Interpreting Financial Statements — A Necessity for Businesses Big and Small Of the three key financial statements — Balance Sheet, Income Statement, and Cash Flow Statement — the one that often provides the most clarity about a company’s true liquidity and financial health is the Cash Flow Statement. Strong cash flow is fundamental, however, and a business could face serious operational trouble even with profits to boast — at least on paper.
In this comprehensive guide, we’ll take you through what exactly is a Cash Flow Statement, how to read it, the Cash Flow Statement Format, its components and bring it together with an illustrative Cash Flow Statement example.
What is Cash Flow Statement?
A Cash Flow Statement, on the other hand, is a financial statement that illustrates the actual flow of cash in and out of a business over a particular time interval. It records the cash inflow and outflow from operating, investing, and financing activities. This statement helps businesses and stakeholders evaluate how effectively the company manages its cash position — the availability of liquid assets to a company.
The fact that cash flow as a standalone statement shows the actual liquidity condition of a business is why cash flow statement importance can never be under-estimated. Just because a business shows a large profit from trades in the Income Statement, doesn’t mean its money is sat in a bank faring well; that profit can be stuffed in accounts receivable or inventory.
Cash Flow Statement Format
The Cash Flow Statement Format is usually structured and classifies cash flow into three key areas:
Cash Flow from Operating Activities
Cash Flow — Investing Activities
Read More: Cash Flow Forecasting for Small Business Owners
Cash Flow from Financing Activities
Each of these sections provides a unique perspective on the business’ cash inflows and outflows. The format also ends with the increase or decrease in cash and cash balances – beginning and ending cash balances for the period.
Two methods are used in preparing a Cash Flow Statement: Direct vs. Indirect Cash Flow Method.
Direct Method: Shows cash collections and payments, like cash received from clients and cash given to vendors and workers.
Indirect Method: Net income is the starting point, with adjustments made for non-cash transactions, changes in working capital, and other items to find net cash from operating activities.
Most companies prefer the Indirect Method since it has a clear link to data from Income Statement and Balance Sheet.
Read More: What is Cash Flow Forecasting?
Cash Flow from Operations
Cash Flow from Operating Activities represents the conditional revenue-generating activities of the business. This section includes:
- Cash received from customers
- Cash paid to suppliers
- Operating expenses paid in cash
- Interest and taxes paid
Changes for non–cash items such as depreciation, amortisation, and working capital changes
This part uses the Indirect Method that begins with net income and adjusts it for non-cash operations and variations on current assets and liabilities.
Example (Indirect Method):
Net Income: $25,000
Depreciation: $5,000
Reduction in Accounts Receivable: $3,000
Change in Inventory: ($2,000)
Increase to Accounts Payable: ($1,000)
Cash Flows from Operating Activities: $30,000
Thus, although the net income was $25,000, the business generated $30,000 cash since the working capital changes & non cash expenses were added.
Cash Flow from Investing Activities
They deal with the purchase and sale of long-term assets and investments. This includes:
Acquisition of Property, plants and equipment (PPE)
- The proceeds from asset sales
- Investments in securities
- Investment income proceeds
This tells you how much the firms are investing in future operations, or divesting from current assets.
Example:
Equipment purchase: $15,000
Proceeds from the sale of old vehicle: $4,000
Net Cash Used in Investing Activities: $11,000
A negative cash flow from investing activities does not necessarily mean bad news, and may indicate that the company is growing.
Cash Flow from Financing Activities
Cash Movements between the business and its owners or creditors are represented in the Cash Flow from Financing activities These include:
- Between issuing or repurchasing equity
- Borrowing or repaying loans
- Dividend payments
This part of the footnotes guides the investors and creditors understand how the respective company finances its regular operations and expansion.
Example:
Loans proceeds: $20,000
Repayments on loans: $5,000
Dividend payments: $3,000
Cash provided from financing operations: $12,000
Positive CF in this part tends to mean that capital is being raised, while negative CF might mean that there is debt repayments or dividend distributions taking place.
Read More: How to Build a Discounted Cash Flow (DCF) Model
Complete Cash Flow Statement Example
Now, let’s put it all together in a simple Cash Flow Statement Example based on a fictitious company, ABC Ltd., for the year ending December 31.
Cash Flow Statement Example (Indirect Method)
| Column A | Column B |
| ABC Ltd. | |
| Cash Flow Statement (Indirect Method) | |
| Cash Flows from Operating Activities | |
| Net Income: | $25,000 |
| Adjustments: | |
| Depreciation: | $5,000 |
| Decrease in Accounts Receivable: | $3,000 |
| Increase in Inventory: | -$2,000 |
| Decrease in Accounts Payable: | -$1,000 |
| Net Cash from Operating Activities: | $30,000 |
| Cash Flows from Investing Activities | |
| Purchase of Equipment: | -$15,000 |
| Proceeds from Sale of Vehicle: | $4,000 |
| Net Cash from Investing Activities: | -$11,000 |
| Cash Flows from Financing Activities | |
| Loan Proceeds: | $20,000 |
| Loan Repayment: | -$5,000 |
| Dividends Paid: | -$3,000 |
| Net Cash from Financing Activities: | $12,000 |
| Net Increase in Cash: | $31,000 |
| Opening Cash Balance: | $10,000 |
| Closing Cash Balance: | $41,000 |
Cash flow statement: direct vs indirect method
The Direct vs Indirect Cash Flow Method debate is a simple matter of transparency vs convenience. Since the Direct Method uses outlays of cash only, it can sometimes be more intuitive and transparent. However, preparing it takes more effort, because companies have to track each cash transaction.
The Indirect Method, on the other hand, is simpler to prepare based on existing records of accrual accounting. It also provides valuable insight by tying net income to actual cash flow, revealing how accruals and other adjustments impact cash generation.
While the direct method may be clearer for internal management, the indirect method is more widely used for financial reporting, particularly under GAAP and IFRS.
Cash Flow vs Income Statement
Why understanding the difference between Cash Flow vs Income Statement is crucial? Each one is a financial performance report, but they measure different things.
Using an Income Statement, which summarises profitability for a period (e.g. revenues, expenses, and net income).
In contrast, the Cash Flow statement provides the actual cash having come in and cash having gone out, giving much clearer representation of liquidity.
If the revenue has not yet been collected or expenses prepaid, a business can look profitable on the Income Statement but be short cash. And this is exactly why Importance of Cash Flow Statement is so huge! It reveals what the Income Statement may not show.
Importance of Cash Flow Statement
The Importance of Cash Flow Statement has multiple answers. It helps:
- Make sure the business can pay its short-term liabilities
- Accurate operational efficiency identification
- Evaluate the effectiveness of the investment strategy
- Assess financial health for lenders and investors
- Forecast future liquidity
Balance Sheet and Income Statement can be impacted by non-cash transactions, while Cash Flow Statement is based purely on cash, hence is an effective indicator of solvency.
Conclusion
You are familiar with cash flow, which is a pillar of financial reporting and analysis. Knowing how to read this document —digging into its operating, investing and financing activities and distinguishing between the Direct vs. Indirect Cash Flow Method shows stakeholders the whole picture of a company’s health.
Cash flows statements become a strong strategic tool for decision making, they should be used in conjunction with other financial reports such as the Reports of Income or the Balance Sheet. As an investor, you might be assessing risk; as a lender, considering a loan; as a manager, planning for growth—but, whichever the case, a well-prepared Cash Flow Statement provides clarity and insight.
The Cash Flow Statement Format and the Cash Flow Statement Example we covered above should help you learn how to analyse financial data so you can make more sound decisions in your business or as an investor.
