A cash flow statement summarizes a business’s cash inflows and outflows over a period of time. Understanding and analyzing a cash flow statement is crucial for business owners to evaluate their business’s financial health.
Are you a small business owner puzzled by why your income statement shows healthy profits, yet you struggle with cash flow issues like paying bills or investing in growth opportunities?
Your cash flow statement (CFS) holds the answers.
For a business to thrive, it must maintain sufficient cash flow. This enables you to repay loans, purchase inventory, and invest in growth opportunities. Without enough cash to cover debts, a business can quickly face bankruptcy.
The cash flow statement provides insight into where your money is coming from and where it’s going, showing the actual liquidity position of your business.
In this blog, we’ll break down the cash flow statement into simple terms and provide examples, equipping you with the knowledge to interpret your cash flow statement, maintain a healthy cash position, and avoid the pitfalls of poor cash management.
What is a cash flow statement?
Along with the income statement and balance sheet, the cash flow statement is one of the three main financial statements used in accounting. Many business leaders even consider it the most important of all three. It helps business owners, managers, and stakeholders make informed decisions by understanding the company’s cash movements.
But what exactly is it?
A cash flow statement is a financial report that shows how much cash is ‘flowing’ in and out of your business during a certain accounting period, like a month or a year.
By offering insights into actual cash movements, cash flow statements help business owners and financial leaders understand the real liquidity of the business. This clarity is essential for effective financial planning and management.
For small business owners like you, knowing your cash flow statements is key. It helps you see if your company is making enough money to pay bills and keep things going. Understanding this helps you make smart choices to keep your business running smoothly.
Cash flow statements in accounting
Cash flow statements are a critical component of accounting. They provide a bridge between the income statement and the balance sheet by showing how cash is moving through your business. Together, the three fundamentals of accounting form the backbone of a company’s financial reporting and provide a comprehensive view of a company’s financial health.
Therefore, when you create financial statements for your business, you use information from both the income statement and the balance sheet to construct the cash flow statement.
The income statement tracks how money flows in and out of your business, while the balance sheet illustrates how these transactions impact various accounts, such as accounts receivable, inventory, and accounts payable.
Let’s break it down further:
Income statement: Also known as the profit and loss statement, the income statement shows a company’s revenues and expenses over a specific period, typically a quarter or a year. It demonstrates whether a company is making a profit or a loss during that time.
Balance sheet: The balance sheet provides a snapshot of a company’s financial position at a specific point in time, usually the end of a quarter or year. It shows what a company owns (assets), what it owes (liabilities), and the amount invested by shareholders (equity).
Cash flow statement: The cash flow statement, as we have already discussed, shows how changes in balance sheet accounts and income affect cash and cash equivalents. It helps investors understand how well a company manages its cash position, which is crucial for its operational efficiency and financial health.
Together, these statements help business owners and investors assess the company’s profitability, liquidity, and solvency. Understanding all three is crucial for business owners because it allows them to make informed decisions about managing their finances, planning for the future, and ensuring the long-term success of their business.
Understanding cash flow statements is especially crucial if your business uses accrual accounting
In accrual accounting, revenues and expenses are recorded when they are earned or incurred, not necessarily when cash changes hands. This means you might show a profit on your income statement even if you haven’t actually received the cash yet, or you might incur an expense that hasn’t been paid out in cash. The cash flow statement helps clarify this by showing the actual cash available, thus giving a true picture of your business’s liquidity.
For example, imagine you run a cafe. Your cash flow statement would record how much cash you actually receive from customers (cash inflows) and how much cash you spend on supplies like sugar and coffee cups (cash outflows). It would also reflect the impact of changes in Accounts Receivable and Accounts Payable. When your customers pay with credit cards, for instance, the revenue is recorded on the income statement, but the cash hasn’t been received yet, affecting your cash flow.
Similarly, if you owe money to suppliers for inventory you’ve taken on credit, that liability impacts your cash position. So even if your income statement shows a profit, you might still struggle with cash flow if your customers haven’t paid you yet or if you have large upcoming expenses or debts. The cash flow statement helps you see this discrepancy by providing a clear picture of your actual cash on hand.
Did you know?
Did you know that 82%[1] of small business failures in the U.S. can be attributed to poor cash flow management? You can safeguard your business from becoming a statistic in this percentage by regularly reviewing cash flow statements. It will help you detect patterns, anticipate problems, and adjust operations before cash flow issues become fatal.
Why do you need cash flow statements?
Cash flow statements are crucial for businesses using accrual accounting for three main reasons:
1. Liquidity insights
Cash flow statements provide a clear picture of your operating cash flow, showing how much cash is readily available. This helps you determine what you can afford and what you cannot, ensuring you have enough liquidity for day-to-day operations and unexpected expenses.
