One of the most frustrating aspects of managing a small business is the countless lists of financial statements to prepare. It can all be overwhelming.
To run a successful and profitable business, understanding three fundamental financial statements will be in your and your business’ best interest. Balance sheets, income statements, and cash flow statements each serve a unique purpose and are all linked to one another.
One of these documents, however, is commonly overlooked, yet just as important as a balance sheet and an income statement. One of the top two reasons why small businesses and startups fail is running out of cash from improper cash flow management.
Cash is the lifeblood of any business, and this article will provide an in-depth overview of how to prepare, read, and analyze a cash flow statement. But first, we’ll look at the goal of a cash flow statement.
The cash flow statement explained
In financial accounting, a cash flow statement, also known as a statement of cash flows, provides businesses with a snapshot of the company’s current cash on hand.
It shows how much cash was raised and how it was spent during a given period. It also shows how well a company is managing its cash to pay back its debt and fund its operating expenses.
Cash flow statements enable you, as a business owner, to identify trends in your cash flow so that you can make better decisions on how to efficiently use cash to drive the growth of your business. For instance, if your cash flow indicates that your business has less cash on hand in the first quarter of the year, then it may not be the right time to purchase new, expensive office equipment. Instead, you’d need to improve cash collections and focus your efforts on growing revenue to improve profitability.
A cash flow statement is used to attract new investments, improve your fundraising efforts, and have more access to financing options.
How is a cash flow statement used?
For existing and potential investors in your business, a cash flow statement shows how your company’s operations are running, where its money is coming from, and how that money is being spent.
For creditors like lending institutions, on the other hand, the cash flow statement demonstrates how much cash (also known as liquidity) is available. This is to ensure that your company is able to pay back loans or fund its own operating expenses.
How to create your cash flow statement
You can create a cash flow statement manually by using a self-created spreadsheet or a template to organize your income and expenses into a cash flow statement. Our detailed cash flow statement template can help organize your business’s data in an efficient way.
For more convenience, you can create a cash flow statement based on a sound accounting system with accounting software. Before you’re able to create a cash flow statement, you need to record all balance sheet-related activity, such as income and expenses on a regular basis. From there, your accounting software has the information you need to generate a comprehensive cash flow statement.
Accounting software removes the hassle of manually inputting each item of income or expense from your business activities. And it can help keep you better informed about what each category and account description means.
How to prepare a cash flow statement
To create a cash flow statement, you have to choose if you will use the direct or indirect method. The key differentiator between the two methods is how operating activities are handled.
Regardless though, in both methods, investing and financing activities are handled in the same manner.
This method targets the inflows and outflows from operating activities. Essentially, this method subtracts money spent from money received.
To use this method, list the amounts of cash paid and received by your business. With the direct method, the cash flow statement will include cash received from customers, and cash spent on employee salaries, interest, and vendors.
This method starts with your company’s net income (or profit) and factors in depreciation.
To use the indirect method, the cash flow statement begins with the company’s net income and then adjustments are made to convert the accrual net income (i.e. income earned but not yet received) to calculate the operating cash flow.
Some of the typical line items on an indirect method cash flow statement might be: adding back depreciation expenses, adding an increase in accrued expenses payable, adding the decrease in accounts receivable, and deducting any increase in inventory from net income.
Larger U.S. corporations prefer the indirect method when preparing their statement of cash flows because it’s easier to prepare from an accountant’s perspective and it’s presented in a more simplified format.
With the direct method, companies have to report all cash receipts and cash payments from operating activities. Under this method, firms would be required to separately disclose cash receipts and cash payments with detailed subcategories which can overcomplicate the cash flow statement.
With the indirect method, future cash flow projections are simplified due to its consolidated reporting format.
What are the basics of a cash flow statement?
A cash flow statement is broken down into six fundamental elements. We’ll examine all six to help you understand how each of these elements plays a significant role in managing your business’s cash flow.
1. Cash balance
Current assets are used to pay off short-term, or current liabilities, such as accounts payable and the portion of long-term debt that’s currently due. Liquidity is defined as either having immediate cash or maintaining assets that can be converted to cash in a very short period of time. Enough liquidity can help pay for liabilities and debt. If you have not previously created a cash flow statement, you can pull this number from your ledger or accounting records.
2. Operating activities
Cash flows from operating activities are the first section of the cash flow statement and could be called “the cost of doing business.” This section includes any sources and uses of cash to conduct business operations. Examples include cash receipts from goods sold, payments to employees, taxes, and payments to suppliers.
The indirect method of preparing a cash flow statement begins with the net income number, which is a measure of profitability. This number is pulled from the income statement. Following net income, cash and noncash items are reconciled from business activities. Examples include cash receipts from customers and cash paid out to vendors, labor costs, and other operating expenses. The indirect method is widely used, since information is easier to gather. This method reconciles net income to cash flow from operations.
On a cash flow statement that uses the indirect method, you need to categorize each of these costs as positive (incoming) or negative (outgoing) cash flow to accurately reflect those transactions. Here is a breakdown of what’s included in the operating activities category with each of their explanations, including the net income line item:
- Cash from continuing operations: This is the inflow of cash from sales, as well as the outflow of payments to vendors (i.e. suppliers) and company employees.
- Increase or decrease in accounts receivable: Accounts receivable refers to money owed to the business by a customer or client for services or goods already delivered. If the amount of accounts receivable has increased, then it should be subtracted from the total since it represents money that has not been received. If the accounts receivable has decreased, the amount should be added to the total.
