Maintaining a steady cash flow is pivotal for seamlessly operating a business. That is why preparing cash flow statements holds such prevalence. The statement highlights the specifics of cash (and cash equivalents) entering and leaving the organization.
A well-maintained cash flow statement indicates a well-positioned business. As a result, it is included alongside the profit and loss statement and the balance sheet as the three most important statements for companies. This article will explain the key points regarding the statement, helping you better grasp the concept.
Here is everything a business owner should know about cash flow statements.
The first stop on the way to decoding cash flow statements is its definition. A cash flow statement indicates a company’s cash flow, in and out, within a specific period.
It uses three primary channels to express the same:
- Operating activities
- Investing activities
- Financing activities
The cash flow statement is one of the three essential financial statements produced by businesses quarterly/annually. It differs from an income statement examples since it shows exactly how much cash you held throughout the period. Since cash fuels routine business activities, ascertaining how much cash your business possesses at any given point is crucial.
Every business owner understands that not all earnings hold the same value, even if they represent the same amount. Based on the accrual accounting basis, businesses record incomes and expenses when the transactions take place and not when they are remunerated. That is why net income includes numerous accruals or non-cash earnings.
While these are earnings, too, they cannot facilitate a business’ routine functions. As a result, it becomes pivotal to prepare a cash flow statement to keep track of your cash holdings. Additionally, preparing a cash flow statement offers benefits like:
A cash flow statement is designed to keep tabs on different business facets. With its three core sections - operating, investing, and financing, the statement tracks the changes in every sector. It highlights the cash owned, received, and spent, allowing SMEs to measure their performance through an accounting equation.
As mentioned, a cash flow statement shows the specific amount of operating cash a business owns and needs. With this, a business can ascertain what it can afford at a given point.
No business wants to suffer from a lack of liquidity, and a cash flow statement can help prevent this. A thorough cash flow statement can indicate patterns and projections in your business' finances. You can study the statement to create your custom projections and long-term business plans.
You can adopt two approaches to prepare a cash flow statement; via a direct method or an indirect one. Both of them are recognized by the authorities, but SMEs prefer to use the indirect method. Take a brief look at them to understand why:
The direct method records every major operating cash revenue and receipt for the year with its sources. Once the sources are set, the difference between the two categories is deemed “net cash from operating activities.”
While the method is viable, it consumes more effort, making it more unlikely to be used. Plus, it still forces businesses to use the indirect method for reconciling the profit and loss and cash flow statements. The method is also lengthy and requires more resources to be executed.
Since small businesses are already low on resources, adopting the direct cash flow method is not viable.
The indirect method uses the other two statements to calculate the “net cash from operating activities.” Using this method is simpler as you merely need to adjust the net profit and the working capital. Finally, you deduct the tax from the amount, and you get the net cash.
Since all of the required information is already recorded on other statements, the method saves time and resources. As a result, most SMEs prefer using the indirect cash flow method over its alternative.
As mentioned above, businesses can use the other statements to prepare their cash flow statement. The balance sheet shows the change in working capital, while the income statement shows the flow of finances. This results in the formula -
Cash Flow Statement = Balance Sheet + Income Statement
Cash Flow Statement Example
Now that we have the basics out of the way, let’s look at a cash flow statement example:
The example shows how the company proceedings affect a cash flow statement, resulting in the ultimate cash increase/decrease. Another thing to notice is the different sections in the statement. Here is an overview of each section and its purpose.
As mentioned already, a statement of cash flow is divided into three parts. Each section is dedicated to a specific business activity, namely:
• Cash Flow from Operating Activities to calculate the net cash spent/earned through routine business operations.
• Cash Flow from Investing Activities to determine the net income/loss incurred through the sale/purchase of assets.
• Cash Flow from Financing Activities to ascertain the amount spent/earned from financial activities related to loans, credits, and equity.
While every section on a cash flow statement is crucial, small businesses pay the most heed to their operating activities. The section notes every transaction resulting from routine activities, and SMEs mostly make their operations through them. For example, a restaurant will account for the cash received through sales and the cash spent on ingredients.
If you ever wondered how to calculate operating cash flow, here is your chance. Let’s take a look at the example shown above.
The operating activities section has three items, out of which one is positive, and the others are negative. Since the business received $85,000 in cash, this value was added, and the cash spent on inventory and salaries were deducted. This presented us with the net cash flow from operations - $30,000.
This section garners the most attention from mid and large-sized organizations. It specifies the cash generated/spent on investments like real estate, land, and machinery.
Investing activities follow an interesting pattern since the amount spent on purchasing assets is deducted from your earnings. You may think that we are acquiring an asset nonetheless. However, cash flow solely focuses on funds, so an asset purchased is shown as a deduction.
The example shows the two most common entries and ends with the net cash flow from investing.
This section involves the cash generated/spent on financing activities like debentures, shares, loans, etc. There was only one entry worth $6,000 in the example above, and it was deducted.
The accumulation of the three sections’ findings provides us with the net cash generated - $28,000. That is how you can calculate cash flow in the simplest manner.
Also understand about how to calculate account depreciation, which is an accounting method of allocating the cost of a tangible asset
While your accountant must possess one already, here is a cash flow statement template for your reference.
While using the indirect cash flow method is preferable for SMEs, business owners still need to figure out how to use it. Here are two simple tips for doing so:
- A transaction increasing the liabilities equals positive cash flow and vice-versa.
- A transaction increasing the asset side equals negative cash flow and vice-versa.
You are now equipped with the required information regarding cash flow statements. When executed properly, it can help you assess your cash status and even future needs. This significantly simplifies business management for business owners.
You can leverage the information provided in this guide and master your cash proceedings. If needed, you can also contact Fincent to have all your bookkeeping needs taken care of while you focus on scaling your business.