The statement of cash flows, or the cash flow statement (CFS), is a financial statement that summarizes the amount of cash and cash equivalents entering and leaving a company. Like the income statement, it also measures the performance of a company over a period of time. However, it differs because it is not as easily manipulated by the timing of non-cash transactions.
For example, the income statement includes depreciation expense, which does not have an actual cash outflow associated with it. It is simply an allocation of the cost of an asset over its useful life. A company has some leeway to choose its depreciation method, which modifies the depreciation expense reported on the income statement. The CFS, on the other hand, is a measure of true inflows and outflows that cannot be as easily manipulated.
The CFS measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses. As one of the three main financial statements, the CFS complements the balance sheet and the income statement.
In this article, we’ll show you how the CFS is structured and how you can use it when analyzing a company.
What Is a Cash Flow Statement?
- A cash flow statement (CFS) is a financial statement that summarizes the amount of cash and cash equivalents entering and leaving a company.
- The CFS measures how well a company manages its cash position, meaning how well the company generates cash.
- The CFS complements the balance sheet and the income statement.
- The main components of the CFS are cash from three areas: operating activities, investing activities, and financing activities.
- The two methods of calculating cash flow are the direct method and the indirect method.
How the Cash Flow Statement Is Used
The CFS allows investors to understand how a company’s operations are running, where its money is coming from, and how money is being spent. The CFS is important since it helps investors determine whether a company is on solid financial footing.
Creditors, on the other hand, can use the CFS to determine how much cash is available (referred to as liquidity) for the company to fund its operating expenses and pay down its debts.
Structure of the Cash Flow Statement
The main components of the cash flow statement are:
- Cash from operating activities
- Cash from investing activities
- Cash from financing activities
- Disclosure of non-cash activities, which is sometimes included when prepared under generally accepted accounting principles (GAAP).
It’s important to note that the CFS is distinct from the income statement and the balance sheet because it does not include the amount of future incoming and outgoing cash that has been recorded as revenues and expenses. Therefore, cash is not the same as net income—which, on the income statement, includes cash sales as well as sales made on credit.
Cash from Operating Activities
The operating activities on the CFS include any sources and uses of cash from business activities. In other words, it reflects how much cash is generated from a company’s products or services.
Generally, changes made in cash, accounts receivable, depreciation, inventory, and accounts payable are reflected in cash from 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
In the case of a trading portfolio or an investment company, receipts from the sale of loans, debt, or equity instruments are also included because it is a business activity.
Cash from Investing Activities
Investing activities include any sources and uses of cash from a company’s investments. A purchase or sale of an asset, loans made to vendors or received from customers, or any payments related to a merger or acquisition are included in this category. In short, changes in equipment, assets, or investments relate to cash from investing.
The only time that income from an asset is accounted for in CFS calculations is when the asset is sold.
Usually, changes in cash from investing are a “cash-out” item because cash is used to buy new equipment, buildings, or short-term assets such as marketable securities. However, when a company divests an asset, the transaction is considered “cash-in” for calculating cash from investing.
Cash from Financing Activities
Cash from financing activities includes the sources of cash from investors or banks, as well as the uses of cash paid to shareholders. Payment of dividends, payments for stock repurchases, and repayment of debt principal (loans) are included in this category.
Changes in cash from financing are “cash-in” when capital is raised and “cash-out” when dividends are paid. Thus, if a company issues a bond to the public, the company receives cash financing. However, when interest is paid to bondholders, the company is reducing its cash.
How Cash Flow Is Calculated
There are two methods of calculating cash flow: the direct method and the indirect method.
Direct Cash Flow Method
The direct method adds up all of the various types of cash payments and receipts, including cash paid to suppliers, cash receipts from customers, and cash paid out in salaries. This method of CFS is easier for very small businesses that use the cash basis accounting method. These figures can also be calculated by using the beginning and ending balances of a variety of asset and liability accounts and examining the net decrease or increase in the accounts. It is presented in a straightforward manner.
Indirect Cash Flow Method
Most companies use the accrual basis accounting method, where revenue is recognized when it is earned rather than when it is received. This causes a disconnect between net income and actual cash flow because not all transactions in net income on the income statement involve actual cash items. Therefore, certain items must be reevaluated when calculating cash flow from operations.
With the indirect method, cash flow is calculated by adjusting net income by adding or subtracting differences resulting from non-cash transactions. Non-cash items show up in the changes to a company’s assets and liabilities on the balance sheet from one period to the next. Therefore, a company’s accountant will identify the increases and decreases to asset and liability accounts that need to be added back to or removed from the net income figure, in order to identify an accurate cash inflow or outflow.