- Depreciation and amortization: Next calculate any decrease in the value of the business’ assets. For example, if a piece of equipment is worth $10,000 and its life expectancy is about ten years, the depreciation value of that equipment will be $1,000 per year (thus, recorded as a loss of $1,000 for that period). It’s important to note that depreciation and amortization expenses are non-cash expenses. They occur when an asset is used to operate the business, which results in an asset losing value over time. Depreciation refers to physical assets, while amortization refers to intangible assets such as patents (which expire and will, therefore, lose their value over time as well).
- Income Taxes Paid: The payment of income taxes is considered an outflow of cash under operating expenses.
Here are some very common line items found in the operating activities section:
- Accounts receivable (A/R): The amount your business is owed by customers for goods and services that they purchased on credit.
- Accounts payable (A/P): The amount you owe creditors for purchasing goods and other operational equipment.
- Depreciation: A non-cash expense that results from an asset — like a computer or a vehicle — losing value over time as it’s used for business operations.
- Inventories: The dollar amount of goods available for sale to generate income for your business.
- Net cash balance: The total amount of cash deposited, minus any cash disbursements.
- Net income: The amount remaining after you subtract all of your business costs from your total revenue, otherwise known as a profit.
Adding the net income, accounts receivable, accounts payable, depreciation, amortization, inventories, and income taxes paid will give you the net cash flows from operating activities.
3. Investing activities
Cash flows from investing activities is the second section of a cash flow statement. It involves long-term uses of cash, such as a purchase (cash outflow) or sale (cash inflow) of a fixed asset (i.e. property or equipment).
Usually, small business investments are centered around cash spent on property (like purchasing real estate for employees to work out of), plants (this can be a mechanical or an industrial plant depending on the nature of your business), and equipment intended to grow business operations or perform them in a faster, more efficient manner. This is why it’s viewed as an investing activity.
As a business owner, it’s important to note that this section of your cash flow statement will normally be in the negative, due to acquiring those assets in the first place. Purchasing fixed assets, especially in the first year, is considered pure cash outflows.
Here is a further breakdown of what’s included in the investing activities section:
- Capital expenditures: Money that is spent to acquire, improve, or maintain any physical assets such as property, buildings, technology, or equipment.
- Acquisitions: Any funds used to pay for the acquisition of new long-term investments.
- Proceeds from asset sales: When long-term assets are sold, the amount received is referred to as the proceeds. If the proceeds from the assets sold are greater than the original (or book) value of the asset, it’s considered a net gain (cash inflow). If the proceeds are less than the book value at the time of sale, it’s a net loss (cash outflow).
For instance, if the machinery purchased costs $25,000, it will be considered an outflow. If your equipment was sold for $20,000, it’s considered an inflow. Adding these two will give you the net cash flows from investing activities for a total outflow of $5,000 (which is displayed as a negative on the cash flow statement).
4. Financing activities
Cash flow from financing activities is the third category of a cash flow statement. It includes inflows of cash from investors and banks, and outflows of cash to shareholders, referred to as dividend payments.
Companies seek financing by either taking on debt such as taking a loan from a bank, or issuing equity to investors in exchange for their cash. Over time, companies have to pay back those loans as their operations grow, or pay dividends periodically to their investors for initially infusing cash into the business. Here are some types of financing activities that your business might have.
- Proceeds and cash payments related to long-term debt: This refers to the cash received or paid out by the business for long-term debt such as bank loans or government bonds. Cash payments and cash receipts pay principal debt balances and are included in the financing activities category. Any interest payments, however, are reported in the cash flows from operating activities section.
- Short-term notes payable: This type of debt must be paid off in a short amount of time, usually in less than a year.
- Dividends paid: This is a small portion of company profits that are issued to stockholders (i.e. people or institutions who have invested in your business). This should also include payments towards dividend taxes and will be recorded as an outflow of cash.
- Other current liabilities: A grouping of debts that are not covered under common liabilities, such as accounts payable.
Initially, business owners and entrepreneurs look for funding to get their business up and running. If they’re successful and cash comes in (i.e. capital), it’s a cash inflow. When dividends are paid to those investors, it’s a cash outflow.
Totaling up the proceeds from long-term debt, notes payable, dividends paid out, and other current liabilities will give you the net cash flows from financing activities.
5. New cash balance
Total the net cash flows from operating, investing, and financing activities together and you will have a new cash balance.
To summarize the cash flow statement in a formula:
Cash Flows From Operating Activities + Cash Flows from Investing Activities + Cash Flow From Financing Activities = New Cash Balance
This total will be the new cash balance at the end of the period (usually at the end of the fiscal or calendar year). Take this new cash balance and add it to the cash balance from the end of the last period (or the last year). What this does is provide you with the net increase (or decrease) in cash and cash equivalents for the time frame you’ve selected. This will then be used at the beginning of the next period to start these calculations again.
You can use cash flow statements to project future cash flows. Forecasting with these numbers gives you an idea of how your company is operating, and if there’s any cause for concern in the near future.
For example, a company may be valuable for its assets and investments, but a spotty inflow line item on a cash flow statement can be concerning. Conversely, many companies can operate successfully with debt and accounts receivable if their growth is based on reliable future earnings.
Now that we understand the standard essential elements and methods of a cash flow statement, you can easily analyze the information to forecast your future cash flows.
Reviewing and projecting cash flow
Reviewing historical financial statements is useful for identifying trends and learning from previous business decisions. Historical and current data can allow you to make future projections — in the coming quarters or years — to meet both short and long-term obligations.
Cash flow projections keep you informed so that you can make better decisions, whether it’s making a big purchase to improve operational efficiency, reducing expenses, or seeking new financing as you grow.
Now that you know the elements involved in creating, preparing, reading, and analyzing a cash flow statement, you can make better more informed decisions and practice proper cash flow practices.
With all these tools, resources, and knowledge, QuickBooks can make it easier for you to better manage your cash flow as a business owner.