Cash Flow Statement


  • What is a cash flow statement?
  • Why are cash flow statements useful?
  • Components of a cash flow statement
  • Direct method vs indirect method
  • Cash flow statement vs profit and loss statement
  • Interpreting cash flow statements

What is a cash flow statement?

A cash flow statement is a financial report that tracks the movement of cash and cash like assets in and out of a business during a set time frame. This statement is vital for understanding an entity’s liquidity, which is its ability to meet short term obligations. It also provides insights into changes in the entity’s assets, liabilities, and equity, aiding in the assessment of its operational efficiency.

Essentially, it’s a tool used to gauge how well an entity manages its cash, indicating its financial health and stability.

Why are cash flow statements useful?

Businesses use cash flow statements for several valid reasons:

  • Understanding Liquidity: The statement provides clear information about the amount of cash and cash equivalents available to the business. This helps entities understand their current financial position in terms of available cash, and how long they can operate with the existing cash reserves before running out, known as their financial runway.
  • Tracking Financial Changes: It offers detailed insights into how the entity’s assets, liabilities, and equity have changed over a period. This is important for understanding the financial movements within the entity.
  • Standardising Financial Comparisons: Cash flow statements help in neutralising the impact of different accounting practises, like cash basis or accrual basis accounting. This standardisation makes it easier for investors and analysts to compare the financial performance of different entities without accounting method biases.
  • Forecasting Future Cash Needs: By analysing the cash flow statement, businesses can better predict future cash requirements. It helps in understanding the timing, amount, and likelihood of future cash inflows and outflows, aiding in more effective financial planning and risk management.
The statement provides clear information about the amount of cash and cash equivalents available to the business.

Components of a cash flow statement

A cash flow statement typically consists of three main categories of activities:

  • Operating activities
  • Investing activities
  • Financing activities

Cash Flow From Operating Activities

The section of a cash flow statement known as Cash Flow from Operating Activities or Operating Cash Flow (OCF), details the money an entity either earns or spends in the course of its regular business activities.

In terms of incoming funds, this includes the revenue from sales, as well as any money received from interest and dividends. On the flip side, outgoing money includes the cost of goods sold (COGS), payments to employees and suppliers, and any taxes that need to be paid.

The significance of operating cash flow cannot be emphasised enough. It’s a critical indicator of an entity’s financial health, revealing if the business is successfully earning more than it spends in its day to day operations.

A consistent or increasing operating cash flow is a positive sign, suggesting the business is on a sustainable path. However, if this figure isn’t showing steady growth, it might indicate potential long term issues.

By thoroughly understanding your operating cash flow, you can pinpoint specific areas within your business processes, pricing strategies, and more that need improvement. Enhancing these areas can lead to increased cash generation and reduced expenditures over time, contributing to the overall financial health and sustainability of the business.

Cash Flow from Investing Activities

Cash flow from investing activities (CFI) encompasses the cash inflows and outflows associated with non current assets within a business. Incomings in this category include cash received from loans, proceeds from asset sales, and funds obtained from the maturity of market securities. Conversely, outgoing cash flows consist of payments made for the acquisition of property, equipment, and other business investments.

For new small businesses, it’s often normal to have more money going out than coming in for investments (that is having negative CFI). This happens because businesses have to spend money upfront to make more later, but it can take a while to see the profits.

However, as a business starts making money, it becomes easier to have more money coming in than going out for investments. This means a business can use more of it funds for further expansion and growth.

Cash Flow from Financing Activities

Cash flow from financing activities (CFF) reflects the cash movements related to funding the entity’s operations. It encompasses cash transactions associated with debt, equity, and dividend activities. Positive CFF typically arises from loans and the issuance of entity stocks, whereas negative CFF results from dividend payouts and the repayment of outstanding loans.

CFF analysis is vital for assessing an entity’s financial structure and strength, offering valuable insights to investors regarding the business’s stability and potential for growth. However, it’s important to consider the context when interpreting cash flow from financing activities.