The indirect cash flow method allows for a reconciliation between two other financial statements: the income statement and balance sheet.
Changes in accounts receivable (AR) on the balance sheet from one accounting period to the next must be reflected in cash flow. If AR decreases, this implies that more cash has entered the company from customers paying off their credit accounts—the amount by which AR has decreased is then added to net earnings.
If AR increases from one accounting period to the next, then the amount of the increase must be deducted from net earnings because, although the amounts represented in AR are in revenue, they are not cash.
On the other hand, an increase in inventory signals that a company has spent more money to purchase more raw materials. If the inventory was paid with cash, then the increase in the value of inventory is deducted from net earnings.
A decrease in inventory would be added to net earnings. If inventory was purchased on credit, then an increase in accounts payable would occur on the balance sheet, and the amount of the increase from one year to the next would be added to net earnings.
The same logic holds true for taxes payable, salaries payable, and prepaid insurance. If something has been paid off, then the difference in the value owed from one year to the next has to be subtracted from net income. If there is an amount that is still owed, then any differences will have to be added to net earnings.
Example of a Cash Flow Statement
Below is an example of a cash flow statement:
From this CFS, we can see that the net cash flow for the 2017 fiscal year was $1,522,000. The bulk of the positive cash flow stems from cash earned from operations, which is a good sign for investors. It means that core operations are generating business and that there is enough money to buy new inventory.
The purchasing of new equipment shows that the company has the cash to invest in itself. Finally, the amount of cash available to the company should ease investors’ minds regarding the notes payable, as cash is plentiful to cover that future loan expense.
Limitations of the Cash Flow Statement
Of course, not all cash flow statements look as healthy as our example or exhibit a positive cash flow. However, negative cash flow should not automatically raise a red flag without further analysis. Poor cash flow is sometimes the result of a company’s decision to expand its business at a certain point in time, which would be a good thing for the future.
Therefore, analyzing changes in cash flow from one period to the next gives the investor a better idea of how the company is performing, and whether a company may be on the brink of bankruptcy or success. The CFS should also be considered in unison with the other two financial statements.
Cash Flow Statement, Balance Sheet, and Income Statement
As we have already discussed, the CFS is derived from the income statement and the balance sheet. Net earnings from the income statement are the figure from which the information on the CFS is deduced.
As for the balance sheet, the net cash flow in the CFS from one year to the next should equal the increase or decrease of cash between the two consecutive balance sheets. For example, if you are calculating cash flow for the year 2019, then the balance sheets from the years 2018 and 2019 should be used.
What Is the Difference Between Direct and Indirect Cash Flow Statements?
The difference lies in how the cash inflows and outflows are determined.
Using the direct method, actual cash inflows and outflows are known amounts. The cash flow statement is reported in a straightforward manner, using cash payments and receipts.
Using the indirect method, actual cash inflows and outflows do not have to be known. The indirect method begins with net income or loss from the income statement, then modifies the figure using balance sheet account increases and decreases, to compute implicit cash inflows and outflows.
Is the Indirect Method of the Cash Flow Statement Better Than the Direct Method?
Neither is necessarily better or worse. However, the indirect method also provides a means of reconciling items on the balance sheet to the net income on the income statement. As an accountant prepares the CFS using the indirect method, they can identify increases and decreases in the balance sheet that are the result of non-cash transactions.
It is useful to see the impact and relationship that accounts on the balance sheet have to the net income on the income statement, and it can provide a better understanding of the financial statements as a whole.
What Is Included in Cash and Cash Equivalents?
The term “cash and cash equivalents” refers to a line item on the balance sheet. It reports the value of a business’s assets that are currently cash or can be converted into cash within a short period of time, commonly 90 days. Cash and cash equivalents include currency, petty cash, bank accounts, and other highly liquid, short-term investments. Examples of cash equivalents include commercial paper, Treasury bills, and short-term government bonds with a maturity of three months or less.
The Bottom Line
A cash flow statement (CFS) is a valuable measure of strength, profitability, and the long-term future outlook of a company. The CFS can help determine whether a company has enough liquidity or cash to pay its expenses. A company can use a CFS to predict future cash flow, which helps with budgeting matters.
For investors, the CFS reflects a company’s financial health, since typically the more cash that’s available for business operations, the better. However, this is not a rigid rule. Sometimes, a negative cash flow results from a company’s growth strategy in the form of expanding its operations.
By studying the CFS, an investor can get a clear picture of how much cash a company generates and gain a solid understanding of the financial well-being of a company.