Cash flow is one of the most important metrics to track in your businesses. Without solid cash flow you’ll be struggling to fund payroll, pay your vendors and lenders, and continue operations.
Cash flow statements are used to gauge this metric. At their core, they show your cash balance at the beginning of a period, all the cash activities that were added to or subtracted from cash, and your ending cash balance.
The guide below will help you understand the importance, format, structure, and interpretation of cash flow statements.
It’s also related to our other articles on understanding gross vs. net profit, operating income vs ebitda, and how to read a balance sheet.
This guide covers
- The basic layout and essential purpose of a cash flow statement.
- Explanations of its three main parts
- The relationship between the balance sheet, profit and loss, and cash flow statement
- Insights on identifying a robust versus a precarious cash flow situation.
- Essential cash flow ratios
Armed with this knowledge, you’ll be ready to use your cash flow statement not just as a report to file away but as a powerful tool to shape your business’s future.
Let’s get started.
The Basics of a Cash Flow Statement
A cash flow statement, in simple terms, is a financial report that tracks where your money comes from and where it’s going over a specific period.
This document is crucial because it shows the actual cash available to your business, helping you make informed decisions about paying expenses, investing in new opportunities, and growing your business.
Unlike other financial statements that are based on accrual (link here) accounting, the cash flow statement tells you about the real cash situation.
Components of a Cash Flow Statement
Operating Activities: This section is the heart of the cash flow statement. It shows the cash generated or used by the core business operations. This includes cash receipts from sales of goods and services and cash payments to suppliers and employees. Essentially, it answers the question: Is the company efficiently turning its products or services into cash?
Investing Activities: Here, we delve into the cash spent on or generated from investments in long-term assets and securities. This includes purchasing physical assets like equipment or property and selling off assets. This section gives insights into how a company is investing its cash for future growth.
Financing Activities: This part highlights cash flows associated with borrowing and repaying debts, issuing and buying back shares, and paying dividends. It reflects how a company raises capital and returns value to shareholders. It’s crucial for understanding the company’s financial strategy regarding debt, equity, and dividends.
Direct vs. Indirect Method
When it comes to reporting cash flows from operating activities, there are two methods: direct and indirect.
The direct method lists all major operating cash receipts and payments. It directly shows cash flows from customers and cash paid to suppliers and employees, providing a straightforward view of cash flows from operations.
The indirect method, on the other hand, starts with net income and adjusts for changes in non-cash accounts. This method reconciles net income with cash provided by operating activities, accounting for accruals and non-cash expenses like depreciation.
The Relationship Between the Financial Statements
The cash flow statement, profit & loss, and Balance Sheet form a comprehensive financial trio most used in the evaluation of of a businesses health and progress. The Profit & Loss and Balance Sheet both feed information into the Cash Flow Statement.
Connection to the Profit & Loss
The Profit & Loss (Profit & Loss) statement records revenues, expenses, and profits over a certain period. While it tells you how much money your business made or lost, it doesn’t show the whole cash story.
That’s where the cash flow statement steps in. It takes the net income from the Profit & Loss as a starting point (especially in the indirect method) and adjusts it for all cash in and out that don’t appear on the Profit & Loss. This adjustment includes non-cash expenses like depreciation and changes in working capital.
Link to the Balance Sheet
The Balance Sheet shows a snapshot of your business’s assets, liabilities, and equity at a specific point in time. The cash flow statement connects to the Balance Sheet through the changes in these items over the reporting period.
For instance, an increase in asset accounts or a decrease in liability accounts (except for the cash account) typically means cash was used; conversely, increases in liabilities or decreases in assets (other than cash) suggest cash inflows.
The opening and closing balances of cash and cash equivalents from the cash flow statement should align with the cash amounts reported on the Balance Sheet, ensuring the financials are in harmony.
