What is Cash Flow Statement and How the Cash Flow Statement Is Used?

The Cash Flow Statement (CFS), is a financial statement that summarizes the movements of cash and cash equivalents (CCE) that are coming into and going out of a company. CFS measures how well a company manages its cash position, that is, how well a company generates cash to service its debt obligations and fund its operating expenses. As one of the three main financial statements, the CFS complements the balance sheet and income statement. In this article, we will show you how CFS are organized and how you can use them when analyzing a company.

KEY TAKEAWAYS

The statement of cash flows summarizes the cash and cash equivalents that enter and leave the company.
This financial statement complements the balance sheet and income statement.
The main components of CFS are cash from three areas: operating activities, investment activities, and financing activities.

How Is The Cash Flow Statement Used?

The cash flow statement paints a picture of how a company’s operations are going, where its money is coming from, and how the money is being spent. Also known as a statement of cash flows, a CFS helps its creditors determine how much cash is available to fund a company’s operating expenses and pay off its debts (known as liquidity). Child friendly spaces are equally important to investors as they tell them if a company is on a strong financial footing. This way, they can use the statement to make better and more informed decisions about their investments.

The Structure Of The Cash Flow Statement

cash flows from operating activities
cash flows from investing activities
cash flows from financing activities

Disclosure of non-monetary activities, which are sometimes included when prepared in accordance with Generally Accepted Accounting Principles (GAAP).

Cash Flows From Operating Activities

CFS operations include the sources and uses of cash from business activities. In other words, it reflects the amount of money a company’s products or services generate.

These operating activities may include:

Payment of interest
Income tax payment
Payment of salaries and wages to employees
Pay the rent
Any other type of operating expenses

In the case of a business portfolio or investment firm, proceeds from the sale of loans, loans or equity instruments are also included because it is a business.

Important: Changes in cash, accounts receivable, depreciation, inventory, and accounts payable are generally reflected in cash from operations.

Cash From Investing Activities

Investing activities include the sources and uses of cash from the company’s investments. Any payments related to the purchase or sale of assets, loans to sellers, dues from customers, or mergers and acquisitions (M&A) are included in this category. In short, a change in equipment, assets or an investment relates to the cash flow from the investment.

Changes in cash from investments are generally considered to be cash items because the cash is used to purchase new equipment or buildings or short-term assets such as marketable securities. But when a company liquidates an asset, the transaction counts as cash to account for cash from investment.

Cash From Financing Activities

Cash flow from financing activities includes sources of cash from investors and banks as well as cash payments to shareholders. This includes any dividends, share repurchase payments, and repayment of principal(s) incurred by the company.

The change from financing to cash is cash when capital is raised and cash when dividends are paid. Thus, if a company issues bonds to the public, the company obtains cash financing. However, when interest is paid to bondholders, the company reduces cash flow. And remember, even though interest is a cash-exchange expense, it’s reported as an operating activity — not a financing activity.

How Is Cash Flow Calculated?

There are two ways to calculate cash flow: the direct method and the indirect method.

Direct Cash Flow Method

The direct method includes all cash payments and receipts, including cash paid to suppliers, cash receipts from customers, and cash paid in payroll. This CFS method is suitable for very small businesses that use the cash basis of accounting.

These numbers can also be calculated using the opening and closing balances of the various asset and liability accounts and examining the net decrease or excess in the accounts. It is presented directly.

Indirect Cash Flow Method

With the indirect method, cash flows are calculated by adjusting net income by adding or subtracting the differences resulting from non-cash transactions. Non-cash items are reflected in changes in a company’s assets and liabilities on the balance sheet from period to period. Therefore, the accountant will determine which additions and decreases in the assets and liabilities accounts should be added to or removed from the net income figure, to indicate the correct cash inflows or outflows.
Changes in Accounts Receivable (AR) from one accounting period to the next should be reflected in the Balance Sheet in the Cash Flows:

If AR decreases, more cash may flow into the company from customers paying off their credit accounts – the amount by which AR decreases is added to net income.
The increase in AR must be deducted from net income because although the amounts represented in the AR are income, they are not cash.

