The statement of cash flows, or the cash flow statement, is one of the three primary financial statements used to determine a company’s financial health. The other two statements: the balance sheet and income statement, have already been addressed in previous articles. 

This article centers on the statement of cash flows under the accrual accounting method, where transactions are recorded in the general ledger as soon as they are earned or incurred. This recording happens even if the cash has not yet changed hands. 

This process of regulating the cash coming in and going out over a period of time is vital to the success of a business. We will cover the importance of developing a cash flow statement, the components, and how to calculate and interpret this valuable data. 

Why Do We Need a Cash Flow Statement?

The cash flow statement (CFS) takes the previous period’s ending cash or net income. It compares this to the closing amount of the current period while tracking the precise cash movement throughout the entire period.

An important factor from a business perspective is the CFS can verify that the revenues and expenses reported on the income statement are consistent with the actual cash movement in and out of the organization. Because of this, the CFS acts as a bridge between the income statement and the balance sheet. 

Another important factor in creating a cash flow statement is liquidity. Regardless of your company’s revenue, you must ensure enough liquid cash to cover necessary expenses like taxes and payroll. 

Finally, one can use the cash flow statement to create cash flow projections. These projections allow you to plan for the future and understand how much money your business has 6-12 months down the road. If you are secure in your cash flow projections a year from now, you can be more confident in making purchases now. 

Components of a Statement of Cash Flows

There are three main sections within the statement of cash flows. Each examines a different source and uses for the cash. These are operating activities, investing activities, and financing activities. Together, all three comprise the basic structure of the cash flow statement and are detailed below.

    1. Operating activities – are the main revenue-generating activities of the business. These transactions monitor when a company has delivered its goods or services. 
    2. Investing activities – are set outside of the business’ core activities. This group includes selling or purchasing property, stock in other companies, patents, etc.
    3. Financing activities – are related to funding the business. This cash involves repayment or equity to third-party banks or business owners. 

Both revenue and expenses are in each of these groups. Negative numbers represent cash outflows, and positive numbers represent inflows. Generally, a company is successful if it consistently brings in more cash than it spends.

Calculation Methods

To calculate your organization’s cash flow, you need to apply either the direct or indirect method. 

    • Direct method: this method mirrors the income statement. Under operating activities, the cash receipts from customers reflect revenue, and cash paid to suppliers, employees, loan interest, and taxes mirror expenses. The company needs to produce and track cash receipts for every cash transaction. For that reason, smaller businesses typically prefer the indirect method.
    • Indirect method: The indirect cash flow method is more straightforward, as it doesn’t require details of every cash movement, such as the date and amount of cash received and when a customer pays for goods. All the figures needed are on the income statement and the balance sheet.

A benefit of the direct method is that it is more precise. This precision makes the direct method an advantage if a business is experiencing cash flow problems and must calculate these metrics regularly. However, the indirect method is the more practical choice most of the time.

Final Thoughts

Cash flow statements reveal to investors and lenders which phase the business is currently operating. Analyzing the numbers indicate if a company is a rapidly growing startup or a mature and profitable company. It can also reveal whether a company is going through transition or in a state of decline.

The CFS shows a different aspect of your business that the other two financial statements overlook. You can see how much cash a specific product or service generates or if a business is spending too much on its investments. This information allows owners and managers to make appropriate changes to the organization as necessary.

A company’s understanding of its cash inflows and outflows is critical for meeting its short-term and long-term obligations to its vendors and suppliers, employees, and lenders. In addition, seeing how your cash changes over time, rather than an absolute dollar amount at a specific point in time, is a solid metric to recognize for your company’s financial well-being.

 

With FINSYNC’s network of independent financial professionals, you can hire a vetted bookkeeper or accountant to manage your cash flow for your business.