Learning how to read a cash flow statement is a must for any small business owner seeking financial stability. By tracking cash flow from operations, investments and financing, you can spot rising risks, seize growth opportunities and make decisions that improve profitability. Follow our guide on what your financial statement should include, how to analyze each component and why it all matters.
What Is a Cash Flow Statement?
A cash flow statement is a financial statement that tracks the movement of cash in and out of your company. Also called a statement of cash flows, it details your company’s near-term ability to fund operations, pay debts and invest in growth. Cash flow statements are different from income statements and balance sheets, which provide comprehensive information on overall profitability, assets, liabilities and equity.
How to Analyze Cash Flow Statements: The Basics
For most businesses, the goal at the end of each operating period (month, quarter or year) is to have a positive net cash flow, or more cash at the end of the period than at the beginning. Here’s a basic formula to follow:
Net cash flow = total cash inflows – total cash outflows
You should also analyze how cash moves in and out of your business during the operating period. For example, investigate any positive cash flows, especially when they result from investing activities—a business that regularly sells off assets to inject cash into its business operations is unlikely to survive. Similarly, a business might have negative cash flow because it has invested in equipment or other assets that will drive growth in the future.
Essential Components of a Cash Flow Statement
Cash flow statements contain three distinct sections: operating activities, investing activities and financing activities.
Operating Activities
This section illustrates how your company’s day-to-day operations impact your liquidity. Cash inflows include revenue from sales, interest and dividends. Cash outflows include expenses related to core business operations, such as payments to suppliers, wages, utilities, rent and income tax.
An important ratio to consider when analyzing your company’s operating activities is the operating cash flow ratio (OCF). The OCF measures the extent to which a company can pay off its current debts with the cash it generates in the same period. To calculate your company’s OCF, divide operating cash flow by current liabilities.
OCF = Operating cash flow / current liabilities
While an OCF ratio above one is considered high, a low OCF ratio is not always a sign of poor financial health; it may show that a company has invested in a project that will deliver future growth.
Investing Activities
Investments include any source or use of cash outside core business activities, such as purchasing or selling securities or long-term physical assets like equipment. Positive and negative cash flows in investing activities have different implications than they do in operating activities.
For example, unlike negative cash flow in operating activities, which may indicate that a company is struggling, negative cash flow in investing activities often reflects investments designed to spur a company’s growth. When a company makes capital expenditures or invests in new property or equipment, the transactions will show up as investing activities with negative cash flow on the cash flow statement. Investments in stocks and any loans made will also appear as negative cash flows. Positive cash flow in investing activities is generated when a company divests its fixed assets, sells investments, receives a payment from insurance, or receives payment of a loan.
Financing Activities
Financing reflects the cash flow from business loans and investors, transactions like issuing stock or paying dividends to shareholders, and capital lease obligations. To calculate your company’s cash flow from financing (CFF) activities, subtract cash outflows from financing from cash inflows from financing.
CFF = Cash inflows from financing – cash outflows from financing
Cash inflows from financing include money received when a company issues stock. Cash outflows from financing include money used to repurchase shares or for dividends, as well as repayment of long-term debt. Determining whether a positive or negative CFF is good or bad requires an assessment of your company’s strategy and finances. For example, a negative CFF could reveal that a company is paying down its debt (good) or that it is experiencing challenges with liquidity (bad).
Together, these sections of a cash flow statement allow stakeholders to assess a company’s current financial status, strategic direction and long-term sustainability.
How to Read a Cash Flow Statement
A company’s statement of cash flows provides crucial insights that income statements and balance sheets may lack. Follow these steps when reviewing your cash flow statement:
- Assess net cash from operating activities. This shows the cash generated from day-to-day business operations. Look for positive or increasing operational cash flows over time, which indicate a healthy business.
- Evaluate cash from investing activities. This includes outflows for investments and capital expenditures and inflows from divestitures or asset sales. Watch for overinvestment that undermines liquidity.
- Examine cash from financing activities. This includes inflows from borrowing or equity financing and outflows for debt repayments, share buybacks or dividends. Beware dependency on external financing.
