You may have heard it said that the financial statements tell the story of how a business is performing. That is true. The three primary financial statements accountants use to tell the financial health of a business are the balance sheet, the income statement (also known as the profit & loss statement), and the cash flow statement. This article takes a look at how to understand a cash flow statement. Before jumping into understanding a cash flow statement, let us look at what a cash flow statement is.
What Is A Cash Flow Statement?
A cash flow statement is a financial report that lays out the “big picture” movement of a business’s cash activity – inflows and outflows – within a given period. There are two types of cash flow statements; direct method and indirect method. The direct method assumes a business uses the cash accounting method of reporting, while the indirect method is mainly used by businesses that use the accrual accounting method. Regardless of which method a business uses, the bottom-line result (that is, the net cash ending balance) will be the same.
The Three Main Parts of The Cash Flow Statement
Whether a business uses the direct or indirect method, there are three main sections on the cash flow statement. The sections are:
- Operating activities – This section reflects the cash movement of the business’s operational transactions and some non-operational transactions for a given period. For example, inventory, accounts receivable, accounts payable, depreciation, and pension transactions.
- Investing activities – This section shows all the investing transactions of a business for a given period. Examples include capital expenditures (on fixed assets) and property sales (or purchases).
- Financing activities – This section shows all the finance-related transactions of a business for a given period. Examples include selling or purchasing stocks, bonds, long-term debt borrowings, and cash dividends.
The sum of each section is added to the beginning cash balance; the result shows the ending cash balance for the period.
Now that we have briefly discussed what a cash flow statement is, the two types of cash flow statements, and the main sections of a cash flow statement, let us look at how to interpret a cash flow statement.
How To Read A Cash Flow Statement
To help us understand how to read a cash flow statement, we will use the sample statement below for Yetu Design LLC.
Yetu Design shows the following:
- Net cash provided for operating activities = $50,500
- Net cash used for investing activities = $(10,000)
- Net cash provided for financing activities = $15,000
- Beginning cash balance = $10,000
- Ending cash balance = $65,000
So, what do these numbers mean? Let us start from the top and work our way down.
The net operating activities total of $50,500 indicates that at the end of the year (December 31st), the business had a net cash inflow of $50,500 from its operations. Income for the year was $100,000. Depreciation of $4,000 is added back into the equation because depreciation is a non-operational expense. This means no cash left the business to “pay” for depreciation, so it gets added back to the net income.
Since accounts receivable $(35,000) and inventory$(5,000) increased, it means there was less cash flowing into the bank, so both transactions are subtracted out. A decrease in accounts payable, $16,000, means customers paid on their accounts; hence, the business had cash flowing into its bank account, which gets added to the account. A decrease in other assets, $2,500, means more funds were added to the business’ bank account as some assets were sold, or said another way, cash flowed into the business.
The net investing activities section shows one item, capital expenditures for $(10,000). This indicates that the business purchased assets for $10,000; therefore, cash flowed out of the business, causing a deduction on the cash flow statement.
The net financing activities section shows a net cash inflow of $15,000. This comprises $30,000 of cash flowing into the business through a loan the business took and $(15,000) of cash flowing out of the business for a purchase of treasury stock.
What Do The Numbers Mean?
The information from each section is vital as it tells management where the business’s cash was used and where it was received (or provided). Management may prefer to look at the consolidated picture to see what the business as a whole looked like for the year. In this case, the total, $55,500, for the three (3) sections above is added to the beginning of the year’s cash balance, $10,000, to come up with the ending cash balance for the year, $65,500. The net cash ending balance for Yetu Designs shows a positive amount of $65,500, which means the business ended the year with a positive cash balance. This information helps management make financial decisions. For example, can we hire another director? Can we purchase a new van for the business? Do we have enough funds to embark on a new advertising campaign next year that costs $X amount? A business can answer these and other cash-related questions by understanding the cash flow statement.
Does this mean the business had a successful operational year? The cash flow statement cannot answer this question. To answer it, the management team needs to look at their budgeted net income for the year and compare it to the actual net income. They also need to look at their KPIs – key performance indicators. By reviewing these and other factors, a business can tell if it performed well. The importance of the cash flow statement to a business should not be ignored. It is the backbone of every business’s cash decisions.