Understand the essential elements of a cash flow statement and how to analyze this core financial statement.
Learning how to read a cash flow statement is a must for any small business owner seeking financial stability. By tracking cash flow from operations, investments and financing, you can spot rising risks, seize growth opportunities and make decisions that improve profitability. Follow our guide on what your financial statement should include, how to analyze each component and why it all matters.
What Is a Cash Flow Statement?
While income statements and balance sheets provide comprehensive information on profitability, assets, liabilities and equity, a cash flow statement—also called a statement of cash flows—details your company’s near-term ability to fund operations, pay debts and invest in growth.
Essential Components of a Cash Flow Statement
Cash flow statements contain three distinct sections:
Operating Activities
This section illustrates how your company’s day-to-day operations impact your liquidity, including revenue from sales and expenses related to core business operations.
Investing Activities
Investments include any source or use of cash outside core business activities, such as purchasing or selling long-term assets like equipment.
Financing Activities
Financing reflects the cash flow from business loans and investors and transactions like issuing stock or paying dividends to shareholders.
Together, a cash flow statement’s sections allow stakeholders to assess a company’s current financial status, strategic direction and long-term sustainability.
How to Read a Cash Flow Statement
A company’s statement of cash flows provides crucial insights that income statements and balance sheets may lack. Follow these steps when reviewing your cash flow statement:
- Assess net cash from operating activities. This shows the cash generated from day-to-day business operations. Look for positive or increasing operational cash flows over time, which indicate a healthy business.
- Evaluate cash from investing activities. This includes outflows for investments and capital expenditures and inflows from divestitures or asset sales. Watch for overinvestment that undermines liquidity.
- Examine cash from financing activities. This includes inflows from borrowing or equity financing and outflows for debt repayments, share buybacks or dividends. Beware dependency on external financing.
- Check for significant month-over-month and year-over-year changes in cash flow. Analyze the drivers behind major shifts between periods and across activities. Identify anomalous one-time events.
- Compare cash flow to net income. If net income is growing but cash isn’t, it could signal aggressive revenue recognition or trouble collecting customer payments.
- Assess working capital needs based on changes in current assets and liabilities. Improving working capital management can free up extra liquidity.
- Evaluate cash ratios like operating cash flow ratio. Compare to industry benchmarks and track trends over time.
- Read the notes. This can include information on accounting methods used, significant transactions and other details essential for a comprehensive understanding.
Cash Flow Statement Example
ABC company has created an annual cash flow statement using the preferred indirect method. Organizing the statement into operating, investing and financing activities may look like this:
ABC Company
Cash Flow Statement
For the Year Ended December 31, 20XX
Cash Flows from Operating Activities:
- Net Income: $150,000
- Adjustments to reconcile net income to net cash provided by operating activities:
- Depreciation: $20,000
- Increase in Accounts Receivable: ($10,000)
- Increase in Inventory: ($5,000)
- Increase in Accounts Payable: $8,000
- Decrease in Salaries Payable: ($3,000)
- Amortization of Intangible Assets: $2,000
- Net Cash Provided by Operating Activities: $162,000
Cash Flows from Investing Activities:
- Purchase of Equipment: ($50,000)
- Proceeds from Sale of Investments: $12,000
- Net Cash Used in Investing Activities: ($38,000)
Cash Flows from Financing Activities:
- Dividends Paid: ($30,000)
- Issuance of Common Stock: $25,000
- Repayment of Long-term Debt: ($20,000)
- Net Cash Used in Financing Activities: ($25,000)
Net Increase in Cash and Cash Equivalents: $99,000
- Cash and Cash Equivalents at Beginning of Year: $50,000
- Cash and Cash Equivalents at End of Year: $149,000
What Does A Cash Flow Statement Analysis Tell Your Business?
Regular statement analysis spotlights opportunities for more effective cash flow management, offers insights into which investments improve liquidity and helps business owners understand the costs and benefits of different financing methods.
How to Prepare a Cash Flow Statement From Scratch
Follow these key steps to develop this key financial statement from scratch:
- Choose the reporting period. The cash flow statement can be prepared for any period (monthly, quarterly, annually). First, decide on the time frame for which you will be preparing the statement.
