Cash Flow Statement: What It Is and How to Read One (2024)

What Is a Cash Flow Statement (CFS)?

A cash flow statement tracks the inflow and outflow of cash, providing insights into a company's financial health and operational efficiency.

The CFSmeasures how well a company manages its cash position, meaning how well the company generates cash to pay itsdebt obligations and fund itsoperating expenses. As one of the three main financial statements, the CFS complementsthe balance sheet and the income statement. In this article, we’ll show you how the CFS is structured and how you canuse it when analyzing a company.

How the Cash Flow Statement Is Used

The cash flow statement paints a picture as to how a company’s operations are running, where its money comes from, and how moneyis being spent. Also known as the statement of cash flows, the CFS helps its creditors determine how much cash is available (referred to asliquidity) forthe company to fundits operating expenses and pay down itsdebts. The CFS is equally important to investors because it tells them whether a company is on solid financial ground. As such, they can use the statement to make better, more informed decisions about their investments.

Structure of the Cash Flow Statement

The main components of the cash flow statement are:

1. Cash flow from operating activities
2. Cash flow from investing activities
3. Cash flow from financing activities
4. Disclosure of non-cash activities, which is sometimes included when prepared under generally accepted accounting principles (GAAP).
   

Cash From Operating Activities

The operating activities on the CFS include any sources and uses of cash from business activities. In other words, itreflects how much cash is generated from a company’s products or services.

These operating activities might include:

• Receipts from sales of goods and services
• Interest payments
• Income tax payments
• Payments made to suppliers of goods and services used in production
• Salary and wage payments to employees
• Rent payments
• Any other type of operating expenses

In the case of a trading portfolio or an investment company, receipts from the sale of loans, debt, or equity instruments are also included because it is a business activity.

Cash From Investing Activities

Investing activities include any sources and uses of cash from a company’s investments. Purchases or sales of assets, loans made to vendors or received from customers, or any payments related to are included in this category. In short, changes in equipment, assets, or investments relate to cash from investing.

Changes in cash from investing are usually considered cash-out items because cash is used to buy new equipment, buildings, or short-term assets such as marketable securities. But when a company divests an asset, the transaction is considered cash-in for calculating cash from investing.

Cash From Financing Activities

Cash from financing activities includes the sources of cash from investors and banks, as well as the way cash is paid to shareholders. This includes anydividends, payments for stock repurchases, and repayment of debt principal (loans) that are made by the company.

Changes in cash from financing are cash-in when capital is raised and cash-out when dividends are paid. Thus, if a company issues a bond to the public, the company receives cash financing. However, when interest is paid to bondholders, the company is reducing its cash. And remember, although interest is a cash-out expense, it is reported as an operating activity—not a financing activity.

How to Prepare a Cash Flow Statement

1 . Gather Financial Statements

Before you begin, collect the necessary financial statements:

• Income statement: Provides information on revenues, expenses, and net income.
• Balance sheet: Shows the company’s assets, liabilities, and equity at the beginning and end of the period.

2. Determine the Reporting Period

Identify the period for which you are preparing the cash flow statement. This could be monthly, quarterly, or annually.

3. Choose the Method

Decide whether you will use the direct method or the indirect method to prepare the CFS.

• Direct Method: The direct method involves listing all cash receipts and payments during the reporting period.
• Indirect Method: The indirect method starts with net income and adjusts for changes in non-cash transactions.

4. Prepare the Statement

Cash Flow from Operating Activities

Direct Method:

1. List cash receipts: Include cash collected from customers.
2. List cash payments: Include cash paid to suppliers, employees, interest paid, and income taxes paid.
3. Calculate net cash flow from operating activities: Subtract total cash payments from total cash receipts.

Indirect Method:

1. Start with net income: Obtain this from the income statement.
2. Adjust for non-cash items: Add back depreciation and amortization.
3. Adjust for changes in working capital: Account for changes in accounts receivable, inventory, accounts payable, and other working capital accounts.
4. Calculate net cash flow from operating activities: Combine the adjusted net income with changes in working capital.

Cash Flow from Investing Activities

1. Identify cash transactions for investments: Include cash spent on purchasing fixed assets, cash received from selling assets, and cash spent on or received from investing in securities.
2. Calculate net cash flow from investing activities: Subtract cash payments for investments from cash receipts from sales of investments.

Cash Flow from Financing Activities

1. Identify cash transactions for financing: Include cash received from issuing stock or debt and cash spent on repaying debt or buying back stock.
2. Calculate net cash flow from financing activities: Subtract cash payments for financing activities from cash receipts from financing activities.

5. Combine All Sections

Add the net cash flows from operating, investing, and financing activities to determine the overall change in cash and cash equivalents for the period.

