It’s no secret that cash flow is often a major challenge for many small and midsize businesses – there are abundant stats about how many businesses fail because they run out of cash. The good news is that understanding a cash-flow statement can help business owners manage their cash flow and plan for the future.
The cash-flow statement is one of the three primary financial statements that profile a company's financial health. Small-business owners are usually more familiar with the income statement, which shows revenue and expenses for a particular period (typically month, quarter, or year) and the balance sheet, which shows assets, liabilities, and equity balances.
However, the cash-flow statement can provide even more insights to help business owners optimize their cash flow. This guide will help you understand what’s on a cash-flow statement, why it matters, and how to interpret it.
The cash-flow statement shows the sources of cash coming into a company and the uses of cash flowing out over a given period of time, such as a month, quarter, or year.
What Is Cash Flow Versus Profit?
The cash-flow statement is key to maintaining a company's financial health. Most businesses use the accrual basis of accounting – which is required by U.S. Generally Accepted Accounting Principles (GAAP) – as opposed to the cash basis.
In accrual accounting, cash flow differs from profit because revenue is “recognized” when it is earned, not when it arrives in the business’s bank account. Expenses are also recognized when they are incurred, not when the business pays the bill. So net income (a.k.a. profit) or net loss for a period is calculated by subtracting expenses incurred from revenue earned.
Because the “when” of revenue collection and expense payment is not considered, the timing differences between recognition and actual collection can create a cash crunch for businesses. For example, a company can’t pay employees with earned but uncollected revenue. Therefore, the cash-flow statement can help small-business owners better understand their money and where it's going.
Interpreting Sources and Uses of Cash
The cash-flow statement shows the sources of cash coming into a company and the uses of cash flowing out over a given period of time, such as a month, quarter, or year.
Identifying sources shows how a company generates cash, which helps business leaders better understand and predict cash inflow. It’s important to know whether a company is generating cash from its core operations – such as sales of products and services – versus from selling equipment or taking out a loan, for example.
Similarly, a cash-flow statement can give insight on cash disbursements – like whether the company’s cash balance is increasing because it’s not paying bills, causing an increase in liabilities.
Public company cash-flow statements must comply with GAAP’s standardized format with three sections:
- Cash Flow From Operations
- Cash Flow From Investing Activities
- Cash Flow From Financing Activities
GAAP-compliant cash-flow statements may also be required for any company that seeks investors or acquires debt. GAAP standardization allows more useful comparisons between companies and makes the statement easier for external stakeholders to use.
How to Read a Cash-Flow Statement
The cash-flow statement shows the beginning and ending cash balance for a stated period of time.
When the sum of the sources and uses in all three sections causes the cash balance to rise, that means the company is “cash positive” – generally considered a good thing. When the sum of the three sections causes the ending cash balance to fall, the company is “cash negative.”
It’s not always a bad thing to be cash negative, especially if the details show the company is investing for the future, but most businesses can't weather long cash-negative periods.
Additionally, cash-flow statements usually include comparisons to the same period in the prior year. For example, a cash-flow statement might list activity for the nine-month period ended September 30, 2022, side-by-side with the nine-month period ended September 30, 2021. The comparison adds another dimension of insight, allowing readers to draw conclusions about the direction of the company’s health and liquidity.
Cash-flow statements can be prepared for different business units, in addition to the company-wide statement. A divisional or department manager may look at their area’s cash-flow statement to understand how the department is contributing or detracting from the company’s overall financial health. An external investor might rely on company-wide cash-flow statements to determine whether a company is primed for growth.
Cash Flow From Operations
This section is usually the most important because it gets to the heart of whether a company generates cash from its core operations.
Cash flow from operations includes sources, such as monies collected from customer payments, and uses including disbursements for raw material inventory, payroll, utility payments, and all other transactions from the normal course of business.
The 'Cash Flow From Operations' section works more like a reconciliation than just a list of transactions. It usually starts with the company’s net income from the income statement for the same period. Each entry modifies that net income by stripping out non-cash activity or adjusting for changes in working capital.
For example, depreciation reduces net income, but does not involve spending cash, so depreciation is added back to net income when calculating cash flow from operations.
On the flip side, an increase in accounts receivable, which is from sales made to customers on credit, is part of net income, but it does not technically increase a company’s cash flow. Therefore, that would be subtracted from net income when calculating cash flow from operations.
These adjustments can appear dizzying at first. What’s important to know is that after all the adjustments are made, 'Cash Flow From Operations' shows the “cash version” of a company’s net income. You usually want it to be positive.
Cash Flow From Investing Activities
The second section on a cash-flow statement shows activity from changes in capital assets and long-term investments.
These changes tend to involve large amounts that occur relatively infrequently and are outside the organization’s day-to-day operating activity. Examples include buying or selling equipment, machinery, land, buildings, vehicles, or warehouses. Proceeds from selling capital assets is a source of cash, while spending on capital assets is a use of cash.
It’s important to note that these examples apply when the buying or selling is done via cash – not when using loans or other financing.
Investment activity, such as buying and selling marketable securities, is also captured here. Any interest income from these securities is included in the 'Cash Flow From Operations' section. Acquisitions and divestitures of business units are also included in this section if they’re done with cash.
When evaluating quality of cash flow, investing activities are considered secondary to operating activities because they’re not part of the company’s core operations.
Cash Flow From Financing Activities
'Cash Flow From Financing Activities' outlines how a company is funded using debt and equity and is related to changes in long-term liabilities and equity accounts on the company’s balance sheet.
Raising capital appears as a source of cash. Examples include proceeds of loans, capital contributions from owners or investors, and proceeds from selling shares of stock.
Paying stakeholders is a use of cash. Examples include repaying loan principals, paying cash dividends, or repurchasing company stock. Non-cash financing transactions, such as a conversion of debt to common stock, are not included.
Further analysis of these cash-flow figures can help determine a company’s overall financial health. Large financing cash inflows may be positive, signaling future growth, but could instead mean that a company is using debt to stay afloat. Large cash outflows may mean that debt is being repaid or that profits are being shared through dividends.
Ending Cash Balance – What to Do With It
The final number at the bottom of a cash-flow statement is the ending cash balance as of the last day in the covered period.
This balance, which should match the company’s balance sheet as of the same date, is the result of all the sources and uses listed in the three sections. There is no right or wrong when it comes to this cash balance – bigger isn’t always better. Excess cash might be a sign of underinvestment in the future or missed opportunities.
The Takeaway
The cash-flow statement is a historical document that can be used as a template for modeling future cash flows. Cash-flow forecasting can help business leaders predict what their cash balance might be in the future, which can make the difference between a company’s survival or failure.
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