Perhaps one of the most frustrating things about small business management is the seemingly endless list of “statements” you should prepare. And the fact that all kind of sound alike. How is a cash flow statement different than an income statement? Is a balance sheet really that much different from an asset and liabilities statement?
It’d be great, and a lot simpler if the answer to the above questions was no. Being able to use terms interchangeably would definitely cut down on the amount of details to keep straight. But unfortunately, to run a successful and profitable business understanding these different statements you’ll need to know the specifics.
This article will provide an in-depth overview of how to prepare a cash flow statement. We will discuss how to read a cash flow statement, as well as all the necessary information to include. And we’ll answer the most fundamental question: What is a cash flow statement?
What is a cash flow statement?
A cash flow statement provides businesses with a snapshot of the company’s current “money on hand.” This figure is decided by reviewing not only revenue and payments received, but also taking a look at outstanding invoices, overdue payments, and other payments made during a specific time frame. It also enables you to identify trends in your cash flow so you can make better decisions regarding expenditures. For example, if your cash flow shows that you have less cash flow in Q1, that’s not the time to purchase a new, expensive piece of office equipment.
What are the basics of a cash flow statement?
A cash flow statement includes six basic elements:
- Cash Balance
- New Cash Balance
Let’s examine each of these so that it’s easier to understand on the figures work in tandem to paint a clear statement of cash flows in your organization.
Element #1 – Cash balance
This is the current amount of liquid money available to your company for a set time period. If you have not previously created a cash flow statement, you can pull this number from your ledger or accounting records.
Element #2 – Operations
Operating activities comprise the main source and cost of a company’s cash. You might call it “the cost of doing business.” Operations costs can include everything from materials to shipping to labor to marketing. On a cash flow statement, you need to categorize each of these costs as positive or negative cash flow (also known as inflows and outflows). It will also include your business’ income from sales, which can be found on an income statement.
However, you will need to figure a few other numbers to ensure you have a comprehensive overview of your operating costs included on your cash flow statement:
- Cash from Continuing Operations: This is essentially the inflow of cash from sales, as well as the outflow of payments to suppliers and company employees. This number can also be taken from the “net income” calculated in the Income Statement.
- Rise or Fall 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, this increase should be subtracted from the total, since it represents money that has not been received—if the accounts receivable has gone down, the amount should be added.
- 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 it will function for 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). Depreciation refers to the loss of value in 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 unless they are directly linked to investing or financing activities.
Element #3 – Investing
Investing activities involve buying or selling assets or securities that are not related to your company’s operating costs. Typical small business investments include property, equipment, stocks, investments and loan payments that have either been given or received by your company. (NOTE: this section of your cash flow statement will normally be in the negative since the primary line items are disbursements of cash for the maintenance or acquisitions of these assets.)
Here are few more details:
- Equipment and Property: Any payments made towards the purchase of fixed assets, such as equipment or property, will be marked as an outflow. Any income from the sale of these assets will be counted as an inflow.
- Securities or Investments: Any outflow or inflow of cash due to the purchase or sale of stock or securities by the company should be marked here.
Element #4 – Finance
Financing activities include issuing or purchasing stock or equity, borrowing money, repaying debt and handing out dividend payments.
- Proceeds From 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.
- Dividends Paid: A small portion of company profits that are issued to stockholders. This should also include payments towards dividend taxes and will be recorded as an outflow of cash.
Element #5 – New cash balance
This figure is calculated by adding up the positive inflows and the negative outflows outlined in the three areas above. From this total, subtract the cash flow balance from your previous cash flow statement (or income statement). This will provide you with the net increase in cash and cash equivalents for the timeframe you’ve selected.
Element #6 – Forecasting
While cash flow statements are vital to understanding the solvency of your company, using the information to further extrapolate future cash flow success is important. Forecasting with these numbers give you a snapshot of how your company operates and if there is any concern for the near future.
For example, a company may be worth a lot of money due to assets and investments, but a spotty inflow line item on a cash flow statement is cause for concern. 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 of a cash flow statement, let’s discuss how to prepare a cash flow statement.
How to prepare a cash flow statement
Because you have already gathered all the information discussed above, the next thing you must do to create a cash flow statement is to determine if you will use the direct or indirect method. The difference between the two methods is how the information from the operating costs section is handled. In both methods the information relating to investing and finance are the same.
Direct Method: This tracks specific actions of inflows and outflows from operating activities. Essentially, this method merely subtracts money spent from money received.
To use this method, list the amounts of cash paid and received by your business. Typical line items on a direct method cash flow statement will include cash from customers; cash paid to employees; cash paid for interest, and cash paid to vendors.
Indirect Method: This method is more complicated. It starts with net income 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 figure into operating activity cash flows. Some of the typical line items on an indirect method cash flow statement might be: adding back depreciation expense; adding an increase in accrued expenses payable; adding the decrease in accounts receivable, and deducting any increase in inventory.
NOTE: Most large U.S. corporations use the indirect method when preparing their statement of cash flows.
How to create your statement of cash flow
To create a cash flow statement manually, review your income and expenses in each of the three categories discussed above. Use a self-created spreadsheet or template to organize your data into a cash flow statement (you can download a free cash flow statement template here). Essentially, your entries show cash in and cash paid out each month for the period of your cash flow statement (e.g. a year).
Even easier, you can create a cash flow statement based on a sound accounting system, such as QuickBooks. Having recorded your income and expenses on a regular basis, your accounting software has the information needed to automatically generate a cash flow statement without the need to input each item of income or expense from your business activities.
Reviewing and projecting cash flow
Looking back over a specific time period is helpful in knowing where your money went and seeing trends in your business activities. Just as important is looking ahead to make sure you’ll have the funds on hand to meet upcoming obligations. Look ahead for a specific period, such as the next quarter or the next year, and use the information in your books to generate your projections.
The projections help you decide 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 cash on hand isn’t enough to pay upcoming bills. Once again, it’s up to you to monitor your projections and review your business activities so you can make adjustments accordingly.
Now that you know the elements involved in creating a cash flow statement and how to prepare a cash flow statement, let’s discuss how to read a cash flow statement.
How to read a cash flow statement
In tandem with your company’s income statement and balance sheet, your statement of cash flow provides with an overview of your business’ financial profile. Here are the most common sections available on a cash flow statement and what they mean for the liquidity of your business.
- 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.
- Current assets: All of your inventory, cash, work in progress, and receivables that will last or be used within a year.
- Depreciation expense: When an asset has stopped contributing to the profit of your business and becomes an expense.
- Inventories: The amount of your business’s current inventory.
- 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.
- Capital expenditures: Money that is spent to purchase, improve or maintain any long-term investments.
- Acquisitions: Any funds used to pay for the acquisition of new long-term investments.
- Long-term debt: Debts that are due after a year or more.
- Other current liabilities: A grouping of debts that are not covered under common liabilities, such as accounts payable.
- Short-term notes payable: Debt that must be paid off in a short amount of time, usually in less than a year.
When reviewing your cash flow statement, also keep the following in mind; despite how many figures may be present, the statement is basically showing you the following formula.
Operations Costs + Asset Investments + Financing = Cash on Hand