Understanding Cash Flow Statements

Understanding Cash Flow Statements When it comes to understanding business finances, the ability to read different financial statements becomes crucial. A cash flow statement is an important and essential part of keeping a record of the business’ financial liquidity. Business’ liquidity matters because it often directly signals the company’s ability to pay off debts and to generate money â€" problems in either can have devastating consequences in terms of business’ long-term survival. © Shutterstock.com | ScandinavianStockIn this guide, you’ll learn to understand the 1) definition of a cash flow statement, with its benefits and disadvantages. The guide will also look at the 2) structure of a financial statement and the 3) different preparation methods you can use to calculate a company’s cash flow.WHAT IS A CASH FLOW STATEMENT?Cash flow statement is one of the core three financial reporting tools companies use. It is designed to complement the balance sheet and the income statement. In most accounting systems around the world, a cash flow statement is part of the mandatory reporting.A cash flow statement is an official record of cash and cash equivalents entering and leaving a business entity. It focuses on showcasing the sources of money in the business as well as how it is spent over a specific period.It usually looks at the general accounting period, such as a financial year, but cash flow statements can be created over any specific period.It is important to note that a cash flow statement doesn’t necessarily include  non-cash items. The statement is similar to the income statement, as a statement to record a business’ financial performance, yet the exclusion of these non-cash items makes it different from the income statement.The cash flow statement is therefore in essence a way to see how much actual cash the company is generating and spending.Who uses and needs a cash flow statement?As mentioned above, a cash flow statement is part of the mandatory accounting reporting in most countries for a business entity. Whether the entity is a corporation, a public company or a sole proprietorship, a cash flow statement will be part of the accounting standards.There are some differences as to who gets to view a company’s financial statements, such as a cash flow statement. Publicly traded companies are required to make statements, such as the cash flow statement, available for the public. But other smaller companies often don’t need to provide a public report, yet must have one in their own records.People and groups that can benefit from viewing a cash flow statement include:The entity’s ownersThe entity’s accounting personnelPotential lenders or creditorsPotential investorsPotential employees or other contractorsShareholders of the businessAll of the above have their own reasons for benefitting from the cash flow statement. The above list simply shows a cash flow statement is widely used and an important part of a company’s financial reporting.While a cash flow statement often looks at a single year, many companies also produce quarterly cash flow statements. These could be very helpful, especially for entrepreneurs who have just started out or entities trying to get out of financial trouble.The benefits and disadvantages of a cash flow statementBefore we look at the structure of a cash flow statement in more detail, it is important to understand why a cash flow statement is essential for a business. Fur thermore, you should understand the limitations of a cash flow statement to ensure you don’t use the statement the wrong way.The biggest advantage of a cash flow statement is its ability to show the company’s short-term viability in terms of its cash position. This allows the company to see how much it has cash available to commit to repayments or investments, for instance.The cash flow statement is good at highlighting this cash liquidity in the company. This is something you cannot see from the profit and loss statement, for example. On the other hand, with a cash flow statement you can see how much money you have available for accounting the issues on your profit and loss statement.The second big advantage of a cash flow statement is its ability to make predictions. As you are able to see the company’s liquidity position, you are able to arrange the company’s finances to better respond to future issues. For example, if you can see your company’s liquidity is currently s trong and there are a few debt repayments in the long-term future, you can try to clear some of them with the current liquidity.Finally, a cash flow statement can benefit companies by attracting more investors to invest in the company. Investors don’t want to make decisions without fully understanding the financial position of the company, and so the more information you can provide for them the better.On the other hand, investors can also benefit greatly from a cash flow statement. It shows plenty of information about the company’s financial health and by comparing it with other financial statements, investors can see whether the finances are correct and up to date.In terms of disadvantages, it is important to understand that a cash flow statement only tells one side of the story. Since it only deals with cash, it cannot be used as a profit and loss statement.Therefore, to truly make the most of your cash flow statement, you need to use it together with other financial statemen ts. Together with statements like the balance sheet, you’ll get a more detailed look into the entity’s finances.THE BASIC STRUCTURE OF A CASH FLOW STATEMENTThe first thing to know about the cash flow statement is its division into three separate sections. A cash flow statement looks at three components of core operations, investing, and financing in order to come to the final conclusion.One of the major distinctions in a cash flow statement, compared to an income statement and a balance sheet, is the lack of reporting on future incoming and outgoing cash. Furthermore, some of the things you won’t know from a loss and profit statement, but which feature at the cash flow statement include:Owner’s draws out of the businessPayment of credit card principalPayment of loan principalA cash flow looks at only the movements in the three sectors during the determined period, not what is going to happen in the future. Therefore, the cash figure announced in the statement is not net inco me of the entity.Let’s now look at the three sections in more detail.OperationsThe operations section of the cash flow statement reflects the company’s cash generation from its products and services. It measures both the inflows and outflows of the core business operations.In a typical cash flow statement, the operations part involves incoming and outgoing amounts, or the changes to cash, accounts receivable, depreciation, inventory and accounts payable.Since cash flow doesn’t involve income from non-cash items, many of the above items need to be re-evaluated when generating a cash flow statement from the balance sheet.The example of depreciation illustrates the issue well. Since depreciation isn’t a cash expense, it is added back to the net profit when calculating operating cash flow.Furthermore, operating cashflow must reflect changes in accounts receivable. If the accounts receivable drops from one accounting period to the other, the change reflects an injection of cash t o the company. The injection will be reflected by calculating the decreased amount and adding it to net profit.On the other hand, if the accounts receivable sees an increase from one accounting period to the other, the