Cash Flow Statement | Definition and Explanation

Definition of Cash Flow Statement

The statement of cash flow or cash flow statement is a financial statement that reflects the flow of cash in and out of your business for a given period. This report analyses the payment that a company receives and also spends on various functions of business, like investing, operating, and financing activities.

The cash flow statement is considered as one of the core statements of finances together with the balance sheet and income statement. All three statements are used to understand and evaluate the financial situation of an organization. Chief Financial Officer or CFO is concerned with generating regular cash flow statements and communicate them to business heads. Decisions regarding investments – if any – are taken based on this statement.

While income statement is a clear representation of what you have earned and what you have lost for a given period, it does not indicate the cash in hand for business for that period. In the case of accrual basis accounting, the income and expenses are noted when they are incurred. They are not recorded when money leaves the bank or comes to the bank.

That is why even if the income is present on the income statement, the actual cash may not be available with the organization. It is the function of the Cash flow statement to make necessary adjustments to the income statement to arrive at actual cash available with the organization. The cash flow statement gives you a definite and precise value for the cash available in the organization at a given period.

Cash flows for smaller businesses are relatively easier to manage, but understanding the cash flow of large companies can be overwhelming. This is the reason why the cash flow statement is prepared regularly to give a clear and organized understanding of the cash and its direction of flow in your finances and business.

Cash flows need to be reviewed periodically to ensure that the business is prepared for the future.

The need for Cash Flow Statements

1. Cash flow statements help to show the liquidity of the organization, which means it helps to determine how much operating cash is present and what percentage of it can be used. This will help your organization to understand what you can afford and what you cannot afford.
2. Cash flow statements help to understand the organizations the changes in their equity and dividends. These changes are shown in terms of cash outflows, inflows, and the cash which is held with the organization at present. These three categories help the business to understand the finances of the organization, and it helps to measure your performance.
3. Cash flow statements help to predict the flow of cash in the future. They are useful in creating cash flow projections so that the company can understand the amount of liquidity your business will have in the future. When the business is making long-term planning, cash flow statements come in handy.
4. Cash Flow statements tell the business the net income and the quality of its earnings. If the cash is more than the net income, then the gains can be termed as of high quality.

Inclusions of Cash Flow Statement

It is a common question of what does a cash flow statement include or what are the elements of cash flow. Let us have a look at it.

Usually, a cash flow statement is divided into three parts which are: cash associated with investing operating in financing activities. A company which drives their money from operations and reinvests it into the capital to see positive cash inflow is considered as a good business.

Following are three parts of the Cash flow statement:

1. Investing Activities

Usually, the investment is on the higher side. Purchase of equipment, purchase of the real estate, expansion are few items in investing activities. They utilize a lot of cash, which is accumulated for a long time from investments in assets. In the long run, these investments themselves become a source of funds for the organization. For example, if office space is rented out, it can generate cash that flows back in the business.

2. Operating Activities

The everyday expenses of the company, as well as daily incomes such as payments to suppliers, salaries of workers or employees, insurances, and incoming cash such as sales of product or service, are considered as operating activities.

3. Financial activities

In this category, the inflows are the loans required for businesses, and the outflow is the dividends that are paid to shareholders. Loan repayment also counts as an outflow in financing activities. Incoming capital from fundraising can be considered as cash inflow.

Cash flow statement is mostly concerned with cash equivalents only, for example, bank accounts, treasury accounts, checks. If the accounts receivable increases, it means that the sales are increasing, but the cash is not received at the time of purchase. This means that the company needs to work on the credit period. While calculating net income accounts, receivable are deducted so that we can get a clear idea of actual income.

On the other hand, if accounts payable increases, then it will reflect as a cash inflow in your statement since they have not been paid off yet.

Let us take a look at the following example of the Cash flow statement.

For an Organization ABC,

Net Income –  $200,000

Depreciation –  $20,000

Increase in Acc receivable – ($10,000)

Increase in Inventory – ($5000)

Increase in Acc payable – $25,000

The decrease in Prepaid expenses – $5000

The decrease in accrued expenses – ($5000)

Net cash flow from operating activities – $230,000

Increase in investments – ($70,000)

Increase in fixed assets – ($ 120,000)

Sales of fixed assets – $50,000

Net cash flow from investing activities – ($140,000)

Repayment of loans – ($70,000)

New loans – $150,000

Interest – ($15,000)

Dividends – ($80,000)

Net cash flow from financing activities – ($15,000)

Net cash balance – $75,000

Explanation

1. In the above example, the cash flows are broken into three categories of operating, investing, and financing activities. The net cash balances positive $75,000 for a given period. Most of the positive cash operating businesses of $230,000 resulted in a positive cash flow, which turned out to be beneficial for the company. It can be seen that the organization also makes some long-term investments, and not a lot of money is borrowed from the market.
2. Depreciation is not a source of cash, but it appears in the cash flow statement. This is done to adjust the net income, which can be reduced because of depreciation expense.
3. Cash flow from operating activities

For many businesses operating activities will include and consist of most of the cash flow. This is because these operating activities are considered as revenue generators. If you have a burger shop, then the cash that is spent on the labor, ingredients, and it is also the cash that is earned by selling the burgers. If you have an aviation company, then operating activities include sales of seats as well as the expenses on the flight crew, fuel expenses, etc.

In the case of our example, net income is the final and total income, which is earned for the given period.

