A cash flow statement is one of the most important financial statements. It shows how much money is coming in and going out of your business over a specific time period. Along with the balance sheet and income statement, a cash flow statement is crucial for measuring an organization’s viability.
First, let’s see what cash flow statements do for business. After that, you will understand why it is vital for business decisions. Then, we’ll go through the different formats, a sample cash flow statement, and how to prepare it.
At the end of this article, you would have become an expert at preparing and analyzing cash flow statements.
According to Wikipedia, a cash flow statement is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents and breaks the analysis down to operating, investing, and financing activities.
Also known as the statement of cash flow, it serves to manage and track the inflow and outflow of cash. Simply put, a business can measure the amount of cash used and for what purpose from the cash flow statement.
It is one of the three key reports (in addition to the income statement and the balance sheet). Users of financial statements need them to measure the financial health of a business. As a result, forecasting and planning are made possible and realistic.
Why the Cash Flow Statement is Necessary
You see, income statements show you how much money you’ve earned and spent. However, they don’t tell you how much cash you have for a specific period. In other words, the income statement lumps up all your financials without showing your liquidity but a cash flow statement shows the liquidity status of a business.
Liquidity measures how much cash a business has to pay its obligations. Such monies can also come in handy to take advantage of investment opportunities.
For instance, an income statement adds earnings that have not yet been received simply because the transaction occurred. They also deduct expenses from income even when the money has not yet been sent to, say, suppliers.
This method of recording transactions is known as the accrual basis of accounting. It measures income and expenses when earned or incurred—not when the money leaves or enters your bank accounts. Because of this, such financial statements may hide the real working capital of a business.
It is not enough to start a business or have a corporate-level strategy. Equally important is the need to understand what the numbers mean. This is where the cash flow statement comes in. This statement makes adjustments to show actual cash on hand per time. In other words, it is based on accounting on a cash basis.
Components of a Cash Flow Statement
Now you have learned about the cash flow statement. Let us look at the 3 components of the cash flow statement.
Cash Flow from Operating Activities
Cash flows from operating activities arise from the revenue-generating activities of an organization. Cash received from the sale of goods or services is an example. Also, royalties from using the company’s intellectual property, commissions on sales for other entities, and so on.
Cash Flow from Investing Activities
This arises from the changes due to gains or losses from the organization’s investment activities. Additionally, it can come from investments in or sales of assets, that is, fixed assets.
Cash Flow from Financing Activities
This is a result of changes in monetary value during a specific period. This arises from transactions with owners or lenders to provide long-term funds to the company or to pay back such funds to the lenders
A Guide on how to Prepare Cash Flow Statement
#1. Determine your Starting Balance
Firstly, in preparing a cash flow statement, you must determine the starting balance of cash and cash equivalents. You can find this value on the income statement, which covers the same accounting period.
Additionally, you should gather other important documents – you need to obtain your balance sheet, a statement of changes in equity, a statement of cash flows for the previous reporting period, and other information about the current period from investment documents for instance.
#2. Work out any changes to your balance sheet over the current period…
Take a look at your assets, equities, and liabilities. Subtract the closing balance sheet figure from the opening balance sheet figure.
Put the balance sheet changes on your statement of cash flows. Then look at all the changes you recorded in the previous step. Enter them into a blank cash flow statement by placing them in the appropriate section( operating, investing, or financial).
Calculate Cash Flow from Operating Activities
Secondly, calculate cash flow from operating activities. You can do this by using either the direct or indirect method. Cash from operating activities shows the amount of money a business generates from operational activities.
Calculate Cash Flow from Investing Activities
After you determine cash flows from operating activities, you need to calculate cash flows from investing activities. So you need details relating to buying and selling of fixed assets like property, facilities, and equipment.
Calculate Cash Flow from Financing Activity
Then, determine cash flow from debt and equity financing. This is called cash flow from financing activities. It results from raising cash and paying back debts to investors and creditors.
#3. Make Adjustments for Non-Cash Items
This includes depreciation expenses, cash payable, receivables, inventory, income tax expenses, etc. We will see how to do this in our illustration.
Do final calculations by summing up all the individual entries. Next, calculate the overall change in the balance sheet while adjusting for non-cash items. This step will provide you with the total cash movement for the item.
Lastly, once you have accounted for cash flow from the 3 components, determine the ending balance of cash or its equivalents at the closing period.
Cash Flow Statement Formats
As mentioned above, there are two formats for calculating the cash flow. These formats are both acceptable but require different procedures.
Using the direct method, track cash as it comes in or leaves your business. Subsequently, use that information to prepare a statement of cash flow at the end of the month.
In other words, take all the cash from operations and subtract all the cash disbursements. It typically lists all the transactions coming in or going out during the period. This method takes a long time. It requires considering every transaction that took place during the reporting period.
Also note that even if you record cash flows as the transaction happens, you’ll also have to use the indirect method to reconcile your statement of cash flows with your income statement.
In addition to the time required, it also demands more organization – Because of this, smaller businesses mostly prefer the indirect method.
Using the indirect approach, you begin with net income from the income statement. Next, make necessary adjustments to cancel out the impact of the accruals. Keep in mind that accrual accounting means that you recognize income once you earn it. In that case, one of the most common adjustments is depreciation.
