Everything You Need to Know About Cash Flow Statements

What is a cash flow statement?

A cash flow statement — also called a statement of cash flows — is a financial document showing how money flows in and out of a business. Common financial activities, such as applying for a business loan or presenting an idea to business investors, often require cash flow statements and other financial reports. 

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According to Robert Reynolds, chief financial officer and chief operating officer of Tersa, the cash flow statement is a critical tool for small businesses. “It represents the financial ‘oxygen’ a business needs to survive,” Reynolds explained. “As a startup executive, I find our cash flow statement to be the most important report, as cash is vital for navigating daily operations and growth.”

How to use a cash flow statement

In the short term, insufficient cash flow can prevent a business from paying its bills. In the long run, it can stop your business from achieving profitable growth. Investors and lenders carefully scrutinize cash flow statements before doing business with you and many financial activities and analyses rely on accurate cash flow reporting. 

Consider the following six critical ways cash flow statements are used. 

1. Cash flow statements help you predict incoming revenue.

A proper cash flow statement accurately reflects the timing of expected revenue. For companies that receive immediate payment, such as e-commerce or retail stores, this involves using sales forecasts to estimate cash inflows. For companies that extend credit to clients or provide services, such as consulting firms, it requires estimating both when a sale will be made and when payment will be received. These forecasts should be updated continually as new data becomes available to maintain accuracy.

Aileen Wigotow, certified public accountant (CPA) and founder of Wigotow Consulting, offered the following example: “Let’s say a business’s profit and loss (P&L) statement reports $50,000 in revenue from clients for a given period. The cash flow statement might show that only $25,000 of that revenue was actually received, putting the business in a negative cash flow position for that period.”

Wigotow explained that business owners can use this information to plan for the following month or consider offering a small discount to clients for early payment to help collect more revenue in the same period it was earned.

2. Cash flow statements can help you decide when to ramp up sales and marketing.

If the cash flow statement shows a dip in forecasted revenue, the company can take action to increase revenue. For example, it could announce additional employee bonuses to salespeople who hit short-term sales targets or run a promotion to unload excess inventory. 

The cash flow statement will inform management about what marketing or sales-boosting tactics are best at the time. Here are some examples: 

• Low cash outlook: In a very low cash outlook, the company might focus on performance-based methods, such as affiliate marketing, sales commission bumps or bonuses to be paid later. 
• Forecasted low cash flow: If the cash situation is OK now but is expected to get worse, the company might opt to spend some money on digital marketing strategies to generate sales leads that will close when needed.

3. Cash flow statements let you know when to focus on collections.

When many accounts receivable (AR) are late and causing a cash flow problem, you’ll know it’s time to focus on collection strategies. Depending on your situation, you may do one or all of the following to improve cash flow: 

• Require a deposit from new clients to get some cash up front. 
• Tighten credit terms for current clients. 
• Expedite the debt collection process for delinquent accounts. 
• Turn to collection agencies or attorneys for help. 

4. Cash flow statements help you decide when to pay larger bills.

When the company has cash in hand, it can decide when to pay larger bills to vendors with credit lines or payment terms. When the company is flush with cash, payments can be made immediately to ensure products or raw materials continue to flow. Conversely, payment can be delayed or the company could even renegotiate its terms during a slow period.

5. Cash flow statements can indicate when a loan is needed. 

If your business is profitable on paper but short on cash flow, your cash flow statement will help determine if you need short-term financing, such as a bridge loan. In this situation, your business may be a strong candidate for a lender and the funding can help you cover expenses until revenue from sales starts flowing in. The cash flow statement also indicates how much to borrow so you avoid paying interest on funds you don’t need.

6. Cash flow statements can help indicate if your startup needs an investor.

Startup businesses should create cash flow statements as part of their pro forma financial documents. These statements outline the business’s startup costs, the founders’ investments and any shortfalls. If a shortfall is identified, you may consider seeking funding from an angel investor or venture capitalist to bridge the gap. 

The parts of a cash flow statement

While there may be variations by industry and region, the following three elements are typically included in a cash flow statement. 

1. Cash flow from operating: Often referred to as “cash from operating activities,” this section is typically first. It covers the incoming cash from sales or contracts and the outgoing payments for operational expenses, such as overhead costs, taxes, staff or manufacturing costs. 
2. Cash flow from investing: The investing section records capital expenditures, acquisitions and divestments. Expenditures and acquisitions are both cash outflows while divestments are cash inflows. It’s not unusual for this section to primarily consist of cash outflows, as many thriving businesses spend more money investing than cashing out investments.
3. Cash flow from financing: This section details how your company is funded and distributes its funds. Data in this portion may include debt transactions (incoming loan proceeds and outgoing loan payments) and equity. If your company pays dividends to shareholders, you would capture that here.

How to calculate cash flow

To calculate your business’s cash flow, start by adjusting your net income using information from your balance sheet and P&L statement. Adjustments are made to account for noncash items included in net income, such as revenue, expenses and credit transactions.

Consider the following methods and adjustments used to calculate cash flow.