Depreciation is reduced from income. An increase in accounts payable is the money that the business owes to other people. It is the money that is not paid but belongs to someone else.

An increase in accounts receivable means the money which is yet to come from the clients, but we are not paid, however. Although this is classified as an asset, it is not the hard cash that we hold in our hands. An increase in inventory is the growth or improvement in the balance sheet. Inventory is not an asset.

4. Cash flow from investing activities

This section covers investments which the organization has made for the given period, which include the purchase of land, equipment, real estate, and other financial products, which are referred to as cash equivalents. If a $10,000 lawnmower is bought for a landscaping company, then the cash of the same value is gone, but you get a mower of the equal amount. Similarly, if the company decides to invest $50,000 in purchasing new land for setting up a manufacturing facility, then the cash value of $50,000 is shown as an expense – gone from the statement, but the addition of an asset of $50,000 is made in the statement.

In this category, the investments are reversed by removing them. They do have the cash value, but it is not like holding the cash in hand. In the case of small businesses, the majority of the cash flow will not make up for investing activities because it is considered to affect the working capital of the business.

5. Cash flow from financing activities

This section includes the assets that are spent on financing activities. When another one is paid off, the money leaves the bank account, and when you get a loan, cash is received in your cash account.

Cash flow from financing activities, repayment of loans, usage of the ones which are obtained for the business, the interest which is paid for the loans which are already acquired, the dividends which are paid out to shareholders all of them are part of financing activities.

How to prepare a Cash Flow Statement?

Software: One of the best ways to develop a cash flow statement is to use automated software. There are many software available in the market, like QuickBooks, online, or wave. The software assists the businesses to maintain all of the records, including the details which are required to prepare a cash flow statement.

You will be able to generate software statements automatically, and the software will calculate everything for you. The software can also be scheduled to prepare statements weekly, monthly, or quarterly.

Another method for preparing cash flow statement includes a direct or indirect way. The operating section can be shown as either the indirect method or the direct method. The financing and investing sections are similar in either of the methods, with the difference being only in the operating section. Gross cash payments and cross cash receipts are majorly shown in the direct method. On the other hand, the indirect way begins with the net income and later adjust the profit or loss. Finally, the cash flow from the operating section is expected to give the same result, which is obtained with any of the approaches used. The only difference will be in the presentation.

In the case of the direct method of cash flow, all the individual transactions of cash are paid out or received are summed up, and the resulting total is the net cash flow.

On the other hand, in case of indirect method depreciation, that income and such accounting line items help to arrive at the cash flow. In the case of financial modeling, an indirect method of cash flow is used.

Negative vs Positive cash flow

When the cash is negative at the bottom, it means that the business has lost much money for the given accounting period. This is the reason why cash flow has become negative. It is important to remember that if you get a negative cash flow, it is not always bad; instead, it means the organization is thinking in the long run. Sometimes you have to spend cash to get money. Investments in land, equipment is an example in which the organizations spend money and possibly get a negative cash flow, but in the long run, it turns out to be fruitful and positive for the business.

Positive cash flow at the bottom means that you have positive cash for the business, but positive cash flow is not always a good thing for the company, especially in the long term. Of course, it offers more liquidity, but it also means that there could be many negative reasons that you have money lying around. For example, when you take a significant loan for the business. It results in positive cash flow.

Cash flow with the Balance sheet and Income Statement

A cash flow statement is prepared by using information from the balance sheet and income statement. The importance of income statement is it helps to understand how money is left or entered your business on the other hand balance sheet helps to show how different accounts are affected by these transactions like inventory, accounts receivable, and accounts payable.

So in general terms,

Income statement + balance sheet = Cash flow statement.

Getting the most out of your Cash Flow Statement

Preparing a cash flow statement is one thing and getting the most out of it as an entirely different thing. The cash flow statement can help to make your business better decisions regarding spending and sales.

To begin with, consider the final value in your cash flow statement if it is negative or positive. If there are multiple negative cash flows over several months or several quarters, then measures to build revenue and cut costs should be undertaken so that the cash flow is positive. There could be different methods of doing that, like increasing the prices, reducing the excess inventory, modifying marketing strategies, etc.

The cash for the numbers can also help you to understand the different areas of the company and its financial health. For example, the ratio between operating activities cash flow and net sales can help you determine the final sales, which is getting into your business rather than the overhead expenses. The ultimate aim is to increase the cash flow as sales increase, which translates to the cash profit from sales.

Once the basics of analyzing and tracking cash flow or determined, then you can move on to more complicated figures such as the free cash flow of the company, which is essential for the venture capital list. It is also necessary for other investors who are considering investing in your business. These cash flow ratios are considered to be of higher level and can help you to give a broader picture of the finances and financial health of your organization.

Cash Flow Statement – Final words

Finally, it is imperative to understand how cash flows into the business and how to prepare a cash flow statement for your business. Since it is one of the three critical financial statements of your organization along with a balance sheet and income statement, the cash flow statement will help you to understand the financial health of the organization, and this report can also be used to grow and nurture your business. It can help to get more investors and, in turn, get more investors in the company.

Therefore to optimize your financial processes and to make them simpler, it is expected to generate your statement of cash flow. Companies can use a manual method or accounting software such as Wave, QuickBooks, Xero, etc. A business accountant can be equally helpful in preparing cash flow statements and can help you to set the process of cash flow statement generation easy. Many companies have their accountants who would help the businesses to streamline their business. Generating a proper cash flow statement is an integral part of it.