Guide to Understanding the Statement of Cash Flows
As a business owner, the statement of cash flows is one of the most useful financial statements to better understand how your business is generating cash, how that cash is used, and what your cash position is at the end of a period. Having cash available is very important for a business to stay solvent and meet its obligations. Even a profitable business can go bankrupt if it doesn’t have enough cash in the bank to pay its employees, suppliers, rent, utilities, and debtors. As such, understanding your cash inflows and outflows, and whether you have excess cash or are in a deficit position, is crucial to operate and grow your business.
The statement of cash flows is usually broken into the following three sections:
Operating Activities
This section includes information about the cash flow of the company’s main activities, such as selling goods and providing services, and associated costs. Operating activities include cash collected from customers from sales of goods and services, payments made to suppliers, salary and wage payments to employees, rent payments, interest payments, and any other payments made to operate the company. The operating activities section of the statement can also provide insight into the company’s ability to collect on its receivables and manage cash outflows on its payables and liabilities.
Investing Activities
This section includes information about the cash flow from purchasing and selling long-term investments, such as property, buildings, vehicles, furniture, or equipment. Investing activities also include the purchase and sale of investments such as stocks and securities. The investing activities section of the statement reflects how a company is investing in the long-term health of the company and preparing for its future growth.
Financing Activities
This section includes information about the cash flow from both debt and equity to fund the company’s operations. Financing activities include the issuance and repurchase of the company’s stocks and bonds, payments made on debt and loans, and dividend payments.
The operating section of the statement of cash flows can be prepared using the direct method or the indirect method. The direct method is based on cash accounting and uses actual cash inflows and outflows to calculate the company’s cash flows from operating activities. The indirect method, on the other hand, is based on accrual accounting and uses net income on an accrual basis as a starting point. The net income is then adjusted by non-cash items to arrive at the company’s cash flows from operating activities. Even though the presentation will differ, cash flows from operating activities will yield the same result whether the direct method or indirect method is used. The direct method is mostly used by small companies that use the cash basis accounting method. However, the indirect method is the most common method since most companies use the accrual basis accounting method. The investing and financing sections of the statement of cash flows are prepared the same way for both the direct method and the indirect method.
In summary, the statement of cash flows is one of the most useful financial statements as it provides valuable information about a company's incoming and outgoing cash activities and helps determine future cash needs. The statement of cash flows is just as important to lenders and investors because it gives them a clear picture of the company’s health and performance. If you’re unsure how to prepare your statement of cash flows, CPA by Choice can help. We are available to answer your questions, feel free to call us or send us a message.