The Statement of Cash Flows is one of the most important financial statements needed by management and other users of the financial statements to summarize the inflow and outflow of cash and cash equivalents in a business. In business discussions, you will often hear the term “cash is king”, this explains how important the statement of cash flows is as it measures how well a business is generating cash to pay its short- and long-term obligations as they fall due.
When working as part of the finance team, regardless of your job title, learning how to prepare and interpret the statement of cash flow will help you to better understand the inner workings of the business and will allow you to make good contributions on strategies the business can take to improve its cash position.
The figures that are seen on the statement of Cash Flows represents the changes in the business’s cash balances over a particular reporting period. This may be from the start of a month to the end or from the beginning of the financial year to the end of the financial year.
There are three main components/areas of the statement of cash flow. These are cash generated from operating activities, investing activities, and financing activities.
| XYZ | |
| Statement of Cash Flows | |
| For the Month ending March 31, 2022. | |
| Amount | |
| Cash Flow from Operating Activities | xxx |
| Cash Flow from Investing Activities | xxx |
| Cash Flow from Financing Activities | xxx |
| Net increase/(decrease) in cash during the period | xxx |
| Cash at the beginning of the period | xxx |
| Cash at the end of the period | xxx |
This section of the statement of cash flows provides information about the inflow and out flow of cash from the business’s day to day operations. Some of these include receipts from the sale of goods and/or services, salaries and wages paid to the employees and contractors, payments to suppliers for raw materials and services provided (security), rental payments and taxes and interest paid.
Changes reflecting in accounts receivable, accounts payable, inventory and depreciation are generally accounted for under this category.
Depreciation and amortization will reduce the business’s net income; however, these are not actual cash transactions and therefore will not reduce the business’s cash balance. Depreciation and amortization would therefore be added back to net income in the statement of cash flows.
The diagram bellow is an example of the statement of cash flows. The company and the amounts shown are hypothetical: –
| XYZ | |
| Statement of Cash Flows | |
| For the Year Ending December 31, 2022. | |
| Amount | |
| Cash Flow from Operating Activities | |
| Net Income | 150,000 |
| Adjustments to reconcile net income to net cash from operating activities: | |
| Depreciation and Amortization | 45,000 |
| Changes in current asset and current liabilities: | |
| Increase in receivables | -31,000 |
| Increase in Inventory | -40,000 |
| Increase in Payables | 30,000 |
| Decrease in prepaid expenses. | |
| Net Cash from Operating Activities | 154,000 |
| Cash Flow from Investing Activities | |
| Capital Expenditures | -200,000 |
| Proceeds from sale of equipment | 25,000 |
| Net Cash from Operating Activities | -175,000 |
| Cash Flow from Financing Activities | |
| Proceeds from issuing new capital | 100,000 |
| Dividends Paid | -32,000 |
| Net Cash from Financing Activities | 68,000 |
| Net increase/(decrease) in cash during the period | 47,000 |
| Cash at the beginning of the period | 50,000 |
| Cash at the end of the period | 97,000 |
The above statement of cash flows is for the reporting period ending December 31, 2022. If you look closely, you’ll notice that the opening balance of cash and cash equivalents was approximately $50,000.
During the reporting period, operating activities generated a total of $154,000. The investing activities section shows the business used a total of $175,000 in transactions related to investments. The financing activities section shows a total of $68,000 was spent on activities related to debt, equity financing and paying dividends.
At the bottom of the cash flow statement, the three sections are summed to total a $47,000 increase in cash and cash equivalents over the course of the reporting period. Therefore, the final balance of cash and cash equivalents at the end of the year equals $97,000. This would be the same as shown in the company’s balance sheet as at December 31, 2022.
A crucial difference between the statement of cash flows and the other financial statements (income statement and balance sheet) is that the amounts of future transactions of expected cash inflows and cash outflows that has been recorded in revenue and expenses. For example, revenue would include both sales made on credit and cash sales. This is why an adjustment must be made to the net income figure taken from the income statement.
The statement of cash flows is derived from the income statement and the balance sheet. As earlier stated, the net income from the income statement is used to as the starting point to calculate net cash flows from operating activities.
