What is the Purpose of a Cash Flow Statement?

One of the most important ways to measure a business's health is through a cash flow statement — here’s why.

Updated: May 20, 2024
Matt Crabtree

Written By

Matt Crabtree

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Tracking your company’s financial data using reports gives you insights that can improve your business's bottom line, expansion prospects, and more — including helping you to sell your business.

As part of your financial reporting, your cash flow statement should not be overlooked. Owners, investors, and lenders all use this document to get insight into the company's cash flow and future prospects.

But first, let's define “cash flow”.

What is cash flow?

A company's cash flow is money coming in and out. In technical terms: it’s the net inflow of cash and outflow of cash equivalents. Inflows are defined as cash received, while outflows are defined as cash spent. 

The liquidity, adaptability, and overall financial success of a business can be gauged by carefully analysing its cash flows.

Your revenue is simply the sales earnings, whereas expenditures are the costs incurred in running the business. Revenue may also include things sold on credit or money obtained from interest, investments, royalties, or licensing agreements. 

Shareholder value is created when a firm is able to sustainably increase its free cash flow (FCF) over the long term. Whatever is left after capital expenditures (CapEx) get subtracted from your total cash flow is called the ‘FCF’.

Good Cash Flow 👍

When cash is coming in at a faster rate than it's going out, it's a good sign that the company is thriving.

A company's ability to meet its financial commitments, fund growth, distribute profits to shareholders, run operations, and weather economic storms depends on its ability to generate positive cash flow. 

Of course, when it's going the other way around, costs are outpacing earnings, which is not good — although companies like Uber have notoriously managed to stay afloat regardless.

As per Uber, cash flow isn't the be-all and end-all of a company's success. Cash flow statements are useful, but you should also look at your income statement and balance sheet to make sure your organisation is doing well.

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What are cash flow statements?

The cash flow statement is simply an overview of money in and out: your company's comprehensive cash/cash equivalent inflows and outflows. 

How efficiently a firm earns cash to meet its debt commitments and support its operational expenditures is shown in this statement, which assesses the company's cash position. The CFS, together with the income statement and balance sheet, makes up the three primary financial statements. 

The health of a company may be gleaned from its cash flow statement, making it one of the most important financial records.

Whether you're a potential investor, you may use this data to determine whether the firm is worth putting money into. As an entrepreneur or business owner, you can use this information to better gauge your company's success and fine-tune any necessary efforts or plans. 

If you're a manager, this may improve your ability to handle finances, keep tabs on your staff, and forge stronger ties with upper management, all of which will propel you to greater prominence in the company.

In order to present your firm in the best light possible to potential investors, you need to grasp the function of a cash flow statement. 

Is it a legal prerequisite?

In the United Kingdom and the Republic of Ireland, organisations that meet certain criteria are excluded from the need to provide a cash flow statement under Financial Reporting Standards (FRS 102).  

According to the Companies Act of 2006, in order to qualify as a “small company”, an organisation must satisfy two of three criteria for both the current and preceding fiscal years. These are the terms: 

  • Earnings must exceed £7 million.
  • The sum of £5.1 million or less on the balance sheet.
  • Employ less than 50 people.

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Cash flow statement sections (typically)

These three sections are typically used for cash flow statements, as per FRS 120 requirements. All business operations can be broken down into three categories: financing, investing, and operating. 

Operations

Once the company's normal products or services have been delivered, the total cash flow created by those sales and purchases gets listed in this section.

The purpose of analysing a company's cash flow from operations is to get insight into the revenue produced by the company's goods and services as well as the cash outflows caused by running the core business. Variations in the sections of inventory, depreciation, accounts receivable, and accounts payable make up this section. 

It is considered a legitimate commercial activity for a trading portfolio or investment firm to profit from the selling of loans, debt, or equity securities.

When operational cash flow is positive, it signifies that cash inflows from business activities exceed cash outflows. Even if the company has a negative cash flow from operations for the foreseeable future, this is a promising indicator that the firm is scalable.

A negative operating cash flow is not always a bad thing. Companies of all sizes have seasonal slowdowns, during which they may experience negative cash flow. Knowing why and when cash flow was negative is critical for making future preparations.

Investments

All cash inflows and outflows related to an organisation's investments are considered part of its investing operations section.

All payments made or received as a result of a mergers and acquisitions (M&A), such as the purchase or sale of assets, loans to or from suppliers, or customer payments, also fall under this heading. Cash from investing is directly related to any upgrades or downgrades in machinery, assets, or investments.

Since cash is often used to purchase long-term assets like land and buildings, as well as short-term assets like marketable securities, changes in cash from investing are typically seen as a negative item on the statement. However, a sale of an asset results in positive cash from investment for the corporation.

A decrease in net cash flow from investment activities is a common sign of expansion. It demonstrates the company's dedication to investing in long-term growth.