- Check for significant month-over-month and year-over-year changes in cash flow. Analyze the drivers behind major shifts between periods and across activities. Identify anomalous one-time events.
- Compare cash flow to net income. If net income is growing but cash isn’t, it could signal aggressive revenue recognition or trouble collecting customer payments.
- Assess working capital needs based on changes in current assets and liabilities. Improving working capital management can free up extra liquidity.
- Evaluate cash ratios like operating cash flow ratio. Compare to industry benchmarks and track trends over time.
- Read the notes. This can include information on accounting methods used, significant transactions and other details essential for a comprehensive understanding.
Cash Flow Statement Example
ABC company has created an annual cash flow statement using the preferred indirect method. Organizing the statement into operating, investing and financing activities may look like this:
ABC Company
Cash Flow Statement
For the Year Ended December 31, 20XX
Cash Flows from Operating Activities:
- Net Income: $150,000
- Adjustments to reconcile net income to net cash provided by operating activities:
- Depreciation: $20,000
- Increase in Accounts Receivable: ($10,000)
- Increase in Inventory: ($5,000)
- Increase in Accounts Payable: $8,000
- Decrease in Salaries Payable: ($3,000)
- Amortization of Intangible Assets: $2,000
- Net Cash Provided by Operating Activities: $162,000
Cash Flows from Investing Activities:
- Purchase of Equipment: ($50,000)
- Proceeds from Sale of Investments: $12,000
- Net Cash Used in Investing Activities: ($38,000)
Cash Flows from Financing Activities:
- Dividends Paid: ($30,000)
- Issuance of Common Stock: $25,000
- Repayment of Long-term Debt: ($20,000)
- Net Cash Used in Financing Activities: ($25,000)
Net Increase in Cash and Cash Equivalents: $99,000
- Cash and Cash Equivalents at Beginning of Year: $50,000
- Cash and Cash Equivalents at End of Year: $149,000
What Does A Cash Flow Statement Analysis Tell Your Business?
Conducting regular cash flow statement analysis is a critical step in understanding the financial health of your business. Cash flow analysis highlights your company’s liquidity, telling you whether the business is generating enough cash to sustain its operations, generate growth and meet its obligations.
It also spotlights opportunities for more effective cash flow management, offers insights into which investments improve liquidity and helps business owners understand the costs and benefits of different financing methods. Cash flow analysis can reveal trends that may signal emerging challenges, such as declining cash flow over time or frequent sales of assets intended to increase liquidity.
How to Prepare a Cash Flow Statement From Scratch
Follow these key steps to develop this key financial statement from scratch:
- Choose the reporting period. The cash flow statement can be prepared for any period (monthly, quarterly, annually). First, decide on the time frame for which you will be preparing the statement.
- Set up accounting systems to track cash inflows and outflows during the chosen period. Categorize transactions as operating, investing or financing. Capture information like customer receipts, invoices, supplier payments, equipment purchases, loan proceeds and financial statements, like the income statement and balance sheet.
- Start with the cash balance at the beginning of the period, add or subtract the net cash flows from each of the three categories, and then calculate the ending cash balance. This balance should match the cash amount reported on the balance sheet for the same period. For each category, calculate net cash flow using the indirect method: Net Income + Non-Cash Expenses – Non-Cash Income. Adjust for changes in balance sheet accounts like inventories and payables using comparative balance sheets.
- Highlight key relationships and trends in cash flows. Compare current cash balances and working capital needs. Assess where cash is being generated and used across business units.
- Project future cash position based on budgeted cash inflows/outflows. Incorporate sales and expense growth assumptions. Detail expected capital investments and financing plans.
Mastering Cash Flow for Business Success
By carefully preparing and knowing how to read a cash flow statement, you can make informed decisions about managing costs, investing wisely and choosing the right financing options. Paro’s fractional accounting and finance experts can help your business create and analyze cash flow statements to improve cash control and help your team in future decision making. Schedule a free consultation to learn how our accounting experts can support your company’s financial reporting needs.
