Cash Flow Statement: Definition, Importance, and How To Prepare One

The cash flow statement is one of the three basic financial statements in bookkeeping. By reporting cash flow, the cash flow statement helps businesses understand their liquidity, flexibility, and efficiency in generating cash. Our guide takes a deeper look at cash flow statements, why they are important, and how to prepare them. 

What is a Cash Flow Statement?

A cash flow statement is a financial statement that reports the cash earned and spent over a designated period of time. It illustrates how cash moved in and out of the business. 

The cash flow statement consists of three main sections:

• Cash Flow from Operating Activities reports cash gained and lost from core business activities
• Cash Flow from Investing reports cash gained and lost from investing activities
• Cash Flow from Financing reports cash gained and lost from money owed, such as debts and shareholder investments

The accrual method of accounting requires businesses to record transactions as they occur, not when cash is exchanged. This means that the income statement and balance sheet don’t always reflect how much usable capital moved in and out of the business. 

The cash flow statement helps illuminate a company’s operational efficiency. It shows the quality of a company’s earnings by determining whether the usable capital generated can cover all expenses necessary for sustaining operations. 

Investors use the cash flow statement to determine whether a company can operate efficiently and profitably. Good cash flow increases a company’s chances of securing funding and improves its capacity to pay back shareholders. 

Parts of a Cash Flow Statement

The cash flow statement has three distinct sections, each corresponding to different cash flow sources. Below, we provide a detailed discussion of the three sections and the items typically included under each. 

Cash Flow from Operating Activities

Cash flow from operating activities constitutes the bulk of your cash flow statement. They include all cash generated and used in core business activities. It represents the amount of cash earned or lost by selling products or services. 

Typically, this section of the cash flow statement features the following items:

• Cash receipts from the sale of products or services
• Payments for inventory, supplies, and other services used in operations
• Employee wage payments
• Utility and rent payments
• Interest payments
• Other operating expenses

Not all items included under operating cash flow represent revenue and expenses. This section also accounts for adjustments, such as non-cash expenses. 

Why are non-cash expenses included in cash flow?

The operating cash flow section typically covers non-cash expenses, such as depreciation, amortization, and depletion. They are recorded as additions to cash because they have an indirectly positive effect on cash flow through tax.

As non-cash expenses, depreciation, amortization, and depletion decrease the amount of income tax the government can charge you. Because cash outflows are reduced, non-cash assets are added to the cash flow statement as additions to cash. 

Cash Flow from Investing Activities

After listing cash flow from operating activities, the cash flow statement reports cash flow from investing activities. These include any money earned or spent on non-current assets and investments. 

Examples of transactions that impact cash flow from investing activities include purchases and sales of the following:

• Equipment
• Property
• Buildings
• Bonds and securities
• Patents and trademarks
• Acquired brands

Cash Flow from Financing Activities

The final section reported in the cash flow statement is cash flow from financing activities. This section includes borrowing and repaying cash from outside sources, such as lenders and shareholders. Examples of items include:

• Issuance of equity
• Issuance of debt
• Repayment of equity
• Repayment of debt
• Payment of dividends
• Capital or finance lease payments

Cash Flow Statement Calculation Methods

There are two ways to report cash flow from operating activities: the direct method, which works forward based on cash receipts and payments, and the indirect method, which works backward by adjusting the net income using increases and decreases in the balance sheet. 

Direct Method

The direct method of calculating operating cash flow for cash flow statements reports all cash as it is received and paid, providing a complete picture of company operations. It then takes the total of these items to generate net cash flow over the selected period. 

To illustrate, let’s use an example. Over a month, you generated the following cash inflows and outflows from operating activities:

• $30,000 in wages paid to employees
• $50,000 in expenses paid to vendors
• $150,000 earned from customer payments
• $20,000 in taxes paid 

You would write your operating cash flow as a list of inflows and outflows, then get the sum of all amounts. The table below shows what your document might look like:

The direct method of reporting cash flow provides a clear picture of cash inflows and outflows. However, it is more time-consuming to prepare than the indirect method because it requires gathering all cash receipts and payments. Should you miss a receipt, you’ll report the wrong net cash flow. 

Indirect Method

The indirect method is a faster way of calculating cash flow from operating activities. It starts with net income and adjustments are made based on increases and decreases in the balance sheet. 