The net cash flows reported on the statement of cash flows should be equal to the net change on each line items (aged receivables, inventory, payables, etc.) on the balance sheet. However, this does not include cash balances and accumulated depreciation.
To better understand how the figures in the statement of cash flow are arrived at, we use a few transactions to illustrate how accounting entries flow from the income statement through to the statement of cash flow: –
On March 02, 2022, Ford Gayle started his business Gayle Supplies Limited with $50,000 in the bank. Gayle Supplies Limited distributed pharmaceutical supplies to local pharmacies in the town of Farland.
During the month of March 2022, the following transactions took place.
Mach 03, Purchase a motor vehicle for $20,000.
March 08, Purchase supplies on credit from Mega Distributors for a total cost of $29,300.
March 15, Paid rent for $10,000
March 20 Sold supplies to Little Lane Pharmacy for a total cost of $8,800.
Mach 28 Sold supplies on credit to Second Lane Pharmacy for a total cost of $10,000.
March 31 Paid Mega Distributors $26,500 towards the outstanding debt.
March 31 Charged depreciation of $300 on the new truck.
The income statement for Gayle Supplies Limited as March 31, 2022, is shown below:
| Gayle Supplies Limited | |
| Income Statement | |
| For the Month ending March 31, 2022. | |
| $ | |
| Revenue | 18,800 |
| Cost of Sales | -4,000 |
| Gross Profit | 14,800 |
| Rent | -10,000 |
| Depreciation | -300 |
| Net Income | 4,500 |
The income statement recognizes net income of $4,500, however depreciation charge of $300 was deducted before arriving at this figure. Depreciation is not real cash and there an adjustment will be made to the net income figure in the cash flow.
The balance sheet for Gayle Supplies Limited as March 31, 2022, is shown below: –
| Gayle Supplies Limited | ||
| Balance Sheet | ||
| For the Month ending March 31, 2022. | ||
| ASSETS | $ | |
| Fixed Assets | 20,000 | |
| Accumulated Depreciation | -300 | |
| 19,700 | ||
| Current Assets | ||
| Inventory | 25,300 | |
| Bank | 2,300 | |
| Second Lane Pharmacy | 10,000 | |
| 37,600 | ||
| Current Liabilities | ||
| Mega Distributors | 2,800 | |
| Net Current Asset/Liabilities | 34,800 | |
| TOTAL | 54,500 | |
| Capital Employed | ||
| Capital Employed | 50,000 | |
| Profit – Retained Earnings | 4,500 | |
| TOTAL | 54,500 | |
The balance sheet reports the value of the unsold supplies at the end of the month (inventory). It also reports the closing the cash balance and amounts for aged receivables and aged payables.
From the information in Gayle’s Supplies Limited income statement and balance sheet, we are now able to prepare the statement of cash flows for the month of March 2022: –
| Gayle Supplies Limited | |
| Statement of Cash Flows | |
| For the Month ending March 31, 2022. | |
| Amount | |
| Cash Flow from Operating Activities | |
| Net Income | 4,500 |
| Adjustments to reconcile net income to net cash from operating activities: | |
| Depreciation and Amortization | 300 |
| Changes in current asset and current liabilities: | |
| Increase in receivables | -10,000 |
| Increase in Inventory | -25,300 |
| Increase in Payables | 2,800 |
| Net Cash from Operating Activities | -27,700 |
| Cash Flow from Investing Activities | |
| Capital Expenditures | -20,000 |
| Net Cash from Operating Activities | -20,000 |
| Cash Flow from Financing Activities | |
| Proceeds from capital | 0.00 |
| Investment by Owner | 50,000 |
| Net Cash from Financing Activities | 50,000 |
| Net increase/(decrease) in cash during the period | -47,700 |
| Cash at the beginning of the period | 0 |
| Cash at the end of the period | 2,300 |
The net cash flow from operating activities was prepared using the indirect method starting with net income, which was arrived using the accrual basis, hence adjustments were done to convert the amount of $4,500 to real cash.