6. Reconcile with Beginning Cash

Add the change in cash to the beginning cash balance to arrive at the ending cash balance, ensuring it matches the cash balance reported on the balance sheet.

How Cash Flow Is Calculated

There are two methods of calculating cash flow: the direct method and the indirect method.

Direct Cash Flow Method

Thedirect methodadds up all of the cash payments and receipts, including cash paid to suppliers, cash receipts from customers, and cash paid out in salaries. This method of CFS is easier for very small businesses that use the cash basis accounting method.

These figures can also be calculated by using the beginning and ending balances of a variety of asset and liability accounts and examining the net decrease or increase in the accounts. It is presented in a straightforward manner.

Indirect Cash Flow Method

With theindirect method, cash flow is calculated by adjusting net income by adding or subtracting differences resulting from non-cash transactions. Non-cash items show up in the changes to a company’s assets and liabilities on the balance sheet from one period to the next. Therefore, the accountant will identify any increases and decreases to asset and liability accounts that need to be added back to or removed from the net income figure, in order to identify an accurate cash inflow or outflow.

Changes in accounts receivable (AR) on the balance sheet from one accounting period to the next must be reflected in cash flow:

• If AR decreases, more cash may have entered the company from customers paying off their credit accounts—the amount by which AR has decreased is then added to net earnings.
• An increase in AR must be deducted from net earnings because, although the amounts represented in AR are in revenue, they are not cash.

What about changes in a company's inventory? Here's how they are accounted for on the CFS:

• An increase in inventory signals that a company spent more money on raw materials. Using cash means the increase in the inventory's value is deducted from net earnings.
• A decrease in inventory would be added to net earnings. Credit purchases are reflected by an increase in accounts payable on the balance sheet, and the amount of the increase from one year to the next is added to net earnings.

The same logic holds true for taxes payable, salaries, and prepaid insurance. If something has been paid off, then the difference in the value owed from one year to the next has to be subtracted from net income. If there is an amount that is still owed, then any differences will have to be added to net earnings.

Limitations of the Cash Flow Statement

Negative cash flow should not automatically raise a red flag without further analysis. Poor cash flow is sometimes the result of a company’s decision to expand its business at a certain point in time, which would be a good thing for the future.

Analyzing changes in cash flow from one period to the next gives the investor a better idea of how the company is performing, and whether a company may be on the brink of bankruptcy or success. The CFS should also be considered in unison with the other two financial statements (see below).

Cash Flow Statement vs. Income Statement vs. Balance Sheet

The cash flow statement measures the performance of a company over a period of time. But it is not as easily manipulated by the timing of non-cash transactions. As noted above, the CFS can be derived from the income statement and the balance sheet. Net earnings from the income statement are the figure from which the information on the CFS is deduced. But they only factor into determining the operating activities section of the CFS. As such, net earnings have nothing to do with the investing or financial activities sections of the CFS.

The income statement includes depreciation expense, which doesn't actually have an associated cash outflow. It is simply an allocation of the cost of an asset over its useful life. A company has some leeway to choose its depreciation method, which modifies the depreciation expense reported on the income statement. The CFS, on the other hand, is a measure of true inflows and outflows that cannot be as easily manipulated.

As for the balance sheet, the net cash flow reported on the CFS should equal the net change in the various line items reported on the balance sheet. This excludes cash and cash equivalents and non-cash accounts, such as accumulated depreciation and accumulated amortization. For example, if you calculate cash flow for 2019, make sure you use 2018and 2019balance sheets.

Example of aCash Flow Statement

Below is an example of a cash flow statement:

From this CFS, we can see that the net cash flow for the 2017 fiscal year was $1,522,000. The bulk of the positive cash flow stems from cash earned from operations, which is a good sign for investors. It means that core operations are generating business and that there is enough money to buy new inventory.

The purchasing of new equipment shows that the company has the cash to invest in itself. Finally, the amount of cash available to the company should ease investors’ minds regarding the notes payable, as cash is plentiful to cover that future loan expense.

The Bottom Line

A cash flow statement is avaluable measureof strength, profitability, and the long-term future outlook of a company.The CFS can help determine whethera company has enough liquidity or cash to payitsexpenses.A company can use a CFS to predict future cash flow, which helps with budgeting matters.

For investors, the CFSreflects a company’s financial health, since typicallythe more cash that’s available for business operations, the better. However, this is not a rigid rule. Sometimes, a negative cash flow results from a company’s growth strategy in the form of expanding its operations.

By studying the CFS, an investor can get a clear picture of how much cash a companygenerates and gain a solid understanding of the financial well-being of acompany.