Common adjustments to net income include the following:

1. Non-cash expenses: As mentioned above, non-cash expenses like depreciation, amortization, and depletion must be added to net income to account for their impact on taxable income. They decrease the potential cash outflows (taxable income), and thus indirectly contribute positive cash inflow.
2. Current assets: Increases and decreases in asset accounts, such as accounts receivable, inventory, and prepaid expenses, impact your cash balance. Any increase in an asset account results in a decrease in cash and should be subtracted from net income. For example, a $30,000 increase in inventory means $30,000 worth of cash has left your business. Naturally, decreases in asset account balances lead to increases in cash. A $20,000 decrease in accounts receivable means a $20,000 increase in net income.
3. Current liabilities: Your net income also adjusts based on changes in current liability accounts, such as accounts payable, taxes payable, and accrued expenses. Similar to non-cash expenses, current liabilities decrease the amount of income tax the government can charge against your company. Therefore, they decrease potential cash outflows, which means additions to liabilities should be added to net income. Decreases in liabilities should be subtracted from net income because they represent cash paid out.

To summarize:

We’ll illustrate the indirect method of reporting cash flow through an example.

Your income statement and balance sheet provide the following information:

1. You had a net income of $70,000
2. Your depreciation expense amounted to $5,000. 
3. You increased inventory by $35,000.
4. Accounts receivable increased by $15,000.
5. Wages payable decreased by $30,000.
6. Taxes payable increased by $20,000.
7. Accounts payable increased by $45,000.

The table below illustrates what your cash flow document might look like:

The indirect method of reporting cash flow is less time-consuming than the direct method. Because the income statement and balance sheet serve as easy references, the indirect method is also less prone to error. 

How to Prepare a Cash Flow Statement

If you’re familiar with the sections of the cash flow statement and the methods of calculating operating cash flow, preparing a cash flow statement should be easy. Simply determine the method that aligns with your preferences, then make calculations based on your financial documents. 

Step 1: Select Between Direct and Indirect Method

The first step in preparing a cash flow statement is determining your preferred method of reporting. To help you choose, we’ve formed a tabulated summary of the pros and cons of direct and indirect reporting. 

Step 2: Identify a Reporting Period

Determine the start and end date that you intend to report on. Companies typically report cash flow statements at the end of a fiscal year. 

Monthly and quarterly reports are also common. Shorter-term reports provide insight into the impacts of seasonal changes and newly implemented business decisions on cash generation. 

For example, you can compare a first-quarter cash flow statement with a second-quarter cash flow statement to assess the direct effects of first-quarter business decisions on cash generation. These impacts would be harder to track with a yearly cash flow statement. 

Step 3: Gather Relevant Documents

The next step is to gather source documents. These differ based on your method of choice. 

• Direct Method: If you’re using the direct method of reporting, you might need evidence of cash payments and receipts, such as invoices, cheques, and receipts. 
• Indirect method: If you’re working with the indirect method of reporting, you only need your income statement and your balance sheet. 

Step 4: Calculate Cash Flow from Operating Activities

The cash flow statements always start with cash flow from operating activities. Again, the process will differ depending on your method of choice. 

For the direct method, the steps are as follows:

1. List all cash received from customers as positive numbers.
2. List all cash paid to vendors and other sources as negative numbers.
3. Calculate net cash flow from operating activities by getting the total of all cash receipts and payments.

The indirect method consists of the following steps:

1. Take the net income from your income statement.
2. Add back all non-cash expenses, such as depreciation, amortization, and depletion.
3. Accommodate changes in working capital. To summarize:
   1. Add back decreases in current assets and increases in current liabilities.
   2. Subtract decreases in current liabilities and increases in current assets.
4. Calculate the net cash flow from operating activities. 

Step 5: Calculate Cash Flow from Investing Activities

After finishing the section on cash flow from operating activities, begin calculating cash flow from investing activities. Unlike cash flow from operating activities, you do not need to implement the direct or indirect method when calculating cash flow from investing activities. Simply follow the following steps:

1. Add cash receipts from long-term investments.
2. Subtract cash receipts from purchases of long-term investments.

Step 6: Calculate Cash Flow from Financing Activities

Finally, calculate the cash flow from financing activities. Again, you don’t need to implement the indirect or direct method. Simply follow the steps below:

1. Add cash receipts from the issuance of debt or equity.
2. Subtract cash payments from repayments of debt or equity.

Step 7: Generate an Ending Balance

Once you calculate net cash flow per section of the cash flow statement, add up the totals to generate the ending balance.

Example of a Cash Flow Statement

Below, we’ve provided an example of a cash flow statement reported using the indirect method. 

