What is a Cash Flow Statement?

What is a Cash Flow Statement?

Essentially a cash flow statement is used to see exactly how money is moving in and out of a business. This, in tandem with an income statement and balance sheet, comprises the three key financial statements that a company will need to generate to keep tabs on the overall financial health of the company. A cash flow statement is usually created quarterly and yearly as well. Some may opt to generate these statements monthly too to be able to more closely monitor where/when money is being spent in conjunction with how quickly it is coming in.

A cash flow statement includes three separate sections: Operating Activities which is that which outlines how revenue is being generated; this can include cash flow as a result of assets and liabilities as well. Investing Activities—this will tally cash flows that stem from investments as well as transactions surrounding any long term assets. And finally, Financing Activities which deals with the business's stocks, bonds, and dividend related activity.

A Few Key Definitions

To understand a cash flow statement and its consequent purpose, there are a few keywords/phrases that you will need to know. The term "cash flow" refers to both the in and outflow of cash and/or any such equivalents. "Cash equivalents" simply means anything that is held as cash, for instance, bank deposits and consequently, anything that can be quickly converted to cash, so this might include any overdrafts.

Understanding the 3 Types of Cash Flow

As mentioned, the cash flow statement is divided into three sections. Let's take a closer look at each of the different cash flow types.

1. Operating Cash Flow

So a business's operating cash flow comes from the principal activity by which revenue is generated. This would include things such as sales, purchases of inventory, and any other expenses associated with the operations of the company. This can be shown in one of two ways: via Direct Presentation or Indirect.

With Direct Presentation of operating cash flows, the statement will show a list of all relevant cash flows. Again, that could include the cash that comes in as a result of sale transactions and also that which is going out because of purchases made.

More common, however, is the Indirect Presentation method. With this particular method, operating cash flows are presented in light of a company's profit. That is to say, it illustrates why cash flow and profit differ, ultimately trying to reconcile the two.

It will usually begin with net income but then will add or subtract based upon actual cash impact. Whereas a balance sheet takes into account debits and credits where money hasn't necessarily changed hands yet, the statement of cash flow using this indirect presentation method will account for all relevant assets and liabilities to arrive at the actual cash flow.

2. Investing Cash Flow

When dealing with cash flow from investing activity, a company will include any transactions involving assets and investments that are not cash equivalents. For instance, this is often associated with the sale/purchase of property, plant, or equipment (PP&E/). In other words, investing cash flows involves primarily capital expenditures.

3. Financing Cash Flow

In terms of financing activity, this is focused upon any changes as far as equity capital and borrowings. So for example, if a company has borrowed money for business financing purposes it would fall under this section of the statement. This would also include the issuing of company shares as well as paying out dividends.

Preparing a Statement of Cash Flows

As noted, the operating section can be presented either via the direct or indirect method. That said, the other two sections: investing and financing are almost always shown in the same way. Again, using the direct method, the company shows a list of all gross receipts and payments, And in the indirect presentation, the statement begins with net income and adjusts according to actual transactions and subsequent cash impact. The results will be the same, as only the methods of arriving at said results will differ. Most companies—according to a recent study, roughly 90%--will use the indirect presentation method in preparing a statement of cash flows.

Using the direct method, the statement will show a tally of all instances of cash coming in and going out. The total, in the end, represents the resulting cash flow for that given period, be it quarterly, monthly, or yearly. In the indirect method, they will use items such as depreciation and net income to reconcile cash flows to profit.

Why Generate a Cash Flow Statement?

Companies of course will create income statements and balance sheets, but why a cash flow statement? In other words, what exactly can this type of statement reveal about a firm's financial picture, and why consequently, is that important?

  • The cash seen as a result of operating activities can be read against a firm's net income and this in turn will give an idea regarding the quality of their earnings. So for example, if the cash coming in due to operating activities is higher than net income then this is seen as high-quality earnings.
  • When going to get a loan or looking to attract investors, a company is most definitely going to need a cash flow statement. This gives investors insight into how healthy the company truly is. Being able to see what is coming in versus what is going out is a very good indicator of overall performance.
  • The statement of cash flows is incredibly helpful as far as allowing stakeholders to predict future cash flows which in turn enables them to make smarter decisions.

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