What Is a Cash Flow Statement and Why Is It Important to a Business?

As a manager or business owner, it’s important to know whether or not your business is making a profit. For this, most people usually refer to their income statements. But having a profit doesn’t necessarily mean you have enough cash on hand to pay for immediate expenses.

That’s when the cash flow statement comes in. A cash flow statement is a powerful tool to track your business’s cash inflows and outflows. In addition, it lets you know the money that is available for your business at a certain time. In today’s article, we’ll walk you through the most essential things you need to know about a cash flow statement. 

What is a cash flow statement?

The cash flow statement is a financial statement that outlines the amount of cash and cash equivalents entering and leaving a business in a given period of time. It’s one of the three most important financial documents, along with the income statement and balance sheet.

Much like the income statement, the cash flow statement measures a company’s performance over a given time. However, while income statements are helpful in determining your company earnings, spending, and profitability, they don’t always indicate how much cash you have on hand.

Instead, the cash flow statement adds adjustments to the data on the income statement, so you can see your net cash flow—the exact amount of cash you have on hand for that period.

For example, a depreciation expense, which is recorded as a monthly expense on the income statement, doesn’t have an actual cash outflow associated with it. It’s basically an allocation of the cost of an asset over its useful life. You’ve already paid for the asset you’re depreciating. Now you’re just keeping track of it on a monthly basis to see how much it costs you each month. Each business has some flexibility in selecting its depreciation method, which affects the depreciation expense reported on the income statement.

Read also: What’s Net Cash Flow and How Do You Use It?

Structure of a cash flow statement

The three main sections of the cash flow statement are cash from operating activities, investing activities, and financing activities. 

Cash from operating activities: This source denotes how much money a company makes from its core operations. 

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

Cash from investing activities: This is the cash generated from the sales and purchases of equipment and assets (tangible or intangible), loans paid to suppliers or received from consumers, and any payments related to a merger or acquisition. In a nutshell, changes in equipment, assets, or investments are related to the cash generated by investing activities. 

Cash from financing activities: This type of cash comes from investors or banks, as well as the uses of cash delivered to shareholders. Short and long-term debt, issuance of equity, purchase/sale of treasury stock, payment of dividends, etc., are included in this category. 

How do you calculate cash flow?

There are two formulas to calculate your cash flow: the direct method and the indirect method.

The direct method

The direct method for calculating cash flow is based on cash accounting information. This method measures the funds that come in, mainly from sales, and the money that goes out, which are usually payments to suppliers. Thanks to its simplicity, small companies often use this method to calculate their cash flow.

The indirect method

In contrast to small businesses, big companies adopt accrual accounting as their main accounting method. Under accrual accounting, transactions are recorded when they are incurred rather than awaiting payment. This means a purchase or expense is recorded as a transaction even though the funds are not received or bills are not paid immediately.

This causes a mismatch between net income and actual cash flow because not all transactions on the income statement involve actual cash items (for example, depreciation expenses). Therefore, some elements must be re-evaluated regarding cash flow from operations. With the indirect method, cash flow is calculated by adding or subtracting non-cash transactions from net income. 

You may be also interested in: What You Need to Know about Operating Cash Flow Ratio

Why do you need the cash flow statement?

1. It shows your liquidity

The cash flow statement lets you know how much money you have at a specific time. As a result, in case you need to purchase an asset, you’ll know what you can afford and what you can’t.

2. It gives insight into spending activities

If you want to know how your company is spending and where your money is going, look at the cash flow statement. Cash flow statements provide a comprehensive view of a company’s payments that aren’t shown in a profit and loss statement. For example, if your business took out a loan and is paying it back, those payments will not appear on your profit and loss statement.

3. It helps you with short-term planning

When it comes to short-term planning, cash flow statements are very valuable. Using the cash flow statement, managers can predict cash flow in the near future and keep track of expenditures to accomplish particular, short-term goals. 

4. It suggests ways to increase cash inflow capability

When it comes to increasing a business’s cash inflows, people often think of generating higher revenue. But it isn’t the only option. You can improve your cash inflow by “adjusting” some expenses. For example, if a company’s employees discover that they are spending a lot of money on inventory, they could find ways to efficiently use inventory to collect receivables faster.