2. Tracking financial changes
They highlight changes in your assets, liabilities, and equity through cash inflows, outflows, and cash held. These three categories are fundamental to your business’s financial health and form the accounting equation, allowing you to measure your performance accurately.
3. Predicting future cash flows
By analyzing past cash flows, you can create projections for future cash flow. This enables you to plan for the liquidity your business will have, which is essential for making informed long-term business decisions and ensuring financial stability.
Sections of a cash flow statement
The cash flow statement breaks down how money moves in and out of a business into three main parts:
Operating activities
This section shows the cash generated from day-to-day business operations and uses of that cash, like selling products or services and covering expenses.
It includes, but is not limited to:
- Receipts of sold goods and services
- Income tax payments
- Salary payments to employees
- Interest payments
- Payments made to suppliers
- Rent payments
- Any other operating expenses
If the company has a trading portfolio or is an investment company, it will also include receipts from the sale of financial products, debt instruments, or equity securities in this section.
Investing activities
Investing activities cover any cash a company uses or receives from its investments. This includes buying or selling assets, giving or getting loans from vendors or customers, or making payments for mergers and acquisitions (M&A).
In simple terms, changes in equipment, assets, or investments are part of cash from investing, using available cash, not borrowed money.
Usually, changes in cash from investing are seen as cash going out because money is used to buy new equipment, buildings, or short-term assets like stocks. However, when a company sells off an asset, it’s considered cash coming in for calculating cash from investing.
Financing activities
Cash from financing activities covers where a company gets its cash from investors and banks, as well as how it pays cash to shareholders. This includes dividends, payments for buying back stock, and repaying loan principal (money borrowed) by the company.
Changes in cash from financing are considered cash-in when money is raised and cash-out when dividends are paid. For example, if a company sells bonds to the public, it gets cash financing. But when the company pays interest to bondholders, it’s reducing its cash. It’s important to note that while interest is a cash-out expense, it’s reported as an operating activity, not a financing activity.
Disclosure of non-cash activities
Take note that there is a fourth item sometimes included in the cash flow statement: disclosure of non-cash activities.
This section, when prepared under generally accepted accounting principles (GAAP), sheds light on transactions that affect a company’s financial position but don’t involve actual cash exchange.
Understanding these sections helps you see where your cash is coming from and going, allowing you to make informed decisions for your business. Remember, while profit shows how much money you’re making, cash flow shows how much cash is actually flowing through your business. Both are important for keeping your business healthy and growing.
Example of a cash flow statement
Cash Flow Statement
Gallagher’s Landscaping Services
For the Month Ended May 31, 2024
| Cash flow from operations | |
| Net income | $100,000 |
| Additions to cash | |
| Depreciation | $5,000 |
| Increase in accounts payable | $15,000 |
| Subtractions from cash | |
| Increase in accounts receivable | ($25,000) |
| Increase in inventory | ($10,000) |
| Net cash from operations | $85,000 |
| Cash flow from investing | |
| Purchase of equipment | ($20,000) |
| Cash flow from financing | |
| Notes payable | $10,000 |
| Net cash flow for the month ended May 31, 2024 | $75,000 |
Starting off with the net income of $100,000 is what the business earned after all the usual expenses are paid off.
Then, we have depreciation at $5,000. Even though it’s technically an expense on the books, it doesn’t actually take any cash out of our pocket—it’s just accounting doing its thing to spread out the cost of equipment over its useful life. So, we add this back to our cash pile because, in reality, our cash hasn’t decreased.
Next up, there’s an increase in accounts payable of $15,000. This means we owe more to our suppliers than before. It sounds bad, but it’s actually helpful for our cash flow because it means we held onto our cash a bit longer instead of paying it out.
On the flip side, we see an increase in accounts receivable of $25,000, which means we sold more services but haven’t seen all that cash yet since some customers haven’t paid us. This is cash that we’ve earned but don’t have in hand, so it counts as a cash outflow.
Similarly, an increase in inventory by $10,000 shows we bought more stuff to keep the business running—things like plants, tools, whatever we need for landscaping, and more inventory means more cash spent.
When we pull all these together for the operating activities, we end up with $85,000 as our net cash from operations. This tells us how much cash we actually ended up with from our regular business activities, after considering money that came in and went out.
Moving to investments, we spent $20,000 on new equipment. It’s a cash outflow because, well, buying new tools costs money.
Lastly, there’s the financing part where we got $10,000 from notes payable—this is new borrowing that brought in some extra cash.
