This is the third installment in our “Cash Flow 101” series—our ultimate guide to help you understand and manage your business’s cash flow, and prevent future cash flow problems. Need to catch up? You’ll find links to the previous installments in this series at the end of the article.
This article is part of our “Business Startup Guide”—a curated list of our articles that will get you up and running in no time!
In order to make sure that their businesses are always able to access the cash they need to grow, many business owners—or at least their accountants—produce cash flow statements at monthly, quarterly, or even yearly intervals.
While large organizations, such as Google or Apple, that are flush with cash might wait until the end of the year to produce these statements (by law, all publicly traded companies are required to produce them), small business owners are usually inclined to prepare them more regularly, so there aren’t any extra surprises when December rolls around.
Most simply, cash flow statements very quickly tell the story of how much revenue a company has coming in (inflows), and how much it has going out (outflows). That information can be leveraged to gauge an organization’s liquidity and to predict where a company will stand financially in the near future.
Cash flow statements are important to many different stakeholders for many different reasons. For example, accountants use cash flow statements to make sure companies can pay their bills on time. Creditors might look at them to decide whether an organization is well-situated to repay loans. And, before buying shares, investors will probably want to take a peek at them as well.
The components of a cash flow statement
Generally speaking, cash flow statements are comprised of three core components:
1. Operating activities
How does your business make money on a day-to-day basis? Your organization’s operating activities include everything that relates to how you generate revenue.
Most basically, cash inflows are generated whenever customers buy your products or services; outflows occur when you pay employees, suppliers, taxes or interest, among other things.
2. Investing activities
Most transactions relating to the sale or purchase of property, equipment, or other non-current assets are included in your investing activities, as are any expenses tied up in mergers or acquisitions.
If your business plays in the stock market at all, you’ll also have to indicate when you buy or sell securities here as well.
3. Financing activities
This section of the cash flow statement includes information about taking out loans to buy property or equipment; issuing stock to employees, the public, or other stakeholders; paying out dividends, and so on.
It’s worth noting that cash flow statements can be affected by non-cash transactions, like depreciation or bad-debt expenses. Additionally, many businesses choose to add supplemental information about large transactions that don’t involve cash, like converting debt to equity or issuing shares in return for assets.
Cash flow statements—which are considered one of the four major financial statements along with income statements, balance sheets and statements of retained earnings—can be prepared using one of two methods: the direct method or the indirect method, both of which produce the same results.
Because it’s easier to do, most businesses build their statements of cash flow via the indirect method, so let’s turn our attention there first.
Building a cash flow statement: The indirect method
Many businesses choose to construct their cash flow statements using the indirect method because the numbers they need are easily gathered from the accounts and numbers they already maintain. Cash flow statements generated this way reconcile reported net income with cash generated through operations.
To construct an indirect cash flow statement, you first need to focus on operating activities. To do that, determine net income and remove non-cash expenses (e.g. depreciation and amortization) from that number.
Next, you need to consider your gains and losses on any sales of assets made during the pertinent reporting interval. You also need to report changes in receivables, payables and inventories, as well as any bad debts you might decide to write off.
Once you’ve figured out your net cash provided by operations, you need to then record your cash flows from investing and financing activities. These two sections are reported in the same manner on cash flow statements prepared using both the indirect and direct methods using the criteria discussed above.
Building a cash flow statement: The direct method
Due to the differences in reporting operating activities, cash flow statements prepared via the direct method provide a much clearer view of how cash moves through a business. But they’re harder to prepare—which is why they’re less common.
Instead of starting from net income, cash flow statements made through the direct method instead focus on gross cash inflows and gross cash outflows that occur naturally through operations. Businesses that use the direct reporting method need to consider cash received from client accounts; cash paid to employees and suppliers; interest payments; income tax payments; and any interest or dividend revenue that was received.
Unlike the indirect method, when cash flow statements are generated through the direct method, it’s considerably easier to see where cash payments were made and where cash payments were received. But because most accounting reports don’t include the necessary information the direct method requires, many businesses choose to take the easier route and produce their statements of cash flow using the indirect method.