Since their inception back in 1988, cashflow statements and income statements have become an integral part of an enterprise’s financial report.
A cash flow statement summarizes all the expenses, depreciation, increases in inventories, and the total amount of cash received and left a company (cash-tracking). The statement of cashflow maintains and records the revenue side of a company. You will find several statements of cash flows example over the internet, but to understand them, you will need some assistance.
Through a cash flow statement, one can quickly tell the profits, income, finance, operational costs, and much more. The statement of cash flow also indicates the measurements of how well a company manages the incoming cash/revenue. How it redirects the cash, and how well is it maintaining the cash to pay its debt while funding the operational expenses.
In this article, we are going to discuss an in-depth detail of a cash flow statement. Why is it important? How is it beneficial for businesses? and how it benefits a company’s planning and coordination?
The below key points will give you a brief and concise introduction to the cash flow statement so that you can recall it easily.
- A cash flow statement manages and maintains the amount of cash that comes, i.e. (revenue), and leaves a company, i.e. (operational costs/losses).
- The statement of cash flows determines a company’s efficiency in cash positioning and cash generation to pay its debt obligations and operational expenses.
- The cash flow statements were formalized back in 1988, and they have been an integral part of an organization’s financial report ever since.
- A statement of cash flows is based on three core principles:
- Investing Activities.
- Financial Activities.
- Operating Activities.
- The direct and indirect methods are widely used to calculate cash flow.
The Types Of Cash Flows
There are three types of cash flows: investment cash flow, operating cash flow and financing cash flow. Let’s go step by step while understanding each one of them.
1. Investment Cash Flow
The investment cash flows typically involve the process of buying and selling property, goods, plants, or equipment.
This type of cash flow is also related to the acquisition and disposal of useless or non-current assets and various investments not included in cash equivalents.
2. Operating Cash Flow
This type deals with the activities influencing the revenue production of the company. Operational cash flow is closely linked with sales, purchases, and various other expenses.
There are two presentations of this type of cash flow:
1. Direct Presentation
In the direct presentation, the operational cash flows are presented in a list format. This list contains sales and cash out for expenditures. The indirect presentation method is more used than the direct method.
2. Indirect Presentation
In the indirect presentation, the operational cash flows are presented as a reconciliation from profit to cash flow.
It is essential to know that the cash flow statement items are not precisely cash flows, but they are reasons. They explain why cash flow is different from profits.
3. Financing Cash Flow
The factors or activities that affect the equity capital in terms of size and composition are called financing cash flow activities. These activities usually include cash flows related to borrowing or repaying bank loans or issuing buying back shares.
Moreover, the payment of a dividend is also considered as a financing cash flow.
Relation Between Cash Flow Statement And An Income Statement?
Both the cash flow statement and income statement are tied together. However, both have some different characteristics and usage.
An income statement is a part of a corporate balance sheet. It determines the number of cash inflows and outflows over a targeted period. The income statement can also be called “the simplest form of a financial statement,” in which total expenses, accounts, depreciation ratio, and an organization’s revenue are present.
Both of the statements have net profit/net burn incorporated in them. In the cash flow statement, this element is used to calculate the operational costs.
Relation BetweenRetained Earnings And Cash Flow
Retained earnings is a record that is based on the accumulated profits. An organization uses these profits to boost its operations by reinvesting rather than distributing the profits as dividends among partners.
In comparison, cash flow is the total change in the business cash and cash equivalents, which occurs due to operational expenses for a designated period.
Relation BetweenAccounts Receivable (AR) and Cash Flow
If any changes are observed in the accounts receivable on the balance sheet, the changes must also be reflected in cash flow.
Let explore the two case scenarios in which accounts receivable has increased and the second in which it has decreased.
1. Accounts Receivable Increased.
If accounts receivable increases from one accounting period to another, the amount increased should be subtracted from the net sales. They should be deducted because although this increase counts as revenue, they are not cash.
2. Account Receivable Decreases
If accounts receivable decreases, more cash enters the company because of customers paying off their credit accounts. This amount is deducted from the AR and added to the net sales.
Relation Between Cash Flow And Inventory Value
An inventory is the items a company has acquired. If your inventory increases, it means that your company has spent money to purchase items/materials.
If the expenses of increasing your inventory were paid with cash, an increase in inventory value is deducted from sales. If you purchase the inventory on credit/loan, an increase in the accounts payable would be observed on the balance sheet.
And finally, the amount of increase from one year to another would be incorporated into the net sales. The same logic is applied for taxes and salaries payable, and prepaid insurance. If you have paid something off, then the value owed from one year to another would be subtracted from the net income. However, if there is an amount you have still owed, then the difference shall be added to the net earnings.
Why Is Income Statement Important?
Income statements are generally a part of the financial statement. They show the profitability of a company. An income statement can also give you details regarding your organization’s efficiency to turn expenses into revenues.
If you need to know about the profits your business could earn in the long run, an income statement will help you determine it. You can also make essential business decisions, i.e., if you want to buy equipment or hire more staff or if you have to wait until your company’s financial conditions stabilize.
Why Does A Company Need A Statement Of Cash Flow?
You already know the advantages and importance of a Cash flow statement. See a statement of cash flow example below, and then we’ll start exploring why companies need cash flow statements.
1. Predicting your future cash flows
Organizations can use cash flows to determine their future operational costs. Through a cash flow projection, you can plan for future resources and liabilities. This advantage enables you to make important decisions to prepare for a safer and more sustainable business future.
