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Chapter 1 – What is a Cash Flow Statement?
Chapter 2 – Structure of Cash Flow Statement:
Chapter 3 – The Direct Method of Cash Flow
Chapter 4 – Cash Basis vs. Accrual Accounting
Chapter 5 – The Indirect Method of Cash Flow
Chapter 6 – The Direct or Indirect Method of Cash Flow
Chapter 7 – Income Statement and Balance Sheet
Chapter 8 – Negative Cash Flow vs. Positive Cash Flow
The cash flow statement is one of the three main financial statements that tells a company how much cash it has on hand, in a specific period of time.
While the income statement is to show the amount of cash a business earns and spends, the cash flow statement tells a different story of how a business is performing, where it gets its cash from, and where it spends it.
There are many ways to talk about the Cash Flow Statement but, here are some easy points to remember:
Number #1! The cash flow statement’s main job is to summarize the movement of all cash that comes in, and goes out of your business.
Number #2! The cash flow statement’s main goal is to oversee your company’s cash management in terms of assets, liabilities, and equities and to understand how it generates its cash.
Number #3! The cash flow statement is merely a supplement to the two other main financial statements, such as the Income Statement and Balance Sheet. And together they help us see the entire picture of our business in a given period of time.
A cash flow statement usually has three main components:
#1. Cash Flow from Operating Activities
#2. Cash Flow from Investing Activities
#3. Cash Flow from Financing Activities
Operating Activities are a crucial part of a business, since they show the exact amount of cash that is generated from the actual operations of the company.
Operating Activities in a cash flow statement must include all the sales of products and services, interest payments, wages and salaries, tax, rent and every other operating expense…
Investing Activities, as the name suggests, are all about the cash earned or spent on investments. In other words, it’s outside of the primary activities of the company, which is selling their services.
Investing Activities might include purchases-or sales of new assets and equipment, new loans to customers and vendors, and deposits on Mergers & Acquisitions…
Finally, Financing Activities, may refer to the exact amount of cash that is received from investors or banks, as well the cash paid out to shareholders.
Financing Activities in a cash flow statement must clearly reflect, if new shares of the company were issued, if a loan was taken out, or if the principal of a debt was repaid or not.
So, how do we calculate the Cash Flow of a business?
Well, there are two ways to do it:
The Direct Method and the Indirect Method.
Direct Method of Cash Flow, is exactly how it sounds like:
It is Direct!
In the Direct Method, a business simply keeps a record of all its cash as it enters and leaves the company. It then uses this information to prepare a statement of its cash flow.
Even though the direct method sounds simple enough, it actually requires more work and organization. The business needs to track down and produce each cash receipt from every transaction in order to show its cash flow.
In a regular Cash Flow Statement, Direct or Indirect, each entry written in (parenthesis) shows the outflow of cash from the business.
For instance, if we put a ($10,000) next to a slight increase in the Inventory of the business. It means that even though the company bought $10,000 worth of inventory, their cash balance, in fact, decreased by that similar amount.
On the other hand, each cash entry written without any parenthesis, shows the opposite: An inflow of cash to the business.
So, when we see $50,000 on depreciation of our equipment, even though that amount will be shown as an expense on our income statement, since depreciation doesn’t actually cause a decrease in our cash, we can add that to our net income.
To find out more about the Direct Method of Cash Flow in detail
and a tutorial on How to Prepare One please find our video here,
on the corner, or check out the link in the description box below.
At this point, it’s quite important to understand that, in the world of accounting, profits and cash can be two different things.
That’s why most companies today use a method called ‘Accrual Accounting’ instead of ‘Cash Basis’.
And in Accrual Accounting, the revenue of a company is never recognized when it is received, but rather when it is earned.
So let me explain the difference!
As we all know, not all transactions in a business are actual cash items, and this fact sometimes causes a disconnect between the actual cash flow of a business and its net income.
This means that, in Accrual Accounting, earning a revenue doesn’t always increase cash immediately, and incurring expenses doesn’t always decrease cash right away.
That’s why most businesses use the Indirect Method of Cash Flow to balance this problem.