increased amount needs to be deducted from net sales. While these are revenue, they are not cash.In terms of the inventory, an increasing inventory means the company has spent money. If the inventory was bought off with cash, the value is deducted from net profit. On the other hand, if the inventory sees a decrease the amount is added to net profit.Finally, any payable credit, taxes and salaries, for instance, will result in an increase in accounts payable and the increase from one period to another will be added to net profit.As a rule of thumb for these sorts of payments, you can consider that everything that has been paid off will be subtracted from net income.InvestingThe second part of a cash flow statements deals with the incoming and outgoing cash relating to i nvesting. This includes the changes in equipment, assets and other investments.In most instances, this section is cash leaving the company, since companies mostly use cash to buy new equipment and tools, for example. Businesses’ even invest in assets such as marketable securities.It is crucial to note that if a business entity divests an asset, the transaction will be accounted as incoming cash.FinancingThe third part of the statement deals with financing. It isn’t possible to start a company without some sort of financing and this section deals with both the money the owner has invested into the company, as well as the money they have borrowed to keep the company going.In short, this section includes incoming and outgoing cash changes in debt, loans and dividends. The items considered in this part of the statement can be both short- and long-term liabilities and equities. Therefore, some of the most common items in the section include:Interests paidDividends paidIssuance or pur chase of common stockIssuance or repayments of debtIf the company is raising capital, then the amount is calculated as cash coming into the business. On the other hand, if dividends are paid, the cash is considered to leave the company.Non-cash activitiesIt is also worth pointing out that while non-cash activities are not part of the cash flow statement, some non-cash activities must be mentioned as a footnote in the statement. These generally include any non-cash investing and financing activities.These might include the following non-cash financing activities:Leasing to purchase an asset for the businessConverting part of a debt to equityExchanging non-cash assets or liabilities for other such assets or liabilitiesIssuing shares in exchange for assetsAn example of a cash flow statementBelow is an example of a cash flow statement. You can see all the different sections and how the figures are calculated. As you can see, the bottom of the statement shows the total cash flow of the c ompany for the accounting period.Cash Flow StatementBusiness ABCFinancial Year ended 31 December 2014Figures in USDCash Flow from OperationsNet EarningsAdditions to CashDepreciationDecrease in Accounts ReceivableIncrease in Accounts ReceivableIncrease in Taxes PayableSubtractions from CashIncrease in InventoryNet Cash from Operations3,000,00025,00020,00015,0003,000(40,000)3,023,000Cash Flow from InvestingEquipment(450,000)Cash Flow from FinancingNotes payable15,000Cash Flow for Financial Year2,588,000The above example statement shows you the company’s total cash flow, as well as where majority of the liquidity came from.Naturally, not all cash flow statements show a positive cash flow. But it is important to remember that a negative cash flow doesn’t necessarily mean the business is failing. Sometimes a negative cash flow is part of a company’s decision to heavily invest in new inventory, for example, which might increase the cash flow the following year. Therefore, as mention ed, you need to use a cash flow statement as part of your financial analysis, but not rely solely on it.Overall, you also want to compare your cash flows from different periods. While a single negative cash flow statement might not signal trouble, if your cash flow is constantly on the negative, your business is clearly having liquidity problems. It usually means the business is having difficulties paying debt and relies too much on credit.You should also consider calculating the operating cash flow ratio based on your cash flow statement. This will help you understand the business entity’s ability to service its loans and interest payments. You can calculate the ratio by comparing the total amount of cash generated to the company’s total outstanding debt.DIFFERENCES IN PREPARATION METHODSThe above section dealt with the structure of the cash flow statements, but there are different ways of preparing the actual statement. The two most common methods include the direct and the in direct method.The difference between the two preparation methods deals only with the operations part of the cash flow statement. While there often aren’t any rules regarding which method companies should use, the direct method is often suggested as the better option.Direct methodAs mentioned, the direct method is often the recommended preparation style. It is also referred to as the income statement method.The direct method separates the operating cash receipts and payments into major classes. It first outlines the money received and moves on to subtract any money spent. This provides the net cash flow.The direct method doesn’t include depreciation into its calculations. This is because, while being an expense that affects net profit, it is not money spent or received by the entity.Indirect methodThe indirect method is often called the reconciliation method. Unlike the direct method, it focuses on looking at the net income and net cash flow from operations.The method starts with net income and then adds back depreciation, while calculating changes in the balance sheet. In the end, the result is the same net cash flow produced by the direct method, the way it receives it just differs slightly.The reason indirect method adds depreciation into the mix is on the way the net cash flow is calculated. Since it starts with net profits, which doesn’t include depreciation as it is considered an expense, it wants to include it later. In our example above we used the indirect method.As mentioned already, regardless of the method the net cash flow from operations should be the same in both methods.It is possible to find readymade charts for both of these methods online. These charts can be a great help in getting to grips with your cash flow statements. For instance, the US Small Business Administration provides a free cash flow worksheet for business owners to use, and other such worksheet can be found elsewhere. You can also use the above example as a basis for you r cash flow statement.You can also find out more about the two different methods from the below YouTube video: CONCLUSIONFor a business entity, the use of a cash flow statement is a crucial part of predicting future liquidity. It is therefore, an essential part of budgeting and any business owner should regularly use an up-to-date statement as part of its financial planning strategy.A cash flow statement will reflect the entity’s financial health and therefore, it isn’t just crucial for business owners but for investors as well. While the statement tells a lot about the company’s cash flow, in terms of where the cash is coming from and where it is going, business owners and investors cannot see everything from the cash flow statement. In order to get a proper, wide-ranging look into the entity’s financial health, a cash flow statement should be used together with statements such as a balance sheet and an income statement.