A Synchronized View
Together, these three statements offer a 360-degree view of your business’s finances. The Profit & Loss shows profitability, the Balance Sheet reveals what your business owns and owes, and the cash flow statement clarifies how cash is generated and used, highlighting liquidity. This interconnected view helps you grasp not just the profitability but also the sustainability and growth potential of your business.
Analyzing Cash Flow Statement Sections
Operating Activities Analysis
The cash flow from operating activities offers a window into the health of your business’s core operations. To assess cash generation efficiency, focus on the net cash provided by or used in operating activities.
A positive number indicates your business is generating sufficient cash to cover its bills and invest in growth, a sign of operational health. Look for trends over multiple periods: consistent cash generation is a hallmark of a strong business model. Variations can hint at underlying issues with sales, collections, or expense management that may need attention.
Investing Activities Insights
The investing activities section reveals how a business is allocating resources toward future growth. Significant cash outflows here could indicate investments in property, plant, and equipment, or acquisitions—activities aimed at long-term growth.
Conversely, cash inflows suggest selling or collecting on assets (like Accounts Receivable), possibly to reallocate resources or streamline operations. Analyzing this section helps you understand the company’s strategy for sustaining and expanding its operations. Large investments aren’t inherently good or bad; they need to be evaluated in the context of the company’s growth strategy and operational needs.
Financing Activities Examination
Financing activities reflect how a company manages its debt or investments and returns value to its owners. When examining this section, look at how the company raises capital (through debt or issuing equity) and how it returns capital to shareholders (dividends or share buybacks).
Frequent raising of capital might indicate growth or possibly a need to cover operational shortfalls. Regular dividends or share buybacks could be a sign of a mature, profitable business returning value to shareholders. However, too much reliance on debt could raise concerns about financial sustainability and interest obligations.
Cash Flow vs. Profit
While profit is often seen as the ultimate indicator of success, cash flow holds the key to understanding the real financial health of your business.
Profit, calculated as revenues minus expenses, can be misleading due to the timing of income recognition and expenses, as well as non-cash items like depreciation. Cash flow, on the other hand, tells you about the actual cash that’s moving in and out of your business, offering a clearer picture of its ability to sustain operations, invest, and grow.
A business can be profitable on paper but still struggle if its cash is tied up in inventory or unpaid invoices, underscoring why cash flow is often deemed a more reliable measure of financial vitality.
Depreciation and Amortization
Depreciation and amortization are accounting methods used to systematically allocate the cost of tangible and intangible assets over their useful lives. While these charges reduce reported profit, they don’t involve actual cash outflows.
On the cash flow statement, especially under the indirect method, depreciation and amortization are added back to net income. This adjustment is necessary because these expenses decrease net income on the profit and loss statement but do not reduce the company’s cash balance.
This highlights that cash flow from operations can be higher than net income due to these non-cash charges, providing a more accurate picture of cash available for use.
Working Capital Adjustments
Working capital—current assets minus current liabilities—reflects a company’s short-term liquidity. Changes in working capital components (like inventory, accounts receivable, and accounts payable) have direct impacts on cash flow. For instance:
- An increase in inventory consumes cash, reducing cash flow.
- An increase in accounts receivable indicates sales that have not yet been collected in cash, lowering cash flow.
- Conversely, an increase in accounts payable shows delayed cash payments, effectively boosting cash flow.
Adjustments for changes in working capital on the cash flow statement reconcile net income (which is most accurately based on accrual accounting) with the cash a company generates or uses in its operations.
Cash Flow Ratios
To get the most out of your cash flow analysis, you should calculate specific ratios, understand their optimal levels and their implications for your business’s financial health.
Here’s a deeper dive into each key ratio, its formula, and what constitutes a preferable outcome.
Operating Cash Flow Ratio = Cash Flow from Operating Activities / Current Liabilities
Optimal Level: A ratio greater than 1 is ideal.
Relevance: This ratio measures your business’s ability to cover short-term obligations with cash generated from operations. A higher ratio signifies a strong liquidity position, indicating that operations alone generate more than enough cash to meet current liabilities.
