As a business owner, it's important for you to have a good read on your company's fiscal health, and cash flow statements can help you do this. Cash flow is critical to running a successful business. This important report shows you the amount of money going in and out of your business.
What is a cash flow statement?
A cash flow statement is a report that states how much money your business has earned and spent over a certain period of time. Cash flow statements also show you how much money you have on hand, as well as cash equivalents, like bank deposits, short-term investments and other assets that can be converted into cash. This does not include credit items, like invoices you've sent but haven't yet received payment on or bills that you've received but haven't yet paid.
"A cash flow statement is a great tool to give business owners insight into where their actual cash is spent, since most businesses are run on an accrual basis," said Katie Thomas, a certified public accountant and manager of Rivers and Moorehead PLLC.
What is the purpose of a cash flow statement?
A cash flow statement allows you to see the financial status of your company – specifically, whether you're bringing in enough money to pay the bills.
For instance, if you have a deficit, you may need to make some changes to increase your cash flow, such as raising prices or shortening your payment terms. Or, if you have a cash surplus, you may decide that now is a good time to buy new equipment.
A cash flow statement, along with your balance sheet and income statement, is often required by banks or investors when you seek financing. Using the cash flow statement, the lender can determine if your business is fiscally sound and will be able to repay the loan or investment. [Read related article: Everything You Need to Know About Cash Flow Statements]
What is included in a cash flow statement?
A cash flow statement has three parts: operating activities, investing activities and financing activities.
The operating activities section of the cash flow statement shows how much cash you have coming in and going out as part of your daily business operations within a specific period. It includes money you spend on materials and payroll, as well as money you bring in from sales.
The investing activities section shows the amount of cash you've earned or spent on long-term investments within a specific period. In addition to stocks and bonds, investments can include buying or selling large assets such as buildings, property or equipment.
The financing activities section shows how your business raises its capital and pays back its debts. Anything associated with loans or the issuing or buyback of stocks is included in this section.
How do accounts payable and accounts receivable relate to cash flow?
It's important to understand your accounts receivable and accounts payable, because they affect your cash flow. Accounts payable are the money your company owes its suppliers, and accounts receivable are what your customers owe you. To calculate the amount of cash flow affected by your accounts payable or accounts receivable, follow these two steps:
- Subtract the current period's dollar amount for accounts payable from the last period. For accounts payable, if the difference is a positive amount, your cash flow has increased by that number within that period. If the number is negative, it means the cash flow has gone down by that dollar amount.
- For accounts receivable, the calculations are the same. However, when the difference is a positive number, this is considered the use of cash and represents the dollar amount your cash flow has decreased. A negative number represents how much your cash flow has increased.
What are the limitations of a cash flow statement?
A cash flow statement is a good tool for examining your past financial decisions, but it doesn't help you predict your business's future.
"A cash flow statement is historically based," said Katie Swanson, a certified public accountant, certified valuation analyst and manager at Wilson Toellner CPA. "It does not help a business look forward to manage cash today, next week or a month from now. Business owners are concerned with the ongoing operations of their business, not what happened last year."
Swanson also noted that business owners who do not have a background in accounting may find it hard to understand cash flow statements.
"The information is not presented in a way that makes sense to non-accountants," she said. "Therefore, the information is difficult for small business owners to use when making decisions."
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How is cash flow calculated?
The easiest way to calculate cash flow is to run a cash flow report in your accounting software. If you plan on calculating it manually, you'll need your balance sheet and income statement.
Cash flow statements are made up of two main parts: operating cash flow and financing cash flow.
Operating cash flow
Operating cash flow comes from the daily work within your business. It is made up of your net profit or loss and changes in assets and liabilities between periods. According to David Duryee, business consultant and author of 60 Minute CFO: Bridging the Gap Between Business Owner, Banker and CPA, this is the equation for operating cash flow:
Net profit (loss)
+ Change in current assets, excluding cash
+ Change in current liabilities, excluding bank and shareholder debt
+ Change in net fixed assets
+ Change in noncurrent assets
= Operating cash flow
Financing cash flow
Financing cash flow is made up of changes in your bank debt, shareholder debt and other long-term debt between periods. You can calculate this cash flow based on the following formula from Duryee:
Change in bank or lease debt
+ Change in shareholder debt
+ Change in other noncurrent debt
+ Equity adjustment
= Financing cash flow
Net cash flow
In a cash flow statement, the goal is to measure your operating cash flow and financing cash flow. When you add them, you get your net cash flow, Duryee said.
Operating cash flow
+ Financing cash flow
= Net cash flow
"Both operating cash flow and financing cash flow may be positive or negative in any given period," Duryee said. "But over time, net cash flow must be positive. If it is not, debt will continue to increase with no possibility of repayment, and the business will fail."
How is a cash flow statement prepared?
Again, the easiest way to create a cash flow statement is to use your accounting software to generate it as a report. If you don't like using accounting software, or your program doesn't have this option, you can use free cash flow statement templates that are available online.
Wherever you choose to get your cash flow statements, it's important to decide whether you will use the direct method or the indirect method.
Many businesses use the indirect method because it's simpler. Starting with the net income, you add or subtract the increases or decreases, using the line items from the balance sheet, Thomas explained. Keep in mind that a company's income statements are done on an accrual basis, so only earned revenue (not received earnings) is considered.
The indirect method includes nonoperating activities that don't affect a business's operating cash flow. Depreciation, for example, isn't a cash expense, but it is used to calculate cash flow.
The direct method uses gross cash receipts and gross cash payments to prepare cash flow statements. This includes money paid to suppliers, receipts from customers, interest and dividends received, cash paid out or received, interest paid, and income taxes paid.
The direct method is more time-consuming, because unlike the indirect method, it requires you to track operating cash receipts and payments for every transaction. You must also reconcile your cash flow statement with your income statement.