The bottom line

The cash flow statement is one of the three key reports, along with the income statement and balance sheet, used to determine a company’s success. The cash flow statement tracks your business’s cash inflows and outflows in a given time. 

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What You Need to Know about Operating Cash Flow Ratio

If you’re running a business, make sure you’re analyzing your business health regularly. This lets you know how your business is doing and whether or not to adjust any strategies. Liquidity is one of the four areas of financial health along with solvency, profitability, and operating efficiency. Liquidity refers to how easily your business’ assets can be converted into cash.

But do you know how to calculate the liquidity of your business? It’s not complicated at all because all you need is the right tool. Today, we’ll introduce you to the operating cash flow ratio, a metric to gauge your company’s liquidity.

What is the operating cash flow ratio?

Operating cash flow ratio measures how well a business can pay off its current liabilities with the cash flow generated from its core business operations. As earnings can be manipulated by managing assets, this ratio is considered a more accurate measure of a company’s liquidity in the short term.

Because operating cash flow is related to the ability to pay off liabilities (debts and financial obligations of a business), the higher ratio, the better. A high number indicates that a company has generated more cash in a period than what is needed to pay off its current liabilities. On the other hand, a low number points out that there isn’t enough cash to cover its current liabilities. Therefore investors and analysts will have to call for more capital. 

Operating cash flow ratio equation

Understanding operating cash flow ratio components

Before we learn about the operating cash flow ratio formula, let’s have a quick tour of its components. 

Current liabilities

Current liabilities or short-term liabilities are debts that must be paid within a year and can be found on the balance sheet. These include:

  • Supplier payments
  • Short-term debt payments such as loans to the bank or credit union
  • Dividend payments to investors
  • Taxes charges

It’s an obligation of every business to pay off its current liabilities. To do so, set current liabilities against current assets. It’s a good sign if they balance each other. It’s even greater if your business’s current assets are more than enough to cover your current liabilities. On the other hand, if your business doesn’t have enough assets to make up for short-term liabilities, you could face financial trouble.

Operating cash flow

Operating cash flow reports inflows and outflows as a result of regular operating activities. It includes the money your company gains from ongoing activities, such as manufacturing and selling goods or providing a service to customers. However, it doesn’t cover any other funds within the business, such as capital expenditures or investments. 

Operating cash flow is calculated by deducting the business operating expenses from the total sales revenue. It shows business owners and operators the big picture concerning their business’ money flow, where funds are coming from, and going to. 

By looking at the cash flow from operating activities, you can determine the financial success of your business’s core activities. As a result, it greatly impacts the company’s liquidity. It allows you to plan out how to generate and maintain sufficient cash necessary for operational efficiency and other necessary needs.

The equation

Now that we know about two components associated with the operating cash flow ratio, it’s time to learn the equation.

Operating Cash Flow Ratio = Operating cash flow / Current Liabilities

As you can see, there’s nothing complex here, simply divide cash flow from operations by current liabilities, and you’ll have an answer. 

However, the preciseness of the equation lies in the accuracy of the numbers input. To make sure there’s no error in the amount of operating cash flow and current liabilities, your bookkeeper or accountant needs to keep and record all the payment receipts and sales proposals accordingly.

Isn’t it frustrating to go through that process manually when you’re living in the technological era? To be honest, there’s no benefit of doing things that way anymore because it takes up a lot of time. As a result, you’ll have to pay the price of working extra hours to cover other tasks that you don’t have enough time to finish. 

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Example of the operating cash flow ratio

Imagine that Company A has a net cash flow from operations of $500,000 and a current liabilities of $120,000. Apply the formula and you’ll have:

500,000 / 120,000 = 4.17

This means that Company A earns $4.17 from operating activities per every $1 of current liabilities. Alternatively, it can be viewed as, “Company A can cover its current liabilities 4.17x over.”

The bottom line

Operating cash flow ratio provides you with a snapshot of your regular operating activities. By looking at this number, you can determine how sufficient your business is doing. Additionally, accessing the operating cash flow ratio to know your ability to pay off liabilities in a given period will keep your business out of trouble from financial litigation.