The cash flow statement shows cash and cash equivalents as they enter and leave the business and gives you a summary of financial health. The cash flow statement is one of the 3 most important financial documents to understand financial health, alongside the balance sheet and income statement. At its core, cash flow comes down to 3 sources, each with its own impact on the business’ finances:
1. Operational cash flows
Cash spent or received as the result of normal business operations (e.g. revenue from sales or payment for materials)
2. Investment cash flows
Cash spent or received via investment activities (e.g. buying inventory or the purchase of marketable securities)
3. Financing cash flows
Cash received from debt payments or paid out as repayment against debt.
Companies need to account for each source to calculate cash flow. The actual calculation occurs via one of two methods: direct or indirect.
The direct method simply involves accounting for all cash inflow and outflows, and subtracting the end period account balances from the beginning balances to measure the net gain or loss.
The indirect method takes net income off a company’s balance sheet, since the accrual basis of accounting recognizes revenue and payment at the point of origination, not transaction. Then, the company adds back in non-cash expenses and adjusts for working capital.
The cash flow statement is useful for budgeting and predicting future cash flow. Companies can look back at previous accounting periods to examine the cash flow statements and identify trends. This helps with forward-looking assumptions and sets expectations. It also gives a clear picture of strength and weakness in cash flow.
Distinguishing cash inflows and outflows, and understanding their impact on the financial health of the business is the key to making smart investment decisions about a company. The ability to study a cash flow statement together with an income statement and balance sheet will show real insight into the trending financial health and stability of a company.
Sven Franssen