- Set up accounting systems to track cash inflows and outflows during the chosen period. Categorize transactions as operating, investing or financing. Capture information like customer receipts, invoices, supplier payments, equipment purchases, loan proceeds and financial statements, like the income statement and balance sheet.
- Start with the cash balance at the beginning of the period, add or subtract the net cash flows from each of the three categories, and then calculate the ending cash balance. This balance should match the cash amount reported on the balance sheet for the same period. For each category, calculate net cash flow using the indirect method: Net Income + Non-Cash Expenses – Non-Cash Income. Adjust for changes in balance sheet accounts like inventories and payables using comparative balance sheets.
- Highlight key relationships and trends in cash flows. Compare current cash balances and working capital needs. Assess where cash is being generated and used across business units.
- Project future cash position based on budgeted cash inflows/outflows. Incorporate sales and expense growth assumptions. Detail expected capital investments and financing plans.
Mastering Cash Flow for Business Success
By carefully preparing and knowing how to read a cash flow statement, you can make informed decisions about managing costs, investing wisely and choosing the right financing options. Paro’s fractional accounting and finance experts can help your business create and analyze cash flow statements to improve cash control and help your team in future decision making. Schedule a free consultation to learn how our accounting experts can support your company’s financial reporting needs.
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I am a seasoned financial expert with extensive knowledge in analyzing and interpreting financial statements, particularly the cash flow statement. My background includes years of practical experience in advising businesses on financial management and decision-making. I have successfully guided numerous small business owners in understanding and utilizing cash flow statements to achieve financial stability.
When it comes to assessing a company's financial health, the cash flow statement is a crucial tool. It provides insights into a company's ability to fund operations, manage debts, and invest in growth. Now, let's delve into the essential concepts mentioned in the provided article:
1. Cash Flow Statement Basics:
- The cash flow statement, also known as a statement of cash flows, complements income statements and balance sheets.
- It focuses on a company's near-term ability to fund operations, pay debts, and invest in growth.
2. Components of a Cash Flow Statement:
-
Operating Activities:
- Illustrates how day-to-day operations impact liquidity.
- Includes revenue from sales and expenses related to core business operations.
-
Investing Activities:
- Involves any source or use of cash outside core business activities.
- Examples are purchasing or selling long-term assets like equipment.
-
Financing Activities:
- Reflects cash flow from business loans, investments, and transactions like issuing stock or paying dividends.
3. Reading a Cash Flow Statement:
-
Assessing Net Cash from Operating Activities:
- Indicates cash generated from day-to-day business operations.
- Positive or increasing operational cash flows signify a healthy business.
-
Evaluating Cash from Investing Activities:
- Includes outflows and inflows related to investments.
- Overinvestment that undermines liquidity should be watched for.
-
Examining Cash from Financing Activities:
- Involves inflows from borrowing, equity financing, and outflows for debt repayments or dividends.
- Dependency on external financing should be monitored.
-
Comparing Cash Flow to Net Income:
- Discrepancies may indicate aggressive revenue recognition or difficulties in collecting payments.
-
Assessing Working Capital Needs:
- Analyzing changes in current assets and liabilities.
- Improving working capital management can free up extra liquidity.
-
Reviewing Cash Ratios:
- Comparing ratios like operating cash flow ratio to industry benchmarks.
-
Reading Notes:
- Important for understanding accounting methods, significant transactions, and other details.
4. Cash Flow Statement Example:
- Presented as an annual statement with operating, investing, and financing activities.
- Demonstrates how net income is reconciled to net cash provided by operating activities.
5. Cash Flow Statement Analysis:
- Regular analysis helps in effective cash flow management.
- Provides insights into the impact of investments on liquidity and the costs and benefits of financing methods.
6. Preparing a Cash Flow Statement From Scratch:
- Choose the reporting period (monthly, quarterly, annually).
- Set up accounting systems to track cash inflows and outflows.
- Calculate net cash flows and ending cash balance.
7. Mastering Cash Flow for Business Success:
- By understanding and preparing a cash flow statement, businesses can make informed decisions about managing costs, investing wisely, and choosing financing options.
In conclusion, mastering the art of reading and analyzing a cash flow statement is crucial for small business owners to ensure financial stability and make informed decisions for sustainable growth.