For instance, a positive CFF stemming from stock repurchases during a market downturn may not necessarily indicate a favourable situation and could raise investor concerns. Conversely, a negative CFF could signify excessive debt or simply the entity’s commitment to paying off debts earlier than scheduled.

Furthermore, if the cash flow statement is prepared in accordance with generally accepted accounting principles (GAAP), it might also incorporate information about non cash activities. These non cash activities could encompass factors such as depreciation of fixed assets, amortisation of goodwill, and similar items.

The section of a cash flow statement known as Cash Flow from Operating Activities.

Direct method vs indirect method

A Cash Flow Statement can be prepared using two primary methods: the direct method and the indirect method. The choice between these methods depends on the level of detail needed in the statement and the amount of time a business can allocate to its preparation.

Both methods are acceptable under generally accepted accounting principles (GAAP), but International Accounting Standards and Australian Accounting Standards favour the direct reporting method, while most small businesses commonly use the indirect method.

The primary distinction between the direct method and the indirect method of presenting the statement of cash flows (SCF) revolves around cash flows related to operating activities. In terms of cash flows from investing activities and financing activities, there are no fundamental differences between the two methods; the divergence lies in how they handle operating activities.

Direct Cash Flow Method

This approach relies on cash basis accounting, where financial transactions are recorded based on the actual cash received or disbursed by the business.  

The direct method demands a higher level of organisation and meticulous tracking because it involves subtracting actual cash outflows from inflows. Key components in this method include customer payments, payments to suppliers and employees, receipts of interest and dividends, and income tax payments.

Indirect Cash Flow Method

This method is grounded in accrual basis accounting, wherein revenues and expenses are recognised when they occur, not necessarily when cash changes hands. With the indirect method, financial data from the income statement is examined, and certain adjustments are made to eliminate transactions that do not represent cash movements.  

Additionally, this method requires adjustments to account for non operating activities, such as depreciation, which do not directly impact operating cash flow.

Cash flow statement vs profit and loss statement

While there may be some similarities between a cash flow statement and a Profit and Loss (P&L) report, it’s important to understand that these are two distinct financial documents, and they should be treated as such. 

Mixing up a business’s cash flow and P&L figures could potentially lead to a misunderstanding of the entity’s financial health. 

The primary difference between the two is as follows:

  • A cash flow statement reveals the amount of cash that an entity has available at the end of a specific period, whereas a profit and loss statement shows the total revenue generated during that same timeframe, regardless of whether the actual cash has been received yet.
    For instance, sales made with payment terms attached are fully accounted for on a P&L statement, but on a cash flow statement for the same period, only the cash received up to that point is reflected.
  • Both documents also serve different purposes. While a P&L statement is valuable for assessing a business’s performance over the long haul, cash flow statements gauge the entity’s ability to maintain and support this performance over time.

Due to these distinctions, it’s advisable to use both documents together to gain a comprehensive understanding of an entity’s financial position, considering both the bigger picture and the finer details.

Mixing up a business’s cash flow and P&L figures could potentially lead to a misunderstanding of the entity’s financial health.

Interpreting cash flow statements

Unless a business has achieved exact break even results for the specific period under consideration, its cash flow statement will indicate either a positive or negative cash flow. 

It’s essential to understand that the final cash flow figures should not be accepted at face value. 

In many instances, having a negative cash flow isn’t necessarily a cause for alarm. For instance, new business owners often need to invest a substantial amount of capital to establish and launch their business, and it may take some time before they reach the break even point. Additionally, paying for purchases in full can decrease your cash flow temporarily, but the assets acquired through these purchases can justify the decrease. 

Conversely, an unexpected or unplanned negative cash flow typically signals an issue within the business. However, if a business is meeting its projected cash flow and overall performance targets, occasional negative cash flow shouldn’t be a cause for panic. 

On the other hand, a positive cash flow doesn’t automatically signify a sudden surge in business success. For example, the increase may result from credited purchases that were previously accounted for but are only now being realised. Taking out a loan can also lead to a temporary spike in cash flow. 

With this in mind, it’s important to dig deeper than just the dollar amount displayed and focus on understanding the factors contributing to that number.

This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.