That is to say, you assess the transactions on your income statement, then reverse some of them to know your working capital.
Since it’s easier than the direct method, many small businesses prefer this approach. Also, with this method, you do not have to go back and reconcile your statements with the direct method.
How to Prepare Cash Flow Statement From the Income Statement and the Balance Sheet
You can use your income and balance sheet information to prepare your cash flow statement. The income statement, as we previously discussed, shows how money enters and exits your business. On the other hand, the balance sheet indicates how those transactions affect various accounts—like inventory and assets.
Therefore, you will need both the income statement and balance sheet when creating your cash flow statement.
Cash Flow Statement Example
See an example of a cash flow statement from a fictional company – XYZ, and its implication:
Cash Flow Statement
Month Ended January 31, 2023
Cash Flow From Operations
Net Income——————————————————- $80,000
Additions to Cash
Depreciation of machinery—————————————-$30,000
Increase in Accounts Payable————————————$20,000
Subtractions from Cash
Increase in Accounts Receivable——————————— ($25,000)
Increase in inventory ———————————————-($10,000)
Net Cash from Operations————————————– $95,000
Cash Flow from Investing
Purchase of Land—————————————————($7,000)
Cash Flow from Financing
Notes Payable—————————————————— $9,000
Cash Flow for Month Ended December 31, 2023——————$97,000
In the illustration above, there is an increase in inventory. This means that the monetary value of inventory is $10,000. This increases the value of inventory in the balance sheet because inventory is a current asset. However, cash or currency was reduced by the same amount because XYZ paid for the purchase in cash.
Similarly, the depreciation of $30,000 is an expense on the income statement. But this does not mean that XYZ Company is paying for depreciation in actual cash. So, because cash isn’t really moving out, we add it back to net income.
Net income is the total amount of income after deducting expenses.
An increase in Accounts Payable refers to money owed by XYZ company to third parties such as suppliers and contractors. This amount is due for payment but has not yet been paid, although it is on record. To ascertain the actual value of the currency of XYZ, we add it back to the cash on hand. This amounts to $20,000
An increase in Accounts Receivable is the amount due to XYZ that has not yet been received. This is recorded on the income statement as accounts receivable. This means there is an earning of $25,000, although the earnings have not been received yet. This could be money that clients owe to XYZ Company. Since it has not been received, we deduct this amount from the cash.
An increase in Inventory means a reduction in the cash reserves of XYZ Company. XYZ has bought inventory that is equivalent to $10,000 in cash. However, the inventory is an asset rather than cash. This is why we deduct it from cash in hand.
Net Cash from Operating Activities is $95,000.
This amount shows the cash available for spending ( from operating activities).
Cash Flow from Investing Activities
This component of the cash flow statement takes care of investments by XYZ company. It includes the purchase of equipment, land, and the like. Recall that whenever you spend on investment, you spend on an asset of equal value.
Such investments reduce the cash available. Consequently, we have to deduct it from cash. Cash flow from investments makes up a small percentage of cash flow. Even at that, to have an accurate picture of working capital, we have to deduct it from available cash. In this case, we deduct the purchase of land costing $7,000 from the cash in hand.
Cash Flow from Financing Activities
This component of the cash flow statement deals with money earned or spent on financing activities. For this reason, we deduct a bank loan (a liability on the balance sheet). Afterward, we add back to the cash available. Do you know why? The loan received leads to an increase in cash on hand (even if XYZ is currently indebted to its creditors).
Conversely, money leaves your bank account when you pay off part of your loan. In that case, there is a deduction from cash.
Cash flow for the month
The total cash flow for the month is $97,000 against the net income at the top of the cash flow statement ( taken from our income statement) of $80,000. This indicates an actual cash receipt of $97,000 for January.
What does this mean? It means that the cash available for spending (void of projections and expected income) for XYZ Company is $97,000.
The good thing about this is that the company has removed the risk of overestimation. Now, there is a tangible picture of cash available. This will guide the company in budgeting, spending, and projection.
Furthermore, those who use the cash flow statement of XYZ company can make good decisions about investment plans based on liquidity.
Apart from financial advisors, users of accounting statements, such as business owners, managers, and stakeholders of any company, study cash flow statements. So, regardless of your position, you should learn how to create and interpret financial statements. This will boost your contribution to your business and organization as an entrepreneur or employee.
How can I prepare Cash Flows in 7 Steps?
To prepare a cash flow statement, follow these simple steps:
Gather all necessary documents
Determine your starting balance
Workout changes to your balance sheet over the current period
Put the balance sheet changes on your statement of cash flow
Calculate cash flow from operating activities, investing activities and financing activities
Adjust for non-cash transactions like depreciation and amortization
Do final calculations by summing up the different entries and making allowances for adjustments.
What is the best formula for cash flow statement?
Cash Flow = Cash from operating activities +(-) Cash from investing activities +(-) Cash from financing activities + Beginning cash balance
What is the first step in creating a cash flow statement?
The first step in creating a cash flow statement is to prepare the operating activities component by converting net income from an accrual basis to a cash basis.