Cash flow in your business can resemble the waves of an ocean, with revenue washing in and payments for expenses flowing out. A picture of cash flow is not easy to capture because the ebb and flow of money in your business is constantly changing. Still, you need a handle on your cash flow at any given moment so you can spot trends in cash management and keep your company solvent.
Importance of the Cash Flow Statement
Your company may have enough revenue to appear profitable, but slow collections of invoiced sales can impede your ability to meet your current financial obligations. Delayed payments to employees, vendors, and other creditors can be massively detrimental to your business, so to get a picture of your cash flow over a specified period of time, you need to create a cash flow statement. A look back over a specific period of time (typically the last month or last quarter) enables you to look forward to the next period and to ensure you have the funds on hand to pay your bills.
Creating a Picture of Cash Flow
The cash flow statement shows changes in your cash on hand (including funds in your bank account and short-term investments that you can easily convert to cash). The cash flow statement reflects these activities of your business:
- Operating activities: Inflow from operating activities includes revenue from selling products and/or services, interest and dividends that the business receives, and other cash receipts. Outflow from operating activities includes payroll costs (wages, benefits and employment taxes), payments to suppliers and vendors, overhead costs (like rent, utilities, and insurance), income taxes and other business taxes, and other operations-related cash payments.
- Investing activities: Inflow from investment activities includes sales of business assets other than inventory, payments received from loans that your business made, and other income not generated by the normal course of business. Outflow includes purchases of capital equipment and loans that you make.
- Financing activities: Inflow reflects money that’s borrowed and the proceeds from the sale of your company’s securities. Outflow includes your debt service and dividend payments.
There are two ways of creating a cash flow statement. The method you choose depends on the information you need from your cash flow statement.
- Direct cash flow method: This method tracks specific actions of inflows and outflows from operating activities. Essentially, this method subtracts money spent from money received.
- Indirect cash flow method: This method is more complicated. It starts with net income and factors in depreciation.
Creating Your Cash Flow Statement
To create a cash flow statement manually, select a time period, and review your income and expenses in each of the three activities discussed above. Use a self-created spreadsheet or template to organize your data into a cash flow statement. Essentially, your entries show cash in and cash paid out each month for the time period that your cash flow statement covers.
In addition, you can easily create a cash flow statement based on an accounting system such as QuickBooks. Having recorded your income and expenses on a regular basis, your accounting software has the information needed to generate a cash flow statement automatically without the need to input each item of income or expense from your business activities.
Reviewing and Projecting Cash Flow
Looking back over the last quarter, month, or year helps you see where your money went and discover trends in your business activities. Just as important is looking ahead to make sure you have the funds on hand to meet upcoming obligations. What are your upcoming expenses? What do you project your future revenue to be? Again, look ahead for a specific period, such as the next quarter or the next year, and use the information in your books to generate cash flow projections.
Projections help you decide which actions to take, such as cutting expenses if too much money is going out compared with revenue coming in, or seeking a short-term infusion of capital if there won’t be enough cash on hand to pay upcoming bills. It’s up to you to actively monitor your projections and review your business activities so you can make adjustments accordingly.
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 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 Vs. Indirect Method
There are two different methods used to construct a cash flow statement: the direct method and the indirect method. The difference between the two methods only affects the cash flow from the 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, and 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 then 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.
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’s easy for you to identify where problems or opportunities occur. You 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, you can estimate how things might 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.
Always evaluate your cash position before major decisions. This includes expansion, research and development, major purchases, or equipment upgrades. Use a bank reconciliation to check current cash available, pending outstanding payments, and deposits in transit, because the current balance of your cash account may materially change due to pending transactions.
Cash is essential for keeping your company afloat. Make sure you have a good understanding of where your money comes from and when, and where your money is spent in meeting your financial obligations. Use a cash flow statement as well as cash flow projections to clarify your company’s position on cash. If you have any concerns about creating or understanding your cash flow statement and projections, work with a CPA or other knowledgeable financial specialist. Improve your cash flow with invoices, payments, and expense tracking. See how much cash you have on hand with QuickBooks.