Understanding a Cash Flow Statement

While there are many ways to measure a company's financial health, a cash flow statement is one of the most important documents to consider.

This document provides an important snapshot of money coming in and out of a company. While it's not the only financial metric that matters, a strong cash flow generally means a business is in a healthy position; otherwise, it could be struggling to meet payroll or order inventory, for example.

Companies with stocks that trade on public exchanges are generally required to periodically disclose a wide range of documents with detailed information about their operations, including cash flow statements. However, these documents are also sometimes used by private businesses, such as entrepreneurs trying to secure loans.

What is a cash flow statement and why is it important?

Cash flow statement definition

Cash flow statements are financial accounting statements that provide a detailed picture of a company's money movement, both what comes in and what goes out, over a certain period of time.

Using the information contained in a cash flow statement (also called a statement of cash flows), business owners, shareholders, and potential investors can see how much cash a business is bringing in and how much it's spending in a given period. In conjunction with other documents, cash flow statements can help you understand how financially healthy a company is.

Usually, cash flow is divided into three main categories: operations, investment, and financing.

"Cash flow statements really just show business operations' impact to cash," says Dondrea Owens, CPA and founder of The Profit Table.

A company's cash flow statement is often used as one of three key reports that investors and other interested parties use to determine its financial performance. The others are the income statement and balance sheet. Together, they provide an overview of primary financial areas such as profit (income statement), assets vs. liabilities and owner's equity (balance sheet), and liquidity (cash flow statement).

In the US, the Securities and Exchange Commission (SEC) requires publicly traded companies to provide these financial statements, among other disclosures.

Though all three documents deal with a company's money, they look at it from different angles. "We find that a lot of folks start with the balance sheet and the income statement," says Meredith Tucker, CPA, principal of entrepreneurial services at Kaufman Rossin. "And yet, I think the cash flow statement is one of the most helpful."

Quick tip: You can find a public company's cash flow statement, income statement, and balance sheet in its Form 10-Q and Form 10-K.

Why is a cash flow statement important?

Cash flow provides important context to information that might not be apparent on other financial statements, like a balance sheet or income statement. If a business makes a sale to a customer, that revenue often goes on an income statement and contributes to the company's overall profit or loss.

However, if an invoice isn't due right away or the company extends a line of credit to the customer, the actual cash may not hit the company's bank account for months. As such, the company might be short on cash and have to borrow money or pause payroll, which can be damaging. This is why understanding cash flow is so important.

In general, cash flow statements show a company's ability to operate. If an organization doesn't have enough cash to pay its expenses during a given period, it may not matter how many sales it has realized.

"From an investor standpoint, I want to know how a company is using the money I'm going to give them," Tucker explains. This is another reason cash flow statements can be important: They don't just show how much money was spent over a given period, but also the categories where it was spent.

"Are they diverting cash to repay debt? Are they distributing it out to shareholders? Are they losing money because they're extending more and more credit to their customers? Those are the kinds of things we want to see," Tucker says.

Quick tip: Companies can use either accrual-basis or cash-basis accounting, so be aware of which method they're using. In accrual-basis accounting, realized sales will be recorded before cash is actually exchanged. In cash-basis accounting, revenue isn't counted until money changes hands.

Key components of a cash flow statement explained

Knowing the key components of a cash flow statement is important for anyone who wants to understand the financial health of a company. Cash flow statements start with the amount of cash an organization had at the beginning of an accounting period and finish with the amount of cash the organization has at the end of the period. Everything in the middle details cash transactions as money entered and left the company, i.e., cash inflows and outflows.

In general, this middle portion will be separated into three distinct categories:

• Operating activities
• Investment activities
• Financing activities

Within each category, line items show where money went or came from, but not always in the way you might assume, like on a profit and loss statement.

For example, accounts payable is positive for cash flow, while accounts receivable are negative. That's essentially because accounts payable means the cash hasn't left the company yet, so even though it might be earmarked, the company still holds more cash.

Meanwhile, accounts receivable are negative for accrual-based accounting because the revenue has been accounted for, but the cash hasn't hit the company's account yet.