The increase in inventory and receivables represented a cash outflow for the company. An increase in inventory means that cash was used up to make the purchases. The receivables balance went up because supplies were sold on credit and our debtors were yet to settle their account and the end of the month.
The cash flow from financing activities section shows the capital investment by Ford Gayle which had a positive effect on the company’s cash balance. The positive cash flow of $50,000 good for the company’s cash balance.
The cash balance at the end of March 2022 in the amount of $2,300 was a combination of the $27,700 outflow from operating activities, $20,000 cash outflow from investing activities and the cash inflow of $50,000 from financing activities.
The cash flow statement is one of the most important financial statements because it provides invaluable information about a company’s financial health and its ability to survive over the long term. Below are some of the reasons why the cash flow statement is important to both managers and investors: –
Cash flow statements help businesses monitor their liquidity, ensuring they have enough cash on hand to meet day-to-day operational needs. Insufficient liquidity can lead to missed payments, supplier issues, and operational disruptions, which can threaten a company’s survival.
By analysing historical cash flows, businesses can forecast future cash needs and plan accordingly. This enables proactive measures like securing loans or lines of credit before a cash crunch occurs, preventing potential crises.
Investors and creditors rely heavily on cash flow statements to assess a company’s financial stability. Positive cash flow from operations signals that a business can generate enough cash to support its activities and pay off debts, making it more attractive to investors and lenders.
A company can be profitable on paper but still struggle with cash flow problems. The cash flow statement helps differentiate between accounting profits and actual cash generated. This is vital for managing operational costs and avoiding over-extension.
Analysing cash flow statements over time can reveal trends in a business’s cash management. Consistent negative cash flows may indicate underlying issues that need addressing, while positive trends can provide confidence in the company’s financial stability.
A well-managed cash flow statement can identify potential risks and vulnerabilities. For instance, it can highlight over-reliance on a single customer, late payments, or irregular cash flow patterns, allowing businesses to take corrective actions to mitigate these risks.
When considering expansion, acquisitions, or major investments, businesses rely on cash flow statements to assess the impact on their liquidity and overall financial health. This informed decision-making is essential for sustainable growth.
Cash flow statements assist in tax planning by showing the timing of cash inflows and outflows. This can help businesses optimize their tax strategies and reduce their tax liability legally.
The indirect cash flow method allows for a reconciliation between two other financial statements: the income statement and balance sheet.
If a current asset’s balance has increased from one period to the next, the amount of that increase is subtracted from net income. The increase in the current asset (other than cash) had a negative effect on the company’s cash balance. The reverse also holds true.
If a current liability’s balance (other than loan payables) has increased from one period to the next, the amount of that increase is added net income. The increase in the current liability’s balance (other than loan payables) had a positive effect on the company’s cash balance. The reverse also holds true.
Answer: – While both methods will result in the same net cash flow from operating activities, neither is better or worse. However, the direct method is more time consuming. The indirect method allows for the reconciliation of amounts on the balance sheet to net income figure.
Answer: – In accounting terms cash includes, currency, coins, petty cash, and cheques received from debtors, while cash equivalents are short term liquid investments which can be turned into cash within 3-6 months.
Answer: – The income statement shows a company’s profitability over a period, while the cash flow statement focuses on actual cash movements. A company can be profitable but experience cash flow issues, so both statements are essential for a complete financial analysis.
Answer: – A negative cash flow from operations may be addressed by improving operational efficiency, reducing expenses, accelerating accounts receivable collections, and managing accounts payable effectively. It may also require securing additional financing.
Answer: – While essential, the cash flow statement has limitations. It may not reflect the timing of cash flows accurately. Hence a negative cash flow in one period may not mean that a business is no longer a going concern. A poor cash flow could just be the result of a project that the business has taken on at a particular point in time. Additionally, it may not provide insights into a company’s long-term sustainability.
You should consider our materials to be an introduction to selected accounting and financial topics and realize that some complexities are not presented. All content on this website is provided solely for informational reasons and should not be interpreted as professional financial advice. Therefore, always consult with a chartered accountant/CPA and tax professionals for assistance with your specific circumstances.
