What Is A Cash Flow Statement And How Do You Prepare One?

What is a cash flow statement?

Cash flow is the amount of cash generated and spent by a business. By cash, we also mean cash equivalents, such as bank deposits and investments that can be quickly and easily converted into cash. Cash received by a business is called inflow (income from sales, asset sales, rebates, etc) while what it spends is referred to as outflow (wages, payments to suppliers, bills, etc).

A company’s cash flow statement shows how much cash it generated and spent in a given period, such as a month, a quarter, or a year. Also called a statement of cash flows, it records all the money a business receives from its primary operations and other investments as well as the cash it spends on these activities and investments. A cash flow statement, therefore, allows a peek into a company’s transactions.

What does a cash flow statement tell you?

It is a business requirement to learn how to prepare a cash flow statement. This document is not only a record of transactions but is also extremely informative for business owners, investors, and analysts. 

• A cash flow statement is a snapshot of how well a company manages its cash – in other words, how good it is in generating cash to operate its business and pay its debts. Even established companies can bring down their performance with poor cash flow management. A cash flow statement tells you if cash is going out of your business faster than it is coming in, thus helping prevent problems such as payment delays and conserving your goodwill with your suppliers, creditors, and investors.
• Cash flow statements help identify problem areas. If your company is losing money from a specific operation or investment, the cash flow statement will make this clear.    
• Many businesses do cash flow forecasting based on their cash flow statements. With cash flow forecasting, you can estimate your earnings and expenses in the foreseeable future. This allows you to invest your cash reserves wisely and plan for times when money might be tight.
• Cash flow statements show potential investors if it is a good idea to invest in a particular company. Similarly, banks and other financial institutions use cash flow statements to assess the risk of lending to a particular business.

• If a business has too much cash in hand, it means it isn’t investing it wisely. Similarly, too little cash points to ill-judged spending. You must pay attention to your cash flow statements if you wish to maintain an optimal cash balance.

Cash flow statement format

To learn how to prepare a cash flow statement, you need to know its contents. A typical cash flow statement format has three sections denoting where cash is flowing from and a fourth section for the disclosure of non-cash activities.

1. Cash flow from operating activities

The first section on a cash flow statement, it records cash flow from a company’s primary revenue-generating operations. Cash flow from operations includes revenue from sales and operational expenses such as supplier payments, salaries, taxes, interest payments, and utility bills. It can be calculated by subtracting operational expenses from sales revenue. Cash flow from operations shows if a company has enough cash to maintain or expand its operations.

2. Cash flow from investing activities

This second section deals with cash generated from or spent on capital expenditures and investment-related activities, such as the sale or purchase of assets (plant, property, equipment) and securities, cash loaned to suppliers or received from buyers, and so on. Heavy spending on investments might lead to negative cash flow but this is not necessarily an indication of poor performance as the investments might be crucial to running the business.

3. Cash flow from financing activities

This section records the flow of cash between a business and its owners and creditors – for example, bank loans that have been taken or repaid, sale or repurchase of stocks, and dividend payments. Money invested or pulled out by a business owner also counts as cash flow from financing activities. This section reveals how a business raises funds for its operations.

4. Disclosure of non-cash activities

Some activities take place without cash changing hands. For instance, when a company acquires an asset (say, a plant) by assuming its related liabilities, or when it gets a new property in exchange for another property. Including such non-cash transactions under the previously mentioned sections would be erroneous and lead to inaccuracies in the cash flow statement. But they can be included under a separate section, either in narrative or tabular form.

How to calculate cash flow

There are two ways to calculate a cash flow statement – the direct method and the indirect method.

Cash flow statement direct method

The direct method lists every cash transaction (purchases and receipts) for a given accounting period, and adds it up. While it sounds simple, it is not the most convenient method and is also time-consuming. The cash flow statement direct method is best suited for businesses that use cash-basis accounting, which is less prevalent than accrual accounting. Direct cash flow reporting suits small businesses with a modest list of cash transactions.

Cash flow statement indirect method

Most companies use the indirect method to prepare their cash flow statements. Under indirect cash flow reporting, the cash flow statement takes net income – which is sales minus cost of goods sold, operating expenses, selling, general and administrative expenses, depreciation, interest, taxes, etc – and then adds or deducts non-cash items to arrive at the actual cash flow from operating activities. Unlike the direct method that records actual cash flow from a cash-basis accounting perspective, the cash flow statement indirect method starts with net income on an accrual basis. Indirect cash flow reporting is more prevalent because it is based in accrual accounting, which is the preferred accounting method for most companies. Those in charge of preparing the cash flow statement can simply use data from the income statement and balance sheet, saving them the trouble of keeping and verifying a large number of payment receipts and disbursement slips.