Not every company will have the exact same line items on its cash flow statement, which Owens says is normal and not a cause for concern. Usually, money entering the company will be written as a numeral, and money exiting the company will include parentheses around the amount. Colors might also be used, such as black for cash increases and red for cash decreases.

Operating activities

While some cash flow statements start with the amount of cash on hand at the start of the year, the first of the three main cash flow statement categories usually covers operating activities.

"The operating section is going to tell you about all the run-of-the-mill things that affect cash," Tucker says. These are the types of cash activities many people automatically associate with running a business: income from customers, wages to staff, inventory purchases, and income taxes, for example.

In the statement above, you can see that customers paid the company $975,000 last year, and the organization spent $563,050 on all operating expenses. In this example, the organization's operating costs come from inventory purchases, operating and administration expenses, wages, interest, and income taxes. The net cash flow from operations line shows the difference between these two numbers, in this case, $411,950. This number is also known as operating cash flow.

Investing activities

The net cash flow from the investing line shows the change in cash flow from all investing activities. In a business, investment activities may include things like the purchase or sale of physical assets, the purchase of securities, or the sale of securities.

In the example above, the business only had two items that could be categorized as investment activities: selling property or equipment for $33,600 and purchasing property or equipment for $125,000. In this category, the company spent $91,400 more than it brought in, making that number its net cash flow from investing.

Also, note that the information in this section can be used to calculate free cash flow. To do so, subtract capital expenditures, e.g., purchase of property and equipment, from net cash flow from operations, which in this case results in $320,450. This free cash flow number gives a good snapshot of the company's ability to generate cash after accounting for core expenses, including capital expenditures, before cash is then used for financing decisions like paying dividends or repaying debts. Free cash flow also excludes things that might temporarily inflate cash flow, like sales of securities.

Financing activities

The final category on the cash flow statement shows all cash transactions that had to do with financing activities. Things that would go in this category include activities that involve debt, equity, or dividends. In our example above, the company paid $38,000 and $52,000 to loan repayments and dividends, respectively. The organization didn't bring in any money through financing activities, so the net cash flow from financing is -$90,000.

Quick tip: It's important to read and understand any financial disclosures that are presented with these statements. For example, notes that show a company took on debt with a high interest rate give more context to cash flows.

What is negative cash flow?

Negative cash flow occurs when a company spends more than it generates in a certain period. A company may have negative cash flow overall or in any one of the sections, as the previous example shows in the investing and financing sections.

"Negative cash flow isn't always bad," Owens says. "Companies do go through growth phases where they are spending money to make money." As long as the negative cash flow is planned, it's not an immediate red flag.

Negative cash flow could also come down to a timing issue. "An accounting firm is a perfect example," Tucker explains. The busy season for accountants is often the beginning of the year when taxes are due, but most of those receivables won't be paid immediately. Though the business is generating revenue, the cash isn't in the account yet.

On the other hand, if there is a pattern of cash flow issues, that could be a warning sign that the company isn't managing its money well. If you see a negative cash flow, it's worth looking into the reason to determine whether or not it's cause for concern. Plus, there's a risk that even with a good explanation for negative cash flow, things might not work out. An accountant, for example, might not collect all of the money it's owed, and thus its revenue would be less than expected and it might have spent money it didn't have.

How to read a cash flow statement

While to some extent, reading a statement of cash flows is straightforward, reading it in a way that leads to deeper insights is a bit more complex. So, in terms of cash flow analysis, you likely want to focus beyond the top-line numbers and dig into what's driving positive or negative cash flows. Consider focusing on the following main areas:

Identifying cash sources and uses

Businesses can obtain cash from various activities, ranging from selling their goods and services to selling securities at a profit. The most basic sources of cash, for example, receiving income from customers, are outlined in the operating activities section of the cash flow statement.

Companies can also generate cash flow by issuing equity or borrowing money. Both of these have unique costs and benefits. Issuing equity does not come with the same obligations as taking on debt. If a company borrows money from a bank and is unable to pay that money back, the lending institution could go after the organization's assets in an attempt to recover the funds it lent out in the first place.

