liabilities | |||||||
Accounts receivable (net) | $ (10,000.00) | ||||||
Inventory | $ (1,000.00) | ||||||
Accounts payable | $ 3,500.00 | ||||||
Cash generated by operations | $ 24,500.00 | ||||||
Investing Activities | |||||||
PPE purchases | $ (8,000.00) | ||||||
Cash generated by investing | $ (8,000.00) | ||||||
Financing Activities | |||||||
Debt repayments | $ (10,000.00) | ||||||
Dividends paid | $ (5,000.00) | ||||||
Cash generated by financing | $ (15,000.00) | ||||||
Net Change in Cash and Cash Equivalents | $ 1,500.00 | ||||||
Closing Cash and Cash Equivalents | $ 31,500.00 | ||||||
While not publicly traded, Demonstrandum Inc. follows an accrual accounting strategy, meaning that it needs to use the indirect method when creating its cash flow statements. For this given accounting period, the business began with a cash position of $30,000.
Within its operations section, the report first lists out the net income from the company’s corresponding income statement for this period: $25,000. Of course, this figure includes various accruals that need to be backed out of the total, so the following lines add back in the company’s depreciation, amortization, and A/P. At the same time, the business needs to account for its unrealized revenue, subtracting the net A/R and changes in inventory value. As such, the cash generated by operations is $24,500.
During this period, Demonstrandum also spent $8,000 on new computer equipment, leading to a negative cash flow of $8,000 in its investing section. Meanwhile, within the financing category, the business didn’t receive any incoming funds, but it did pay out $10,000 on a prior loan. And given that the accounting period coincided with the end of the first quarter of the year, Demonstrandum also paid out a dividend of $5,000 to the firm’s owners, netting a total negative cash flow of $15,000 from financing.
Altogether, the business realized a net positive cash flow of $1,500 during the accounting period, leaving it with an increased cash position of $31,500.
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