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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