The cash flow statement is one of the three major financial reports prepared by a business; the other two are the balance sheet and income statement. Many analysts consider the cash flow statement to be the most transparent of the three reports.
The cash flow statement allows a business to understand and analyze how its operations are running, where capital is coming from, and how money is being used. Learn more about the three major sections of cash flow statements, how the report is prepared and how to use it for forecasting and decision making.
The Operations Section
The first major section of the cash flow statement is focused on company operations. This section measures the cash inflows and outflows caused by the company’s revenue-generating activities. Changes to the cash accounts, accounts receivable, depreciation, inventory and accounts payable are recorded here. Other cash inflow or disbursements that may be recorded here are royalties, commissions, fines or payments for lawsuits. Operations cash flow is calculated by making necessary adjustments to net income, such as revenue, expense and credit transactions.
Because not all transactions involve actual cash items, evaluate non-cash items when calculating cash flow from operations. For example, depreciation is a non-cash expense, but it is added back into net sales for purposes of calculating cash flow from operations.
The Investing Section
This section provides details about payments made for long-term assets and any cash received from the sale of long-term assets. Some examples of investing activities are:
The purchase or sale of long-term assets, such as equipment, land, buildings and marketable securities.
Long-term loans received from customers or paid to suppliers.
Certain payments made or received due to a merger or acquisition.
Changes made from purchases of these items are recorded as cash out, while changes made from the sale of these items are recorded as cash in.
The Financing Section
This section details the line items that affect the total equity or borrowings of the business resulting from interactions with banks, shareholders or other investors. Some examples of financing activities are the sale of company equity shares, the purchase of company shares and dividend payments. For nonprofit organizations, donor receipts limited to long-term purposes are also recorded here. Changes in net borrowings and changes in debt principal are recorded in the financing section.
When capital is raised, the transaction is labeled as cash in; when capital is disbursed (such as dividends), the item is labeled as cash out.
Direct Method Versus Indirect Method
There are two different methods used to construct a cash flow statement: the direct method and the indirect method. The main difference between the two methods only affects the cash flow from operations section. There is no difference in reported cash flows for the investing or financing section, regardless which method is used.
Using the direct method, cash flows from operating activities are reported as major classes of operating cash receipts and disbursements. Examples of receipts under the direct method include cash collected from customers and cash received from interest and/or dividends. Examples of disbursements under the direct method include cash paid to suppliers for goods, cash paid to employees for services, cash paid to creditors for interest and tax payments.
The indirect method uses net income as a starting point. It makes adjustments to net income for non-cash items and them makes adjustments for all cash-based items. Non-cash items that are taken into account include depreciation, amortization, account receivable loss provisions and losses from the sales of fixed assets. The net income line items are also adjusted for changes in the ending and starting balances of current assets (with the exception of cash). The same type of adjustments must be made for changes in current liabilities.
The indirect method is typically easier to complete because the information is more readily available. Most companies use the indirect method.
Forecasting with the Cash Flow Statement
The cash flow statement is an important forecasting tool for business. Since all inflows and outflows are detailed as line items, it is easy for management to identify where problems or opportunities occur. Managers can locate major issues by category: operations, investing or financing. The details of the overall problem or opportunity can be found by reviewing each line item. From that point, managers can estimate how things will change over the next few quarters or how long it may take for a problem to be fixed. Since all of the major sections of the cash flow statement point back to cash balances, this financial report serves as a business’s early warning system.