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Cash flow statements explained

Cash flow is at the core of a business’s financial health. Without cash, it will be unable to meet its financial responsibilities and eventually be forced to stop operating. Striking the right working capital balance is crucial to business health, and a cash flow statement is key to monitoring this. A cash flow statement is a mandatory part of financial reporting and sets out the amount of cash and cash equivalents that flow through a company. Not only is it a critical resource for finance teams, it also provides vital insight for the outside world regarding the company’s health and operational practices. 

The structure of a cash flow statement

A cash flow statement accompanies the balance sheet and income statement. In short, it shows where the money comes from and how it is used. Unlike an income statement or balance sheet, it doesn’t look at future income or outgoings; the cash flow statement focuses purely on cash flow during a specified period. This is defined by three segments: core operations, investing and financing. 

Core operations

This section of the statement reveals the amount of cash generated by a company’s products or services – in other words by its core business operations. Adjustments are made to net income in the income statement to reflect working capital changes, such as receivables, payables and inventories. 
There are two methods to calculate cash flow from operating activities – the direct method and the indirect method. The former takes data from the income statement using cash receipts and cash disbursements related to operating activities. The net value of the two equates to the operating cash flow. 

The indirect method converts net income to operating cash flow by adjusting for items that contribute to net income calculations but do not affect cash, such as depreciation and amortization.  

Investing

This section encompasses changes in equipment, assets or investments. It is frequently documented as cash spend – for example, when cash is used to purchase or replace a piece of equipment. However, you can also see ‘cash in’ caused by investing if, for instance, a company divests itself of an asset in return for cash. 

Financing

As the name suggests, this section relates to finance-driven changes to cash flow. These may be changes in debt, loans or dividends. This could be when capital is raised and cash enters the company, or it could be when dividends are paid out and cash leaves the company. 

Insights from a cash flow statement

A cash flow statement will reveal many things, but here are some key factors to observe:

•    If the cash from operating activities is consistently larger than the net income, then net income (or earnings) will be labelled ‘high quality’. Conversely, if net income is larger than the cash from operating activities, further investigation is needed to find out why reported net income is not transferring into cash. 

•    If a company consistently generates more cash than it uses, it is in a strong position to increase dividends, buy back stock, decrease debt and even expand by acquiring another company. These are all signs of good financial health.

•    As business activity is often cyclical, cash flow statements can help a company predict future cash flows and budget accurately. If there are considerable changes in cash flow from year to year, it’s important to get to the heart of this. However, when carefully managed as part of a strategy, negative cash flow could be a sign of positive growth as a company expands its operations. 

As the saying goes, cash is king, so it’s important to monitor your cash flow accurately. We’ve also put together some useful tips on how to improve cash flow in your business
 

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