Add it all up, and we increased our cash by $75,000 by the end of May. This tells us how well the business managed its cash during the month, balancing income, expenses, investments, and loans.
Where do cash flow statements come from?
If you manage your own bookkeeping using Excel, you can generate cash flow statements each month from the data on your income statements and balance sheets. If you use accounting software, it can automatically create cash flow statements based on the information you’ve input into the general ledger.
However, keep in mind that the accuracy of your cash flow statement depends on the precision of your overall bookkeeping. For a more assured accuracy, you might consider hiring a bookkeeper. They’ll ensure that all the numbers add up correctly so your cash flow statement consistently provides a true reflection of your company’s financial health.
How to read a cash flow statement
When you look at any financial statement, think about it from a business point of view. These documents are meant to give you an idea of how well a company is doing financially.
For instance, it can show if the company is growing fast, making a lot of money, or if it’s having some troubles. This can help investors decide if they want to invest in the company. If the cash flow is up and down, they might think it’s too risky. But if it’s steady and positive, they might see it as a good opportunity to grow their money.
Even within a company, different departments might use the cash flow statement in different ways. For example, a department head might look at it to see how their team is doing and make changes if needed. Cash flow can also affect decisions like how much money to budget or whether to hire or let go of employees.
Cash flow is usually shown as either positive (when the company is bringing in more money than it’s spending) or negative (when it’s spending more than it’s bringing in).
Positive cash flow
When a company has positive cash flow, it means more money is coming into the business than going out over a set time. This is great news because it gives the company extra cash to do things like reinvest in itself, pay off debts, and explore new ways to grow.
But here’s the thing: positive cash flow doesn’t always mean the company is making a profit. You can have positive cash flow without actually making money, and vice versa.
Recall the cafe example we provided above.
A company can have positive cash flow if it receives cash from customers before paying suppliers, even if it hasn’t made a profit yet. Conversely, a company might report a profit on its income statement due to non-cash transactions like depreciation, which doesn’t involve actual cash changing hands.
Additionally, positive cash flow can result from sources other than operations, such as investments or financing activities. While positive cash flow is generally favorable, it’s crucial to consider profit and other financial metrics for a comprehensive assessment of a company’s performance.
Negative cash flow
On the flip side, negative cash flow happens when a company’s spending exceeds its income during a period. However, this doesn’t necessarily mean the company is losing money. It could be because expenses and income don’t line up, which must be fixed as soon as possible; otherwise, it can lead to several problems for the company, such as financial instability or debt accumulation.
Sometimes, negative cash flow occurs because a company is investing in its future growth by expanding its business. Looking at how cash flow changes over time gives investors a clearer picture of how the company is doing. It helps to see if a company is heading towards bankruptcy or if it’s on track for success.
So, rather than considering a negative cash flow a red flag, it’s crucial to look at changes in cash flow over time to understand how the company is doing overall.
The bottom line
Understanding cash flow statements is crucial for any small business owner. These documents offer a clear snapshot of where your money is coming from and going to, helping you make informed decisions. Without a good grasp on your cash flow, you risk running into financial troubles that could jeopardize your operations.
And without accurate bookkeeping, there’s no way you’re getting a clear snapshot of your cashflow.
As a small business owner, you’re juggling countless responsibilities, and creating and analyzing financial statements requires time and expertise that you might not have. That’s because the complexity of financial management often demands more than a DIY approach; it requires professional knowledge and experience to ensure accuracy and compliance.
This is where CoCountant comes in with bookkeeping services and GAAP-compliant accounting services tailored to take the financial management weight off of small business owners’ shoulders. With our designated bookkeepers and accountants, you get accurate financial reporting and accurate tracking of your income and expenses even if cash hasn’t changed hands.
FAQs
What is the difference between cash flow statement and income statement?
While both the cash flow statement and income statement are financial documents, they serve different purposes. The income statement shows a company’s revenues and expenses over a specific period, indicating profitability, whereas the cash flow statement focuses on cash movements, regardless of when revenue is recognized or expenses are incurred.
How do you analyze a cash flow statement?
When analyzing a cash flow statement, it’s essential to assess the company’s operating, investing, and financing activities to understand how cash is generated and utilized. Look for trends, compare with previous periods, and evaluate the company’s ability to generate positive cash flows consistently.
What are the limitations of a cash flow statement?
While cash flow statements provide valuable insights, they have limitations. For example, they may not fully reflect non-cash transactions, such as depreciation or changes in working capital. Additionally, they may not indicate the timing or sustainability of cash flows, requiring supplementary analysis for a comprehensive financial assessment.
