If you’re putting together a business plan for a loan or investment, your cash flow statement is one of three must-have statements that your plan needs. Not only will investors want to see how cash is moving into and out of your business, but your cash flow statement will help you understand exactly how much cash you need to raise and when you’re going to need it.
Cash flow statements aren’t just for investors, though. More importantly, your cash flow statement is crucial for running your business well. It is one of the best ways to get ahead of cash flow issues before they threaten your long term viability. Regularly reviewing or analyzing your cash flow statement will show you when in the future you might be at risk of running low on cash so you can plan ahead and get a line of credit, loan, or other financing before you’re in the midst of a cash crunch.
What is a cash flow statement?
Most simply, cash flow statements tell the story of how much cash a company has coming in (inflows), and how much it has going out (outflows). A cash flow statement shows how much cash a business has on hand, and how that number is changing over time. A typical cash flow statement shows cash flow on a monthly basis over a 12 month period.
The components of a cash flow statement
Generally speaking, cash flow statements are comprised of three core components:
1. Operating activities
How does your business make money on a day-to-day basis? Your organization’s operating activities include everything that relates to how you generate revenue.
Most basically, cash inflows are generated whenever customers buy your products or services; outflows occur when you pay employees, suppliers, taxes or interest, among other things.
2. Investing activities
Most transactions relating to the sale or purchase of property, equipment, or other non-current assets are included in your investing activities, as are any expenses tied up in mergers or acquisitions.
If your business plays in the stock market at all, you’ll also have to indicate when you buy or sell securities here as well.
3. Financing activities
This section of the cash flow statement includes information about taking out loans to buy property or equipment; issuing stock to employees, the public, or other stakeholders; paying out dividends, and so on.
It’s worth noting that cash flow statements can be affected by non-cash transactions, like depreciation or bad-debt expenses. Additionally, many businesses choose to add supplemental information about large transactions that don’t involve cash, like converting debt to equity or issuing shares in return for assets.
Cash flow statements—which are considered one of the three major financial statements along with income statements, and balance sheets—can be prepared using one of two methods: the direct method or the indirect method, both of which produce the same results.
Because it’s easier to do, most businesses build their statements of cash flow via the indirect method, so let’s turn our attention there first.
Building a cash flow statement: The indirect method
Many businesses choose to construct their historical cash flow statements using the indirect method because the numbers they need are easily gathered from their accounting software. Cash flow statements generated this way to reconcile reported net income with cash generated through operations.
If you’re building a cash flow forecast to predict how much cash you’ll have on hand in the future, the indirect method also works and is the most common choice.
To construct an indirect cash flow statement, you first need to focus on operating activities. To do that, determine net income and remove non-cash expenses (e.g. depreciation and amortization) from that number. You can find the net income number on your profit and loss statement (also called the income statement).
Next, you need to consider your gains and losses on any sales of assets made during the pertinent reporting interval. You also need to report changes in accounts receivable, accounts payable and inventory, as well as any bad debts you might decide to write off.
Once you’ve figured out your net cash provided by operations, you need to then record your cash flows from investing and financing activities. These two sections are reported in the same manner on cash flow statements prepared using both the indirect and direct methods using the criteria discussed above.
Building a cash flow statement: The direct method
Due to the differences in reporting operating activities, cash flow statements prepared via the direct method provide a much clearer view of how cash moves through a business. But they’re harder to prepare—which is why they’re less common.
Instead of starting from net income, cash flow statements made through the direct method instead focus on gross cash inflows and gross cash outflows that occur naturally through operations.
Businesses that use the direct reporting method need to consider cash received from client accounts; cash paid to employees and suppliers; interest payments; income tax payments; and any interest or dividend revenue that was received.
Unlike the indirect method, when cash flow statements are generated through the direct method, it’s considerably easier to see where cash payments were made and where cash payments were received.
But because most accounting reports don’t include the necessary information the direct method requires, many businesses choose to take the easier route and produce their statements of cash flow using the indirect method.