>> FREE TOOL: Cash Flow Calculator

Direct cash flow method 

The Financial Accounting Standards Board prefers this method because it shows the actual flow of cash in and out of a business. To calculate, start by analyzing all cash payments and receipts using your accounts’ beginning and ending balances.

You’ll group cash transactions by type: 

• Operating cash flow: Cash received from customers, cash paid to suppliers and other operating expenses, such as salaries, rent and raw materials:
  • Cash received from customers = Sales + decrease or – increase in AR
  • Cash paid to suppliers = Cost of goods sold + increase or – decrease in inventory + decrease or – increase in accounts payable (AP)
  • Cash paid for operations = Operating expenses + increase or – decrease in prepaid expenses + decrease or – increase in accrued liabilities
• Financing cash flow: Interest payments received and interest paid
  • Cash interest = Interest expense – increase or + decrease in interest payable + amortization of bond premium or – discount
• Taxes cash flow: Income tax refund received and income tax paid (sales tax received and paid should be equivalent)
  • Cash for income taxes = Income taxes + decrease or – increase in income tax payable – income tax refund
• Other cash flow: Any other cash received, such as investment capital

Indirect cash flow method

This method starts with net income from your income statement. It only accounts for revenue earned. Next, you adjust net income for noncash items and changes in working capital that impact cash flow. Then, you add back transactions that do not affect cash flow, such as depreciation.

• Cash flow from operations = Net income + depreciation and amortization + AR + inventory + AP
• Cash flow from investing – Incoming investment cash – outgoing investment cash 
• Cash flow from financing = Incoming financing cash – outgoing financing cash 
• Net change in cash balance = Operating cash flow + investing cash flow + financing cash flow
• Cash balance at the end of the period = Net change in cash balance + cash balance at the start of the period

Key adjustments for cash flow calculations

Specific adjustments are essential for calculating cash flow accurately. Here are two common adjustments:

• AR: Cash flow statements should always include changes in AR during each accounting period. A decrease in AR indicates an increase in cash from customers who have paid off their accounts. This results in an increase in cash flow. However, an increase in AR should be deducted from net earnings because it is not an increase in cash.
• Inventory value: An increase in inventory should be reflected as a deduction from net earnings because it indicates money your company has spent (if it was paid in cash). Inventory purchased on credit would be reflected on the balance sheet as an increase in AP, with the amount added back to net earnings in the cash flow statement.

Risks of relying only on a cash flow statement

While cash flow statements are a valuable tool, they’re not the only financial information you should use when making decisions and assessing your business’s financial health. Here are two risks of relying only on cash flow statements. 

A cash flow statement may cause unnecessary panic. 

If you look at your cash flow statement and see that cash isn’t flowing, you may be unnerved. However, don’t panic. It’s important to examine additional financial data to uncover the true causes. Have you recently purchased equipment? Such a purchase may put a dent in your cash flow now but eventually lower your operating costs. Are you about to receive investment funds or sales revenue? Look at the bigger picture and examine other accounting data to learn your actual cash flow state. 

A cash flow statement may give you a false sense of security. 

Your cash flow statement may make you feel flush with cash. However, don’t relax just yet, as a rosy cash flow statement can be misleading. For example, you may have received a chunk of revenue, but significant expenditures may be on the horizon. 

Examine other accounting reports to truly understand your financial position. Review your balance sheet and income statement and ensure you have a clear picture of your revenue and expenditure forecasts.

John Bell, senior partner and insolvency practitioner at Clarke Bell, emphasized that cash flow statements are excellent tools for understanding where your cash went, but they can’t tell you what’s coming next. “We recommend using [cash flow statements] with cash flow forecasts,” Bell advised. “Forecasts allow you to anticipate your financial needs based on trends, combining past data with a look forward.”

Differences between cash flow statements, income statements and balance sheets

While cash flow statements, income statements and balance sheets are all standard financial reports — and there is some overlap — they are all distinct financial tracking tools. 

• Cash flow statements: Cash flow statements show how and when cash flows into and out of a business. The amount of cash you have on hand determines your ability to invest, pay bills and assess whether you need to focus on generating additional revenue.
• Income statement: Income statements reveal a company’s profit (or loss) in a given period. They include AR on the income side, even if that money has not yet been collected and AP on the expense side, even if it hasn’t yet been paid. The income statement also includes depreciation expense, which is not an actual cash expense but rather a portion of the original cost of a business asset, such as equipment, that is deducted over time as it becomes older and less valuable.

Jackie Rockwell, co-founder of Brass Jacks, an online bookkeeping academy, explained that while cash flow statements allow companies to see actual cash changes over a given period, income statements don’t reveal the same information. “If the company is using credit cards, loans or sends invoices that get paid in a later period, the numbers on the income statement may not represent the actual money that has changed hands,” Rockwell noted. 

• Balance sheets: Balance sheets show the company’s financial position by representing its overall value. Value is determined by subtracting liabilities (what the company owes) from assets (what the company owns). The result or value of the company is the shareholders’ equity. Cash on hand and AR are counted among the assets, while AP is one of the liabilities. Other assets include real estate, vehicles and equipment that are already paid for and, therefore, do not have an associated ongoing cash payment.

Cash flow statement example (direct method)

Here’s an example of a cash flow statement created with the direct method: