A complete guide to understanding cash flow statement

Updated 20 March 2023

Cash flow analysis helps you understand your company's cash flow and returns. The amount of cash it generates can quantify the success of your business over a period of time. A cash flow statement helps in doing so by representing the cash inflows and outflows of your business. In this article, we discuss what a cash flow statement is, find out what it does, why it's important and learn how to calculate it.

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What is a cash flow statement?

A cash flow statement is a financial statement that represents and records the cash generated and used over a certain duration of time. Often, a cash flow statement contains segments such as cash flow resulting from operating activities, financing activities and investing activities. The net cash flow is the summation of all cash flows from operating, financing and investing. Here's what these three segments contain:

Cash flow from operations (CFO)

Operational activities involve the source of a company's cash generation, such as the production, sale and delivery of business proceeds and the disbursal of payments from customers. These could include the purchase of raw materials, an inventory of buildings, advertising and shipment of the product. This is essentially the difference between the cash flow generated by customers and that which is disbursed to suppliers.

Cash flow from finance (CFF)

This is the main component of the net cash flow. Financing activities involve the flow of cash from investors, such as shareholders and financial institutions, and the company's equity, along with the flow of cash to shareholders in the form of dividends. A positive cash flow from financing can indicate the overall financial health of a company.

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Cash flow from investment (CFI)

Investing activities involve changes in investment, equipment, buying and selling assets like securities, real estate, issuance (repayment) of debt and other payments. The cash flow from investing doesn't cover the cash inflow from shareholders or bondholders. When a customer receives a loan, the same applies to the cash flow statement only when they repay the debts.

How to use a cash flow statement

You need a balance sheet and income statement to make a cash flow statement for your business. The summation of the balance sheet and income statement results in a cash flow statement. Here are some of the steps in using a cash flow statement:

1. Calculate the net income

You can generate the net income by referring to the income statement. The income statement defines your company's cash inflows and outflows. At the same time, the balance sheet shows how these transactions affect a variety of accounts, such as accounts receivable and accounts payable, along with the inventory.

2. Convert the net income to net cash flow from operations

Your income statement is based on the accrual method of accounting. Accruals refer to the recording of revenues that a company has earned but for which it's not yet received payment alongside the overdue expenses incurred by the company. This helps in making adjustments to manage net income with net cash flow. The net cash flow is the difference between incoming and outgoing money from your business for a specific period of time.

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3. Determine the net cash flow from investing and financing activities

After determining the net cash flow from operations, the next step is to calculate your net cash flow from financing and investments. You can do this by adding your inflows and subtracting your outflows. After this, you can add up all the net cash flows from the three values, which determine the net increase or decrease in your cash flows for a specific duration of time.

Related: Gross pay vs. net pay: definitions and examples

Methods for calculating a cash flow statement

There are two common methods to calculate cash flow statements. They include:

Direct Method

This approach uses cash flow information from business operations. You calculate the cash flow by taking into account all cash inflows from operating activities and subtracting all cash outflows from operations. The direct method takes more organisation than the indirect method and is most likely used by small businesses whose accounting is cash-based rather than accrual-based.

Indirect Method

This method is dependent on the accrual basis of accounting, in which the accountant records revenues and expenditures at times other than when the fund was paid or received. This means that you select your income statement to eliminate transactions that don't show cash flow. Many businesses prefer this method because of its simplicity.

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Positive and negative cash flow

Here are some of the differences between positive and negative cash flow:

Positive cash flow

A positive cash flow indicates that a company has more cash inflows than cash outflows during a given period. Having excess cash flow can help a company reinvest the cash in itself and its shareholders, find new ways to grow the business and even pay off debts. Having positive cash flows doesn't necessarily translate to profit. Your business can make money without having a positive cash flow, and you can have a positive cash flow without making a profit.

Negative cash flow

Negative cash flow indicates that a company's cash outflow exceeds its cash inflow over a certain period, but that doesn't necessarily mean a loss of profit. Instead, negative cash flows can be due to inconsistencies in expenditures and revenues and calls for quickly addressing and resolving the issues. Negative cash flows may also be due to a company's decision to expand operations and invest in future growth. It's important to analyse the change in cash flows from different time periods, which can indicate an enterprise's overall financial health and performance.

The importance of cash flow statements

The cash flow statement allows users to determine the extent to which a company's revenue generates cash and predicts the potential for a company to generate cash in the future. Here are the reasons why cash flow statements are important:

Assists in making cash forecast

A cash flow statement can help in cash flow forecasting, which shows the projected cash based on revenues and expenditures. This can help a business make decisions regarding activities such as financing, capital spending and investments.

You can carry out cash forecasting for a range of time horizons. A short-term cash forecast may cover a month and help identify any funding requirement or excess cash in the immediate future. A long-term forecast is used to look at sales and purchases further into the future, such as over a year or even longer.

Measures the financial strength of a company

Since a cash flow statement keeps an account of cash and cash equivalents, it provides key insights into the company's generation and spending of cash. This assists shareholders and investors in determining the quality of a company's earnings before making decisions. The other two statements, the income statement and the balance sheet, don't track the actual movements of cash. Cash flow statements remove the non-cash transactions and reflect the true financial health of a company by analysing the following:

  • sources of cash for the company

  • the overall increase or decrease in cash

  • the free cash flow that the company can further reinvest

Ascertains liquidity of a company

Cash flow statements help determine the cash flow from operations, which can help measure liquidity or a company's ability to pay its obligations when they're due. It can identify organisational liquidity and indicate the amount and probability of future cash flows. Having positive cash flows shows that the company has some liquidity.

Helps in financial planning and coordinating

A cash flow statement shows a company's cash resources and how they're used in a given period of time. This helps in conducting financial planning to assess your financial situation and formulate strategies to achieve certain financial objectives. In addition, all the financial units can coordinate to accomplish the same goals. This is important in managing risk and determining financial policies in the future.

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Tips for better cash flow management

The purpose of creating a cash flow statement is to better evaluate and understand the company's cash inflows and outflows in operations, investments and financing. Here are some tips you can follow to achieve better financial health:

  • keep track of expenditures with the help of online cash flow management software

  • avoid unnecessary and excessive spending to manage cash flow more effectively

  • manage future threats like loan repayment dates and debtors

  • preserve cash reserves to cover unforeseen liabilities

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