Cash flow statement: How to prepare and understand it

What is a cash flow statement?

A cash flow statement is a financial statement that aggregates incoming and outgoing cash from various sources, including operating activities, financing, and investments. Cash flow statements usually cover a set period of time, such as a fiscal year.

A cash flow statement is a fundamental document that provides an overall view of your company's financial performance at the liquidity level. It's also one of the three key financial statements, along with your income statement and balance sheet.

Purpose of the cash flow statement

The purpose of a cash flow statement is to show what happens to your business' cash over a period of time. This is important because your business needs cash to continue operating and growing.

Whether you are a business owner, investor, or accountant, a cash flow statement can help you understand the financial performance of a business and improve your cash flow management. Plus, these insights can help you avoid a cash flow crunch.

A cash flow statement can also help you compare your operating cash flow to your net income or profit. If you have a significant amount of cash coming in, for example, but you're only earning a small portion of that cash in profit, you may need to streamline your operations and expenses.

How to prepare a cash flow statement

It's important to understand what goes on a cash flow statement and how to prepare one for your business.

First, let's review the three core business activities covered by a cash flow statement:

• Operations, including sales revenue and expenses
• Investments, including properties and patents
• Financing, including debts and equity

Here's a closer look at how to calculate cash flow from your operating, investing, and financing activities.

Calculate cash flow from operating activities

Cash flow from operations includes any cash that is generated from your business' everyday activities, such as selling products and services. It also covers outgoing cash from your business expenses.

Examples of cash flow from operating activities include sales of goods, inventory payments, income tax payments, employee salaries, and office rent and utilities.

Cash flow from operating activities is calculated using either the direct or indirect method.

Cash flow statement direct method

The direct method of calculating cash flow involves simply tallying up all of your cash receipts and payments, such as those from customers, vendors, and employee salaries. Put more simply, you add up your incoming cash flow from sales and subtract your outgoing cash flow from expenses. In the end, you'll have your net income from cash transactions.

The direct method is helpful for small businesses with payments and receipts that are easy to track.

Cash flow statement indirect method

The indirect method of calculating cash flow involves starting with your total net income (found on your income statement) and adding or subtracting numbers from non-cash transactions (found on your balance sheet). You'll then have your net income from cash transactions only.

The indirect method is best for businesses that don't have a clear tally of their cash transactions and have help from an accountant.

Calculate cash flow from investing activities

Calculate cash flow from investing activities by tallying the gains and losses from your business investments. For example, you might invest in property, vehicles, securities, and equipment.

Calculate cash flow from financing activities

Calculate cash from financing activities by adding up debt and equity from creditors and shareholders. For example, this might include dividends, loan payments, and bonds.

Determine the ending balance

Once you calculate cash flow from these three main types of business activities, you can add them up to calculate your final balance.

How to read a cash flow statement

If your cash flow balance is positive, then your business is bringing in more cash than it's spending. If your cash flow balance is negative, then your business is spending more cash than it's receiving.

With a positive cash flow balance, you can use that extra cash to make new investments, pay off debts, and continue expanding your business. If you have a negative cash flow balance, you may need to cut some expenses and reevaluate your operating strategies.

Still, a negative cash flow balance doesn't mean it's the end for your business. It may simply indicate that you're making investments now that could pay off in the future.

Optimize your business operations

Check out more tips on accounting for small- and mid-sized businesses.