2. Liquidity Ratio
Liquidity ratio means the amount of cash you have reserved to support your operational expenses in case you need it. Through this, you can determine whether your organization would be able to afford additional resources or equipment or not.
3. Variations In Liabilities, Equity, And Assets
You can keep track of the variations in assets, liabilities, and equity by analyzing your cash outflows, inflows, and debt. These three elements are the core components of your business accounting. Together they form an equation that measures your performance.
Difference Between Negative And Positive CashFlow
Cash flow is divided into two parts, negative cash flow, and positive cash flow. Let’s dive into the details and explore how they are different from each other.
Negative Cash Flow
The negative number on your cash flow statement is located at the bottom, and this negative number shows the cash that you have lost during the accounting period.
However, having a digit number in the cash flow statement doesn’t always mean bad news. E.g., When you invest in something that would pay later on.
Positive Cash Flow
Similarly, in this statement, you’ll find a positive number located at the bottom of the statement of cash flow. However, having a positive number in the cash flow statement doesn’t always mean good news.
It does give you more liquidity, but it has some negative reasons/instances due to which there is a positive cash flow. E.g., You might’ve taken a loan from the bank to manage your resources’ expenses or support a failing business. In such cases, having a positive cash flow is not considered beneficial.
The Relation BetweenBalance Sheet And Income Statement And Cash Flow Statement
The balance sheet, income statement, and cash flow statement are closely related because they depend on each other.E.g., your cash flow statement is a derivative of your income statement and balance sheet.
The information displayed on CFS is deducted from the net earnings calculated in the income statement.
For the balance sheet, the result of the net cash flows in the statement of cash flow should be determined by equating the increase and decrease of cash between two consecutive balance sheets. E.g., If you want to calculate the cash flow for the year 2020, the balance sheets of 2019 and 2020 will be used to determine the cash flow.
How Are Cash Flow Statements Created?
By doing your bookkeeping yourself, you can calculate the cash flow statement every month by utilizing your balance sheet and income statement.
However, If you don’t want to do it yourself, you can hire the best online bookkeeping services provider to handle your cash flow statements.
However, keeping your bookkeeping as accurate as possible to extract the most relevant results is recommended. In my perspective, the best way to get accurate cash flow statements is by hiring the best online bookkeeping services provider. The companies providing such services have experienced staff who can quickly and efficiently calculate your cash flow, ensuring a more accurate picture.
What Should A Cash Flow StatementEntail?
To ensure that you have created an accurate cash flow statement, refer to the points mentioned below and compare them with your cash flow statement.
- Your cash flow statement should compare operating activities and the company’s net income to evaluate the earnings quality.
- If the cash of operating activities is higher than net income, the earnings are deemed “high quality.”
- Your cash flow statement should entail information that allows the investor or business owner to get an overall sense of its cash inflows and cash outflows. They should also be able to determine the overall performance in general.
- The cash flow statement should indicate funding losses from operation and financing investments by raising debt or equity.
How To Build A Cash Flow Statement?
There are two main methods of building a cash flow statement: direct and indirect methods. It doesn’t matter which approach you choose because the investing and financing sections remain the same with both.
The difference, however, comes in the operating section.
The direct method entails the gross cash receipts and gross cash payments.
For the indirect method, begin with the net income and adjusts the profit and loss according to the transactions. This method follows a series of addition and deductions.
The results of both methods are the same, but the presentation also differs due to the structure.
Moreover, according to the International Accounting Standards Board, the direct method provides more valuable insights than the indirect method, so they prefer the direct method.
Using TheDirect Cash Flow Method
If you are using the direct cash flow method, you have to add up all the different modes of payments and receipts, i.e., cash paid to suppliers, cash receipts from customers, and cash paid in salaries.
You have to ensure that you calculate the figures by taking the beginning and ending balances of business accounts into consideration. Also, examine the decrease and increase in the accounts because they are a part of the method.
Using TheIndirect Cash Flow Method
You have to determine the cash flow coming from operational activities while using the indirect method.
Consider taking the net income of a company’s income statement. Also, because the income statement is prepared on an accrual basis, the revenues are recognized once earned and not received.
It is important to adjust the earnings before excluding the interest and taxes (EBIT) because they affect net income. Know this; net income is not an accurate representation of net cash flow from operational activities, which is why you should adjust EBIT before moving further on. The indirect method also includes adding non-operational activities that do not affect a company’s operational cash flow.
E.g., depreciation is not what it is thought to be”A Cash Expense.” depreciation is the amount that is deducted from the total value of an asset that has been previously bought and used in an organization.
Difference Between Cash And Accrual Accounting
The most probable difference between the two is related to the timing of taking the revenue and expenses into consideration.
The cash flow takes a more immediate and quick approach towards recognizing revenue and expenses, while accrual accounting focuses on the anticipation of revenue and expenses.
Over To You
A cash flow statement, as told earlier, is an integral part of an organization. It helps you determine the strengths, strategically design maps to boost efficiency, measure profitability, and improve long-term management and planning.
You can also determine whether your organization has enough revenue (liquidity) to pay or bear its expenses through cash flow statements. After looking at the results, you can opt for budgeting to reduce and improve certain aspects of your organization’s productivity and management.
Cash flow statements also represent a company’s financial health. It tells the directors, owners, and investors about the sustainability of an organization and how much cash is available, which can be used to better business operations.
Business owners can see a more transparent and more accurate picture of a company’s cash generated and gain insightful details of its financial conditions.