The Indirect Method of Cash Flow, allows a business to look at all the transactions recorded on their income statement, and then adjust some of it in order to find its actual working capital in cash.
This process serves to selectively backtrack any movement from the income statement by extracting each transaction that doesn’t show any activity in cash.
For example, if a business buys a product on credit, since the cash has not actually left the company, the indirect method of cash flow will consider this as an income. And then it will reflect it accordingly in the cash flow statement.
Whereas, in the Direct Method, we couldn’t include the transaction in the cash flow statement until the amount has been paid in full.
Under the indirect method, the calculation of the cash flow from operating activities begins with the net income. Then this sum is adjusted through several different variables to finally arrive at the amount of cash generated by the company.
For instance, if receivables of a business decrease by %20 prior to the year before, this means that more cash has entered the company from customers paying off their debts.
Then, the same amount of %20 decrease in receivables, would have to be added to net income of the company.
Also with the same logic, a possible increase in Receivables would be deducted from the net income because, although the amount represented in receivables are revenue, they are not cash just yet.
Same thing goes with the inventory, taxes, salaries, insurance and everything.
An annual increase in the Inventory would clearly show that the business spent more cash on their raw materials. Therefore, this is bad for the cash, and the difference will now have to be deducted from the net earnings of the company.
Basically, in the indirect method of cash flow, once something is paid off, the difference between the current and the previous year must be subtracted from the net income.
The same way, if there is an annual difference in a credit or a debt, it has to be added to it.
To find out more about The Indirect Method of Cash Flow in detail
and a tutorial on How to Prepare One, please find our video here,
on the corner, or check out the link in the description box below.
So, which one is better for the Cash Flow Statements?
The Direct or the Indirect Method?
Well, one is not necessarily better than the other.
In terms of GAAP, Generally Accepted Accounting Principles, and IFRS, The International Financial Reporting Standards, both methods are equally acceptable to calculate the cash flow of a business.
However, most businesses choose the indirect method, since it is more useful to see the relationship of the cash flow statement, with the accounts on the balance sheet and the income statement.
All three, together, provide a much clearer overview of the entire financial situation of the company as a whole.
So, how do they complement each other, and how do they work together?
Businesses, in fact, use the information from their income statement and their balance sheet to create their actual cash flow statement.
The income statement is the meter that shows how the money entered and exited the company. It provides the main information of the net earnings of a company from which the cash flow statement would be deduced.
The balance sheet, on the other hand, is the snapshot of how all those transactions affected everything else in the company, like the assets, liabilities, and shareholder equities.
So, together, all three create the magic formula for a business to tell its entire financial story: Income Statement plus the Balance Sheet, must be equal to the Cash Flow Statement.
This is such a crucial part of a business that if you want to learn more about them, I personally recommend that you watch both of our videos on the Income Statement and the Balance Sheet.
You can find both of the links in the description box below.
The cash flow statement is such a powerful component of a business, that anyone with a keen financial eye, can gain a solid understanding about the company’s financial health by simply studying its cash flow.
Typically, the more cash is available for business operations, it is for the better. The cash is always the King.
But this is not an exact rule.
Sometimes, a negative cash flow can be caused by a company’s growth strategy that involves expanding its operations or investments.
The same way, a positive cash flow might not be the best thing in the long run. While cash gives a business more liquidity, there might have negative reasons for having a positive cash flow, like taking on a huge loan to bail failing parts of a business.
So, positive cash flow might not be always positive after all.
So, to sum up with some simple ideas:
The cash flow statement measures the strength, profitability and the long-term outlook of a business.
The cash flow statement determines if a company has sufficient cash or not, to cover its expenses.
The cash flow statement helps to forecast the future cash flow of the company and helps adjusting its steps accordingly.
Therefore, the cash flow statement is a powerful financial report and a major criterion in establishing a company’s financial status.
And together with the income statement and balance sheets, they form the overall financial statement of the company.
And this was the Beginner’s Guide of the Cash Flow Statement.
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15 “balance”
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10 “sheet”
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7 “positive”
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| Client: | Upcounting Ltd., Canada |
| Date: | December 31, 2022 |