Below, we break down what occurred:

Cash Flow from Operating Activities 

1. Following the indirect method, the company listed its net income of $2,000,000.
2. It then listed all cash additions to operating cash flow. Depreciations and increases in taxes payable decreased potential cash outflows from income tax and were thus added back. Decreases in accounts receivable were also liquidated to cash and considered positive cash outflows.
3. After additions, it listed subtractions. Increases in inventory and decreases in accounts payable needed to be paid for in cash and were thus considered cash outflows.
4. The total net cash flow from operations amounted to  $1,995,000.

Cash Flow from Investing Activities 

1. Outflows from investing activities involved purchases of long-term assets. The company listed a purchase of equipment worth $1,000,000 and a purchase of securities worth $90,000. 
2. This resulted in a total net cash flow of negative $1,090,000. 

Cash Flow from Investing Activities 

1. Cash flow from investing activities included the issuance of long-term debt amounting to $500,000. Because the money went into the company, it produced positive cash flow. 
2. The second item was the repayment of debt worth $40,000. Because money went out of the company, it produced negative cash flow. 

The total cash flow for the fiscal year was $1,365,000.00.

How to Interpret a Cash Flow Statement

Cash flow statements provide a snapshot of cash flow from a given period of time. They are best analyzed against previous statements to assess the effectiveness of your business decisions. For example, if you invest in equipment for one month, you can check succeeding cash flow statements to determine the investment’s efficiency at generating usable income. 

Additionally, it’s important to determine whether cash flow trends skew positive or negative. What positive or negative cash flow means for your business depends on the context and the section of the cash flow statement you’re assessing. 

Interpreting Cash Flow from Operating Activities

For most businesses, positive net operating cash flow is the prime indicator of a business’ effectiveness. Positive operating cash flow indicates that your core business activities generate enough cash to support operations. Higher cash flow could also point to an increased capacity to pay back creditors and invest in future growth. 

However, occasional negative cash flow is not always a bad thing. New businesses, for example, might need to spend additional money on marketing and operations to get the ground running. Negative operating cash flow should only be a cause for concern when it becomes a recurring trend. 

Interpreting Cash Flow from Investing Activities

Having negative net cash flow from investing activities is common. This means that the company is purchasing long-term assets that can support growth. Positive cash flow from investing activities means that the company is selling assets that can still generate value. 

However, it’s important to contrast cash flow from investing activities against cash flow from operating activities. Determine whether the outflows generated justify the cost of the investment. 

Interpreting Cash Flow from Financing Activities

It is common for cash flow from financing activities to be positive. However, you need to assess where this cash is coming from. Consistent positive cash flow from the issuance of debt is not always a good thing because it indicates a reliance on creditors that the company needs to pay back. 

Simplify Financial Reporting with EpicBooks

The cash flow statement is valuable for illuminating a company’s financial well-being. It tells you whether your earnings can adequately cover your spending or if your expenses and investments provide sufficient returns. With a cash flow statement, you can glean your company’s liquidity, operational efficiency, and long-term sustainability. 

Preparing financial statements is a time-consuming process. If you want to invest your time more efficiently, consider outsourcing financial management responsibilities to our experts at EpicBooks. Our experts will manage your journals, balance sheets, income statements, and cash flow statements, providing thorough and accurate reports to support your business strategies. Our package includes additional services, such as tax preparation, financial analysis, and budgeting. 

We focus on your statements so you can focus on success. Read the EpicBooks services page for more information. 

FAQs

What is the difference between the cash flow statement and the balance sheet? 

The cash flow statement reports operating cash flow, investing cash flow, and financing cash flow over a given period. It is typically used to gauge a company’s effectiveness in generating cash. Meanwhile, the balance sheet summarizes assets, liabilities, and equity in a given date to estimate a company’s book value. 

What is the difference between the cash flow statement and the income statement?

An income statement summarizes all revenues and expenses over a given period. While both the cash flow and income statements work with revenues and expenses, items on the income statement don’t always require the movement of cash. Sometimes, they represent gains and losses that have yet to generate cash receipts or payments.

Meanwhile, cash flow statements list all cash inflows and outflows. It helps determine whether a company can generate enough usable revenue to cover all necessary expenses. 

What are permissible methods of reporting cash flow statements?

Both the direct and indirect methods of reporting cash flow statements are accepted under generally accepted accounting principles (GAAP). However, the Financial Accounting Standards Board (FASB) prefers the direct method because it more clearly illustrates inflows and outflows.