Cash Flow Statement Explained

One question is fundamental to any business: How much money is coming in versus how much is going out? A cash flow statement answers that and provides a clear picture of whether a company has the cash it needs to pay its debts and fund operating expenses over a set timeframe. It’s one of the most important sources of insight into a company’s financial health.

What Is a Cash Flow Statement (CFS)?

A cash flow statement, also known as a statement of cash flows, is a financial statement that documents the cash and cash equivalents a company generates and spends over a specific period. Cash flow statements reveal a business’s liquidity, help evaluate changes in assets, liabilities and equity, and make it easier when analysing operating performance.

Key takeaways

• Cash flow statements show the cash impact of the decisions a company makes on operating, investing and financing activities.
• A cash flow statement consists of three sections: cash from operating activities, cash from investing activities and cash from financing activities.
• There are two methods for cash flow statement preparation: direct and indirect.
• The direct method determines changes in cash receipts and payments. The indirect method takes the net income generated in a period and adds or subtracts changes in the asset and liability accounts to determine the implied cash flow.
• A key component for any company are the changes in accounts receivable.
• Investing activities should include asset purchases and sales, interest paid on loans, and payments related to mergers and acquisitions.
• Negative cash flow is not always a cause for alarm; some businesses choose to spend more to meet business goals and may rely on financing to get them to positive cash flow generation.

Why Do Businesses Need Cash Flow Statements?

The cash flow statement serves as a bridge between the income statement and the balance sheet. There are four key reasons why a cash flow statement is important:

1. It reveals a business’ liquidity so that companies know just how much cash is on hand, and thus their projected runway to when cash is projected to run out.
2. It details the specific changes in assets, liabilities and equity.
3. It eliminates the effects of different bookkeeping techniques (for example cash basis versus accrual basis accounting), making it easier for investors to compare multiple firms’ financial performance.
4. It helps analyse and forecast the amount, timing and probability of future cash needs.

How Cash Flow Statements Work

All publicly traded companies must file financial reports and statements with the Securities and Exchange Commission (SEC). The cash flow statement is one of three critical documents, along with the balance sheet and income statement, included in SEC filings. It provides information about cash receipts, cash payments and the net change in cash resulting from a company’s operating, investing and financing activities.

Investors look to the cash flow statement for insights into a company’s financial footing. Meanwhile, creditors can use the cash flow statement to gauge liquidity and determine whether a company can fund its operating expenses and pay off its debts.

What Is Included in a Cash Flow Statement?

A cash flow statement consists of three key components:

• Cash flow from operating activities involves any cash flows from current assets and current liabilities. This section includes transactions from all operational business activities, including buying and selling inventory and supplies as well as paying employee salaries.
• Cash flow from investing activities reflects results from investment gains and losses. This section includes transactions such as equipment purchases, loans made to suppliers or mergers and acquisitions. Analysts can rely on this section to find changes in capital expenditures (CapEx).
• Cash flow from financing activities measures cash flow between a company and its owners and creditors. This section involves cash transactions related to raising money from stock or debt or repaying that debt. When cash flow from financing activities contains a positive number, it’s a sign that there is more cash inflow than outflow. When the number is negative, it may indicate that a company is paying off debt, making dividend payments or buying back stock.

Additionally, the cash flow statement may include disclosure of non-cash activities when prepared under generally accepted accounting principles (GAAP)—items like fixed asset depreciation, goodwill amortisation and the like.

How is a Cash Flow Statement Produced?

There are two methods of cash flow statement preparation: direct and indirect. The best choice for your business depends on how much detail you need to include in your statement, as well as how much time you are willing to dedicate. While both methods are GAAP-approved, the International Accounting Standards Board (IASB) prefers the direct reporting method. However, most small businesses use the indirect method.

Direct vs. Indirect Methods of Producing a Cash Flow Statement

The main difference between the direct method and the indirect method of presenting the statement of cash flows (SCF) involves the cash flows from operating activities. There are no differences in the cash flows from investing activities and the cash flows from financing activities under either method—the real difference lies in the operating activities.

• Direct cash flow method: This method relies on cash-basis accounting. Finance records revenues and expenses as cash is received or disbursed by the business. The direct method requires more organisation and legwork, since you subtract actual cash flows from inflows. Common line items using this method include customer receipts, payments to suppliers and employees, interest and dividends received and income tax payments.
• Indirect cash flow method: This method is based on accrual-basis accounting, meaning revenue and expenses are counted when they are incurred rather than when money actually changes hands. Finance looks at the transactions recorded on the income statement and selectively reverses some of them to eliminate transactions that don’t show the movement of cash. This method also requires adjustments to add back any non-operating activities, such as depreciation, that don’t impact operating cash flow.

Accounts Receivable and Cash Flow

When it comes to the balance sheet, any changes in accounts receivable must be reflected in cash flow. A decrease in accounts receivable implies that more cash has entered the company from customers paying off credit accounts. The amount accounts receivable decreased is added to the company’s net sales. However, if accounts receivable increases, the amount of the increase must be deducted from net sales. That’s because, while accounts receivable amounts count as revenue, they are not cash.

Inventory Value and Cash Flow

When inventory increases, it indicates that a company has spent money on raw materials. If cash were used in the purchase of that inventory, the increase would be deducted from net sales. On the flip side, if there were a decrease in inventory, that would be added to net sales. If the inventory was purchased on credit instead of cash, the balance sheet would reflect an increase in accounts payable, and that year-over-year increase would be added to net sales.

Investing Activities and Cash Flow

Investing activities account for the income of a company’s investments. More specifically, these activities may include an asset purchase or sale, interest from loans or payments related to mergers and acquisitions.

Cash changes from making investments are considered use items, because cash is used on expenditures such as property, equipment or short-term assets. But when an asset is divested, that transaction is considered a source and is listed in cash from investing activities.

Cash From Financing Activities

Financing activities involve both cash inflows and outflows from creditors. This category comprises the money that comes from investors or banks, dividend payments, and goes out for stock repurchases and the repayment of loans.

Not all financing activities involve the use of cash, and only activities that impact cash are reported in the cash flow statement. Non-cash financing activities include the conversion of debt to common stock or issuing a bond payable to discharge the liability.

A business’ financing activities shed light on its overall financial health and goals. For example, positive cash flow from financing activities is indicative of growth and expansion. More money flowing into a business signifies an increase in business assets. Meanwhile, cash outflows from financing activities can signify improved liquidity. It may mean that a company has paid off long-term debt or made a dividend payment to shareholders.

Negative Cash Flow Statements

In general, a positive cash flow statement is a sign of a healthy company. And yet a negative cash flow statement is not in itself cause for alarm. It may mean a business is new and has spent a lot of money on property or equipment. Or, it could mean the business is in growth mode.

For example, Netflix had a negative cash flow for years while the company increased spending on original content. It was a gamble, but some investors saw the strategy as a positive. More original content meant the business would be better equipped to compete with other streaming services and TV networks.

Balance Sheet and Income Statement

The cash flow statement serves as a bridge between the income statement and the balance sheet by showing how cash moves in and out of a business during a specific period. The balance sheet involves a company’s assets and liabilities from one period to the next while the income statement covers expenses and income over time.

Finance can reference both the balance sheet and the income statement while preparing a cash flow statement. The net cash flow in the cash flow statement between periods should equal the change in cash between consecutive balance sheets of the period that the cash flow statement covers. The cash flow statement is formulated by subtracting non-cash items from the income statement.

Cash Flow Statement Example

Below is an example of a cash flow statement for Macy’s department stores.