Free Cash Flow (FCF) = Cash Flow from Operations – Capital Expenditures (money invested in assets)
Optimal Level: Positive free cash flow is desirable.
Relevance: FCF indicates the cash available after investing in assets, crucial for evaluating financial flexibility. Positive FCF suggests that the business is generating enough cash to support operations, invest in growth, and return value to shareholders without incurring debt.
Free Cash Flow to Sales Ratio = Free Cash Flow / Total Sales
Optimal Level: The higher, the better.
Relevance: This ratio assesses how much of your sales convert into free cash flow, meaning an increase in sales = increase in cash flow. A higher ratio means your business is effectively turning sales into surplus cash, which can be used for expansion, debt reduction, or dividends.
Capital Expenditure (CapEx) Ratio = Capital Expenditures / Cash Flow from Operating Activities
Optimal Level: A balanced approach is key; too high or too low can be concerning.
Relevance: This ratio sheds light on how much of the cash from operations is reinvested in the business for long-term assets. While investing in growth is positive, it needs to be balanced to ensure enough cash remains for operations, emergencies, or unexpected opportunities.
Case Studies with Examples
Let’s take a look at two different hypothetical companies to understand how their Balance Sheet and Profit & Loss feed into their Cash Flow Statements and ratios.
TechGen Innovations
Background: Despite reporting a net profit of $120,000 on its Profit & Loss due to strong software sales, TechGen Innovations faces cash flow challenges.
Profit & Loss Highlights
- Total Revenue: $500,000
- Total Expenses (including non-cash expenses like depreciation): $380,000
- Net Profit: $120,000
Balance Sheet Highlights (Year-End)
- Accounts Receivable: Increased by $90,000 from the start of the year
- Inventory: Decreased by $10,000
- Accounts Payable: Increased by $30,000
- Current Liabilities: $100,000
Cash Flow Statement Highlights
- Net Cash from Operating Activities: $5,000
- Net Cash Used in Investing Activities: -$50,000 (for new software development)
- Net Cash from Financing Activities: $0
Operating Cash Flow Ratio
Let’s see if TechGen can pay off its short-term debts with the money it makes from its day-to-day business.
Quick Math: We’re taking the cash TechGen makes from sales minus expenses, which is $5,000, and dividing it by what it owes short-term ($100,000)
Result: 0.05
What This Means: A result of 0.05 tells us TechGen is making very little cash from selling its software to cover its immediate bills. This could spell trouble for keeping the lights on without finding cash elsewhere.
Free Cash Flow (FCF)
Free cash flow tells us how much cash flow is left over after spending on assets.
Quick Math: We take the cash left from business operations ($5,000) and subtract what TechGen spent on making new software (-$50,000).
Result: $-45,000
What This Means: TechGen is spending $45,000 more on creating new software than they’re making from their regular business. In simple terms, they’re burning through cash faster on development than they’re earning it, which could spell trouble if it keeps up. They might need to either find more money from somewhere (maybe finding new investors) or cut back on spending to keep things running smoothly.
Free Cash Flow to Sales Ratio
This ratio shows how much of every dollar from sales turns into cash TechGen can actually use, after all the necessary spending.
Quick Math: We figure out the ratio by dividing the cash left ($5,000) by total sales ($500,000).
Result: 1% of sales turn into usable cash
What This Means: For every dollar TechGen makes from selling software, only 1 cent is left for spending on growth or tucking away for a rainy day. While it looks like TechGen is doing okay because it has some cash after investing, the real worry is that they’re not getting cash quickly enough from sales.
Overall Takeaway
Even though TechGen is profitable, it’s struggling to turn those profits into cash in the bank. The main issue is collecting payments on time. If TechGen doesn’t start getting paid faster, it might find itself in a tight spot, despite having a promising product.
Garden Fresh Grocers
Background: Garden Fresh Grocers operates efficiently with a business model that ensures both profitability and positive cash flow.