What about changes in the company’s inventory? Here is how it is calculated in CFS:

An increase in inventory indicates that the company has spent more money on raw materials. Using cash means deducting the increase in inventory value from net income.
Credit purchases are reflected by an increase in accounts payable on the balance sheet, and the amount of the increase from year to year is included in net income.

The same logic applies to taxes owed, payroll, and prepaid insurance. If something is paid, the difference in the amount owed from year to year must be deducted from the net income. If there is an amount still owed, any difference must be included in net income.

Limitations Of The Cash Flow Statement

Negative cash flow should not automatically raise the warning flag without further analysis. Poor cash flow is sometimes caused by a company’s decision to expand its business at a particular point in time, which bodes well for the future.

Analyzing changes in cash flow from one period to the next gives the investor a better idea of ​​how the company is performing, and whether the company is on the verge of bankruptcy or success. CFS should also be considered in conjunction with other financial statements.

Cash Flow Statement Vs. Income Statement Vs. Balance Sheet

The cash flow statement measures a company’s performance over a period of time. But since the time of cashless transactions they have not been easily manipulated. As mentioned above, CFS can be derived from the income statement and balance sheet. Net income from the income statement is the number by which the information contained in the CFS is estimated. But it is only a factor in determining the division of operating activities in the CFS. Thus, the net income is not related to the investment or financing activities division of the CFS.

The income statement includes depreciation expense, which doesn’t really have any cash flow associated with it. It is simply the allocation of an asset’s cost over its useful life. A company has some freedom in choosing its own method of depreciation, which adjusts for the depreciation expense listed on the income statement. On the other hand, CFS is a measure of actual inflows and outflows that cannot be easily addressed.

As far as the balance sheet is concerned, the net cash flow reported in the CFS should equal the net change in the various items on the balance sheet. It excludes cash and cash equivalents and non-cash accounts, such as accumulated depreciation and accumulated amortization. For example, if you calculated cash flows for 2019, be sure to use the 2018 and 2019 budgets.

From CFS, we can see that the net cash flow for fiscal 2017 was $1,522,000. The majority of the positive cash flow is coming from cash from operations, which is a good sign for investors. This means that core operations are generating business and there is enough cash to purchase new inventory.

Purchasing new equipment shows that the company has cash to invest in itself. Finally, the company’s available cash should put investors’ minds at ease regarding notes payable, since the cash is more than needed to cover future debt costs.

Difference Between Direct Cash Flow And Indirect Cash Flow Statements?

Direct Method, the actual cash inflows and outflows are known quantities. With cash payments and receipts, the cash flow statement is reported in a straightforward manner.

Indirect Method, The indirect method starts with the net income or loss from the income statement, then adjusts the data using the increases and decreases in the balance sheet account, to calculate cash inflows and outflows.

Is the indirect method of cash flow statement better than the direct method?

Not necessarily better or worse. However, the indirect method also provides a means of reconciling items on the balance sheet with net income on the income statement. When the accountant prepares CFS using the indirect method, he can identify additions and decreases to the balance sheet that result from non-cash transactions.

It is useful to see how accounts on the balance sheet affect net income on the income statement, and it can provide a better understanding of the financial statements as a whole.

What Is Included In Cash And Its Equivalent?

Cash and cash equivalents are combined into one line item on a company’s balance sheet. The value of the company’s cash assets is reported currently or can be converted into cash within a short period of time, usually 90 days. Cash and cash equivalents include currency, petty cash, bank accounts, and other short-term, highly liquid investments. Examples of cash equivalents include commercial paper, treasury bills, and short-term government bonds with maturities of three months or less.

Bottom Line

The cash flow statement is a valuable measure of a company’s strength, profitability, and long-term future prospects. CFS can help determine if a company has enough liquidity or cash to pay its expenses. A company can use CFS to estimate future cash flows, which helps with budgeting issues.

For investors, CFS reflects a company’s financial condition, as the more cash available for business operations, the better. Sometimes, negative cash flow results from a company’s growth strategy to expand its operations.

By studying CFS, an investor can get a clear picture of how much money a company generates and a solid understanding of the company’s financial well-being.