Cash Flow Statement Explanation

Effective cash flow management isn’t possible without a proper understanding of how the cash flow statement works. Every online business owner should be able to prepare and analyze their own cash flow statements. This lesson gives you a run-through on the essentials.

What is a cash flow statement?

The cash flow statement depicts how much money flows into and out of your business during a given period of time. Unlike the accrual-based income statement, the cash flow statement is limited to actual cash. Meaning it gives you a very specific view of your business and its ability to meet financial obligations based on how much money you have at the moment.

What are the three categories included in a cash flow statement?

They are:

• Operating activities
• Investing activities
• Financial activities

These are the three general subsections. Each helps you identify the cash income and outflow by its source. The total cash amount from each of the above categories is then added up to reflect the total change in cash during the given time period.

Operating

Operating activities cover the cash generated from business operations such as delivering goods and services. This depicts cash inflow and well cash outflow (income and expenses).

Investing

Investing activities are mainly concerned with buying or selling physical assets, such as real estate, office space, company-owned vehicles, and also intangible assets like patents and goodwill. The important point you should note here is that all the transactions must involve free cash.

Financing

Financing activities reflect cash flow generated from debt-related transactions and equity financing.

The primary purpose of a cash flow statement

The main reason why every business owner uses a cash flow statement is to evaluate and compare the difference in cash from operations to the net income provided in the profit and loss statement. This offers highly valuable insight into how well the company is actually running operations. It also shows you how much money you’re actually receiving from business activities.

Difference between cash and profit

 As we’ve mentioned in the previous lesson, the income statement includes both cash accounts as well as accrued accounts. Accrued accounts refer to revenues you haven’t yet collected and outstanding expenses. This is included to comprehensively cover all transactions for the entire accounting year.

The cash flow statement, on the other hand, excludes all accrued accounts. It is only concerned with recording transactions and expenses where actual cash is exchanged.

The cash flow statement also demonstrates how well your business is able to operate in both the short term as well as the long term. After all, anticipating large-scale gains in the future is only viable if you’re able to sustain and meet your immediate short-term financial obligations and expenses. You can’t do this without a detailed picture of how much cash flows in and out of the business during given time periods.

In an ideal scenario, your operating cash flow income should be more than your initiL\net income. That’s what largely contributes to a positive cash flow and helps your business stay solvent.

Since cash flow only pertains to the cash aspect of the net income, you can’t review it in isolation. You need to interpret it alongside the balance sheet and income statement for a complete view of the business.

How does a cash flow statement help your online business?

Almost every business, online or otherwise, uses accrual-based accounting. This is the conventional way of bookkeeping. This is why we need cash flow statements, namely:

• To show liquidity. It helps you become more aware of how much cash you have to save, spend and spare in expenses and investments.

• To reflect changes in your cash outflow, inflow, and savings (as a result of buying or selling assets, clearing liabilities, etc).

• To help you project future cash flow based on the current cash flow statement. In other words, you’ll get an idea of your future liquidity prospects, which also influences long-term decision-making and planning.

• To raise funds. The cash flow statement is a credible document of information that helps you gain trust and confidence from financial institutions and investors when you apply for a loan or make a proposition. It backs up your business claims and helps you make an effective pitch.

There are two major ways of preparing a cash flow statement. One is the direct method and the other is called the indirect method. Let’s briefly discuss each of them.

Cash Flow Statement Direct Method

This method involves recording cash transactions alone and exclusively, with no reference to the income statement. We add all cash collections as inflows and deduct all outflows.

Cash Flow Statement Indirect Method

The cash flow statement under the indirect method begins by taking net income from the P/L statement. This figure (net income)  will include accrued amounts such as outstanding creditors, prepaid expenses, etc. 

Furthermore, it is the sum remaining after deductions such as income tax and depreciation. Such accrued entries will be reversed in the cash flow statement to reflect the true cash flow position of the business at the end of the given period.

Eg: Depreciation is added back and receivable accounts are deducted. In other words, non-cash expenses and incomes are de-accrued.

Cash flow statement structure

1. Operating Cash Flow

The cash flow statement begins with net income or net loss, as shown in the P/L statement. We then proceed to add (or subtract) cash flow that arises from current assets, current liabilities, and also certain non-cash accounts. (cash received from the sale of stocks). The final amount is the net cash income from operations. This could be positive or negative.

Add: Depreciation and Amortization (D&A)

We then proceed to add depreciation and amortization back to the cash flow’s net income. Why? Because these are non-cash expenses that have been deducted from the net income statement. Since the cash flow statement only considers cash transactions, we add these expenses back.

Less: Changes (positive or negative) in working capital

Working capital is the difference between your current assets and current liabilities. It is the amount you retain to reinvest into the business. Changes in the working capital of the previous year in the course of doing business are deducted from the cash balance. These changes directly affect the cash amount in hand. That’s why they are subtracted.

Eg: When you buy more inventory, your current assets increase. However, even though it is a positive change in assets, this is considered a cash outflow and is therefore deducted from the net income. Similarly, accounts receivable are also deducted. This is because they are goods sold on credit (accrued income).

An increase in current assets is deducted from the net income and an increase in current liabilities is added to the net cash income. This is because the business gets to keep that money for the period.

2. Cash from investment

Cash from investment shows the cash inflow and outflow from capital expenditure such as buying property assets, equipment, etc. It also includes money you spent or earned in purchasing (or selling)  debt instruments.

In short, this section deals with all cash flow related to any change in long-term assets, be it an increase or decrease. The cash you spend in purchasing new office equipment and office space for your business is essential to keep the business running. This is why we call them capital expenditure and consider them as a cash outflow.

3. Cash flow from financing

This section deals with cash flow related to the money you receive upon issuing stocks, bonds, etc., or spend on purchasing them. It also includes dividend payments. An easy way to look at it is to consider the balance sheet. All changes in long-term liabilities and owner’s equity come under cash flow from financing, be it outflow or inflow.

Debt- issuance, and repayment

This is where we also include debts that are used to finance the business operations. When you receive the money from willing investors, lenders, or financial institutions, it is recorded as a cash inflow and when you pay it back, it becomes a cash outflow.

Equity- issuance, and repayment

This is yet another way to finance your business operations. Equity is a share in the company’s ownership. So whenever an investor buys a stake in the company, it is recorded as a cash inflow. When you repay them in equity based on future earnings, you record it as a cash outflow. Simply put, equity at the time of issuance is an inflow and at the time of repayment is an outflow.

Net cash from financing

You can calculate net cash from financing activities by summing up all the above-listed cash transactions (inflow and outflow).

Cash balance

The cash balance is the final section of the cash flow statement and sums up the total amount from all the previous sections. This could either be a negative or positive figure.

Closing cash balance

Once you sum up the cash flow from all sections and arrive at a total cash flow amount for the given period, you can then add it to the opening cash balance. This is simply the previous year’s cash balance (the amount of money you have at the start of the year). You can easily find it under current assets in the previous year’s balance sheet.

The amount you get when you add the total cash balance for the given period to the previous year’s cash balance is called the closing cash balance. This is the amount you include in the balance sheet under current assets (cash in hand).

Bear in mind the final cash balance could indicate a net increase or a net decrease in cash when you compare it to the previous year. 

Bottomline

So far we’ve discussed the two methods of preparing a cash flow statement, its structure, and the various items we include in each subsection. In the next lesson, we’ll be detailing how you can read a cash flow statement and infer insights from it.