Profit & Loss Highlights
- Total Revenue: $300,000
- Total Expenses: $250,000
- Net Profit: $50,000
Balance Sheet Highlights (Year-End)
- Accounts Receivable: Increased by $5,000
- Inventory: Increased by $15,000
- Accounts Payable: Increased by $20,000
- Total Current Liabilities: $100,000
Cash Flow Statement Highlights
- Net Cash from Operating Activities: $65,000
- Net Cash Used in Investing Activities: -$20,000 (for store refurbishments)
- Net Cash from Financing Activities: $0
Operating Cash Flow Ratio
Let’s check if Garden Fresh Grocers can easily pay its short-term debts with the cash it makes from selling groceries.
Quick Math: We’re looking at the cash they bring in from daily operations, which is $65,000, against what they owe soon, let’s say $100,000 for simplicity.
Result: 0.65
What This Means: A score of 0.65 shows us that Garden Fresh is doing a decent job at covering its immediate bills with the money it makes. It’s not perfect (a score of 1 or higher is considered optimal), but it’s a good sign that they’re bringing in enough cash from sales.
Free Cash Flow (FCF)
Free cash flow tells us how much money is left after the grocer has paid for its necessary expenses and upgrades.
Quick Math: We take the operating cash ($65,000) and subtract what they spent on fixing up the stores (-$20,000).
Result: $45,000 left
What This Means: After paying for store upgrades, Garden Fresh still has $45,000 left. This is great because it means they have cash left over to grow, save, or even give back to owners without needing to borrow money.
Free Cash Flow to Sales Ratio
This ratio lets us see what slice of every sales dollar turns into cash that the business can freely use.
Quick Math: We get this by dividing the leftover cash ($45,000) by total sales ($300,000).
Result: 15% of sales become usable cash
What This Means: For every dollar Garden Fresh makes from selling groceries, 15 cents are completely free to use as they wish. This is a solid performance, showing that not only are they profitable, but they’re also good at turning sales into actual cash.
Overall Takeaway
Garden Fresh Grocers is in a good spot. They’re making a profit and doing an even better job at managing their cash. They collect payments efficiently, keep enough products in stock without overdoing it, and pay their bills without stretching themselves thin. Plus, they’re smart about using the cash they make to spruce up their stores.
Conclusion
Through this guide, we’ve explored the fundamental structure of a cash flow statement, delving into its three main components. We learned about the direct and indirect methods of reporting, the interplay between other primary financial statements and the cash flow statement, important cash flow ratios, and examples of various cash flow positions in action.
Cash is king, and managing cash is one of the most important jobs of a business owner. With a solid understanding of how to reach a cash flow statement, you’re in a strong position to make sure you’re managing one of your most vital assets.
Next, check out our articles on 14 bookkeeping statistics you need to know, 19 top fractional cfo’s, and online bookkeeping services for small businesses.
FAQ: How to read your cash flow statement
Here's some answers to commonly asked questions about cash flow statements.
What's a cash flow statement?
A cash flow statement is like a financial diary for your business. It tracks all the cash coming in and going out over a certain period. Unlike other financial reports that show profits or what you own and owe, the cash flow statement shows the actual cash movement, helping you see if your business is really making money, if you can cover your bills, and if you have enough left over to grow or need to tighten the belt.
Why do I need to look at the cash flow statement?
Checking out your cash flow statement is crucial because it tells you if you’re actually turning a profit into cash in the bank. You could have a business that looks profitable on paper but is struggling to pay bills if cash is tied up elsewhere. It’s all about knowing if you have enough cash on hand for daily operations, paying off debts, or investing back into the business without running into trouble.
How can I improve my business's cash flow?
Improving your business’s cash flow starts with a few key steps: speeding up how quickly you get paid by customers, keeping a tight leash on spending, and making sure you’re not stocking too much inventory that just sits around.
Also, consider negotiating longer payment terms with suppliers to keep cash longer. Each of these strategies can help ensure more cash stays in your business, giving you a buffer and more flexibility to operate and grow.