In this case, a positive cash flow indicates that the company is liquidating its assets rather than thriving. They could be selling unused assets in an effort to streamline operations.

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Financing

Changes in capital from the issuance of securities such as equity shares, issuing debt, and interest or dividends on securities, and so on all fall under the category of cash flow from financing activities for a given company.

The cash flow statement only includes information on events that have an effect on cash. Non-cash financing operations are those that don't directly affect cash flow. One example is issuing a bond payment to settle a debt or convert a bond into common stock.

A company's financial health and its aspirations can be gleaned from the way it handles its finance. This can indicate future developments and expansion from things like a positive cash flow due to good financing operations. A rise in assets may be seen when the inflow of funds exceeds the outflow.

However, negative cash flows from financing operations can reveal the company's dividend policy and indicate that its liquidity situation is strengthening.

Cash flow: How to work it out

Cash flow can be determined in two ways: directly, and indirectly.

Directly 

The direct method is the first approach used to calculate the operations subsection of the statement, and it is based on the transactional details that had an effect on cash throughout the time period. Using the direct method, you add all cash receipts from operations and subtract cash payments.

For organisations that keep their accounts on a cash basis, the direct approach is the easiest way to calculate cash flow since their books only reflect activity when cash changes hands. Cash transactions include things like earned or accumulated interest, paid costs, and received payments from customers.

Indirectly

This approach is more complicated and technical. The income statement is the starting point for the indirect method since it reveals the company's net profit. Earnings before interest and taxes (EBIT) is one indicator that requires modification to a basic income statement. 

To calculate cash flow from operations indirectly, you must also account for things like depreciation, inventories, accounts receivable, accounts payable, and accrued costs.

For this reason, cash flow from operations differs from net income due to the accrual accounting technique, which requires the accountant to record revenues and costs at periods other than when cash was paid or received.

The accountant will de-accrue the net income by determining the non-cash costs that were incurred during the period, so converting the net income to real cash flow. Depreciation, the gradual loss of an asset's value over time, and amortisation, the spreading of payments over a number of periods, are the most typical and reliable of these.

What will a healthy cash flow statement reveal?

A positive cash flow is, in the end, a matter of opinion. An investor's assessment of a company's riskiness or potential profitability depends in part on the company's current stage of development.  

Since cash flow can impact other decisions like budgeting and employee recruitment, a department head may examine a cash flow statement to gain insight into how their department is contributing to the health and wellbeing of the company.

Even if a company's cash flow statement shows a profit or loss, it doesn't always indicate the company is doing well or poorly. Profitability is not necessarily implied by a cash flow surplus. Both generating a profit and having good cash flow are not necessary for a successful firm.

On the other hand, if a firm decides to develop by investing in new facilities and staff, it might result in a negative cash flow. 

The performance of a business may be gauged by looking at how its cash flow fluctuates from one period to the next. Despite the lack of consensus over what constitutes a good cash flow, several key signs include: 

Consistent growth

Money flowing in and profits over time are of great importance to investors and lenders. This bodes well for the company's future as it shows that it has mastered its core operations, has established a steady stream of income, and is expanding its client base.

A decline in net income is possible even while cash flow is positive when a company is expanding and using all of its newfound funds to grow.

Cash flow investing losses

When a company's investment cash flow is negative, it means it is spending on self-investments. During periods of expansion, this may indicate that the company is reinvesting profits and growing profitably.

Funding for operations coming from revenue, not borrowing

One powerful metric of a healthy firm is the presence of a negative net cash flow from financing activities. That said — if you're trying to grow your firm, having a positive net cash flow from financing operations can be useful at times.

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Telling the difference between income statements, balance sheets, and cash flow statements

A company's success over time can be evaluated using the cash flow statement. The balance sheet/income statement are the sources for this information. 

Cash flow statement data is derived from the net profits amount seen on the income statement. In fact, the cash flow statement's Operating Activities section is determined entirely by the income statement. 

In terms of the balance sheet, the cash flow statement's net cash flow should correspond to the statement's net change in its different line items. Non-cash items, such as cumulative depreciation and amortisation, and cash and cash equivalents are not included.

The purpose of a cash flow statement: Conclusion

A cash flow statement is used to offer a comprehensive account of the company's cash inflows and outflows. In addition, it details the sources and uses of cash throughout the reporting period.

Expenditures on things like business investments and finance are broken out as well. Even if they aren't central to the business, they nonetheless have a major impact on how much money the company brings in now and in the future.

The management strategy and prognosis of a company can be inferred from its cash flow statement. When a company is unable to turn a profit, it may be forced to sell up its valuable assets. Investors need to be on the lookout for and capable of analysing just such unfavourable conditions.

Related Guides:

FAQs

Why is cash flow so crucial for companies?

Where does the cash flow statement fall short?

Cash flows: What's the formula?

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