A cash flow statement is among the most important financial statements of a business, it offers a comprehensive overview of a company’s cash movements over a defined period, typically an accounting cycle. This document illustrates the organization’s capacity to function effectively in both the short and long run, highlighting the inflow and outflow of cash.
What is in a Cash Flow Statement?
Analyzing a cash flow statement allows you to observe the cash generated by various activities, enabling informed business decisions. It’s crucial to recognize that cash flow differs from profit, underscoring the importance of interpreting a cash flow statement in conjunction with other financial documents.
Cash flow statements are divided into three main sections: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.
- Operating activities outline the cash generated when a company provides its regular goods or services, encompassing both revenue and expenses.
- Investing activities involve cash flow associated with the acquisition or disposal of assets using available cash, not debt. This typically includes physical assets like real estate or vehicles, as well as non-physical assets such as patents.
- Financing activities specify cash flow resulting from both debt and equity financing.
Ideally, cash generated from operating income should consistently surpass net income. A positive cash flow reflects a company’s financial stability and its capability to expand its operations.
How to Compute the Cash Flow?
There are two usual approaches employed for computing and organizing the operating activities segment of cash flow statements.
The first approach for calculating the operation section is the direct method. This method relies on transactional details affecting cash within a specific timeframe.
To compute the operation section through the direct method, add up all cash received from operating activities and deduct all cash payments made for operating activities.
The indirect method is another way to prepare the operating section. This method relies on accrual accounting, where the accountant records revenues and expenses at times different from when cash is paid or received. This results in differences between cash flow from operating activities and net income.
Unlike the direct method which organizes transactional data, the indirect method starts with the net income from the income statement. The accountant then adjusts this number to account for the impact of accruals made during the period.
In simpler terms, the accountant converts net income into actual cash flow by identifying and removing non-cash expenses, such as depreciation (a reduction in the value of an asset over time) and amortization (spreading payments over multiple periods).
How to Understand the Cash Flow Statement?
Cash flow statements help identify a business’s current stage, whether it’s a fast-growing startup, a stable and profitable company, undergoing changes, or facing a decline. Managers can use these statements to assess their department’s impact on the company and adjust team activities accordingly. Cash flow also influences internal decisions like budgeting and staffing.
Two Types of Cash Flow
Cash flow is usually shown as either positive or negative. Let’s understand what these labels indicate.
Positive Cash Flow
Positive cash flow occurs when a company receives more money than it spends over a certain time. This is great because having extra cash allows the company to reinvest, pay off debts, and explore new ways to grow.
Having positive cash flow doesn’t always mean making a profit. A business can be profitable without positive cash flow, and vice versa.
Negative Cash Flow
Negative cash flow happens when a company spends more money than it earns. However, this doesn’t necessarily mean losing profit. Negative cash flow can be due to mismatched expenses and income, which should be fixed promptly.
It can also result from a company’s choice to invest in future growth. Monitoring changes in cash flow over time helps assess the overall performance of the business.
Cash flow signifies the movement of cash in and out of a business. For finance professionals, grasping cash flow metrics is crucial for assessing a company’s financial well-being. Profitable companies may face challenges if they experience negative cash flow, affecting their ability to cover expenses and grow. On the flip side, businesses with positive cash flow and growing sales may still struggle to turn a profit, a common situation for startups and expanding businesses.