The differences between the direct and indirect methods are relevant only to the first section of the cash flow statement, which is cash flow from operating activities. Cash flow from investing and financing activities are calculated in the same way under both methods.

How to prepare cash flow statement – direct vs indirect method

Cash flow statement example

Here is a simple cash flow statement example prepared using the indirect method.

(The statement is for a financial year. Figures in SGD). 

Cash flow vs net income

Are cash flow and net income the same? You might have come across this question at some point of time? Net income, as mentioned earlier, is the starting point for calculating cash flow from operating activities under the indirect cash flow method. While the terms are closely related, there are differences you must understand so you know how to read your cash flow statement accurately.

Cash flow, we know, is the cash a business generates and spends in a given period. Net income, on the other hand, is the profit earned in that period. It is calculated by deducting expenses – including the cost of sales, operational expenses, taxes, interest, depreciation, and amortisation – from total revenue. While cash flow includes only cash transactions, net income includes both cash sales and on-credit sales. Net income is commonly referred to as the bottom line due to its positioning on the income statement.

Positive cash flow means a company has enough liquid assets to cover its financial liabilities. A positive net income also points to good liquidity. Both cash flow and net income are, therefore, important metrics for analysing a company’s financial health.

What does negative cash flow mean?

Negative cash flow implies that a company is spending more money than it makes. However, it is not necessarily a bad thing. Negative cash flow can arise when your bills are due before you receive your earnings. It is common for companies to have negative cash flow for some months and recover the deficit in the following months. Your company’s cash flow can also go into negative figures when you are in the process of expanding and growing. The returns you earn in the future will make up for the current shortfall. A negative figure could simply mean you are diligently repaying your debts, paying your dividends, or buying back stock. However, if cash flow remains negative for too long, it could spell serious trouble.

How do you improve cash flow?

Even profitable businesses can face cash flow problems. For example, if their payables are due before their receivables come in, it could stop them from paying their debts and bills on time, hurting not just their operations but also their creditworthiness and reputation. If you want to improve your company’s cash flow, here are a few practices you can adopt.

1. Increase pricing

Instead of worrying about higher prices turning off customers, don’t be afraid to experiment with your product pricing until you find the right price. Discerning buyers will not mind paying a little more for quality goods and services.

2. Offer early payment incentives

Payment delays hurt cash flow and affect your ability to pay your bills. Offering customers a discount if they pay their bills early will not only improve your cash flow, it might even get you new customers. It’s a win-win.

3. Offer more payment options

Allowing your customers to pay through their preferred channel will speed up cash inflow and prevent payment lags.

4. Send invoices out on time

The faster you dispatch them, the faster you get paid. Make sure your invoices clearly mention the payment due date, accepted modes of payment, and late fees if any.

5. Do an inventory check

Inventory can tie up a lot of cash, more so if it isn’t selling well. A quick check will tell you which products have sluggish sales. Don’t stock up on them and try to get rid of what you already have, even if it means selling at a discount.

6. Negotiate payment terms with suppliers

If you’ve been doing business with your suppliers for a long time, it shouldn’t be difficult to ask for better conditions, such as longer payment terms and early payment discounts. Imagine the boost to your cash flow if your supplier agreed on monthly payments instead of upfront payment!

7. Cut back on non-essential investments

Don’t buy what you don’t absolutely need to run your business. Another option is to lease and not buy as this will not tie up your cash. While it is true that leasing plants and equipment often falls more expensive than buying them in the long run, you still need money to run your daily operations. Make a big purchase only if you are flush with cash.

8. Turn liabilities into assets

The golden rule of improving cash flow is to increase assets and decrease liabilities. Make a list of your liabilities and see how you can generate income from them. For example, selling off a property that you rarely use will give your business some much needed liquidity.

Why is interest expense included in operating activities?

Interest paid and interest received are not included in the ‘cash flow from financing activities’ section of a cash flow statement, even if they are linked to the act of borrowing funds. Instead, you’ll find interest expense in the cash flow statement under ‘cash flow from operating activities’. That’s because interest expense is treated as an operating expense that is incurred with the aim of generating revenue. Interest expense in the cash flow statement reveals the cash impact a company’s borrowing activities have on its operating activities. Hence its placement in the operating cash flow section.

Why is depreciation expense a non-cash expense?

Depreciation is the decline in value of an asset over time. It relates to tangible assets such as property and equipment, which gradually lose value due to wear and tear. For intangible assets (copyright, trademark, patents, licences, etc), the term amortisation is used instead.

Depreciation in the cash flow statement is classified as a non-cash expense as it doesn’t involve cash payments. It is found in the income statement and balance sheet too. However, even if there is no cash transaction involved, depreciation can still affect a company’s cash flow, albeit indirectly. Here’s how: companies list depreciation as an expense on their income tax returns. This lowers their taxable income, which in turn reduces their cash outflow.

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