Certain cash sources and uses aren't always inherently better than others, but you'll have to weigh what makes sense for the business and from an investor's point of view. For example, if the company is issuing a lot of equity, that could help it fund operations with less risk than taking on debt, but it dilutes shareholder value.

Analyzing the company's liquidity and financial flexibility

While the balance sheet shows working capital — funds that are used to ensure that a business can operate in the short term — the cash flow statement can show more detail about how a company generates liquidity over a specific period.

For example, a company might have significant working capital — calculated as current assets minus current liabilities — but that might obscure more limited flexibility, like if current assets got a big boost from selling securities. That's not necessarily something that can be repeated in the next period. So, unless the cash flow statement indicates strong liquidity elsewhere, like healthy receipts from customers and low payroll expenses, cash flow analysis might yield concern about the company's ability to have enough working capital in the future.

What to watch for in a cash flow statement

Though a cash flow statement can't tell you everything about a company's financial viability, there are some things to watch out for in them that can be particularly telling.

"A green flag for me is if there is positive cash flow coming from operations," Owens says. "That's a good sign that the company is generating cash just from its operations."

On the flip side, he explains that negative cash flow from operations could be an indicator that something isn't going well with the company and might require additional research.

Owens also recommends looking at the financing section, particularly to see if the business is bringing in most or all of its cash from loans or other sources of financing.

"This isn't always a bad thing," she says. For example, it might be normal in a startup. But if most of the money is coming from financing, it's worth taking a second look, especially if the money will eventually need to be repaid.

In general, the more cash that comes from operations, the better, Owens says.

The significance of cash flow

Cash flow vs. profit: Understanding the difference

Cash flow represents the money moving in and out of a business, whereas profit is what an organization has after subtracting all of its expenses from its revenue.

Both of these terms can be either positive or negative. A company can have positive or negative cash flow, or alternatively, it can generate positive profits or negative profits, which are generally described as losses.

These numbers are often correlated, but don't always move in the same direction. For example, a company could have positive profit but negative cash flow, due to waiting on payments from accounts receivable.

The role of cash flow in assessing company health

Reviewing a company's cash flow will help stakeholders like investors obtain a sense of how well-prepared that organization is to cover its financial liabilities. It can also help give investors greater insight into whether an organization is expanding or in decline. If a company repeatedly experiences negative cash flow, this could hamper its ability to put money toward activities that would generate expansion, such as marketing, sales, and public relations.

Further, a company that continues to generate negative cash flow might have to lay off employees to generate positive cash flow. These cutbacks could, in turn, impact an organization's ability to function.

That said, sometimes companies generate negative cash flow while in expansion mode, like if they're taking on debt to fund expansion into a new market. So, it's always important to analyze what's beyond the headline numbers.

Cash flow statement vs. income statement vs. balance sheet

Though cash flow statements include plenty of helpful information, they alone will not tell you a company's entire financial picture. They work best when analyzed in conjunction with the income statement, which shows its profit or loss, and the balance sheet, which details assets and liabilities.

At times, one statement may answer a question the other poses. For example, if you look at a company's balance sheet from one year to the next and see its cash assets went from $1 million to $500,000, at first glance, this could look alarming. But, if you follow up with the cash flow statement, you may see the money was used as part of an investing activity and went toward the purchase of another facility that could increase the company's profitability long-term.

"Make sure you understand the story that these financial reports are presenting to you," Tucker says. "You really need the interplay to interpret the full story."

Preparing a cash flow statement

What are the main steps to preparing a cash flow statement?

Typically, the first step is determining how much cash (and cash equivalents) a business has at the beginning of the period in question. This gives you the starting balance.

The next step is to determine cash flow from operating activities. One way of assessing this, called the direct method, involves calculating the cash brought in through operations and subtracting the cash spent through such activities, as the cash actually changes hands. This method involves accounting for all transactions that resulted in cashing going into (or out of) a business during the specified timeframe.

The other option, often more popular, is the indirect method. The indirect method starts with net income from the income statement, which is based on accrual accounting. Since the accrual method does not indicate how much cash is actually flowing in or out of a business, the indirect method reconciles this, such as by adding back in non-cash items like depreciation. In other words, depreciation reduces net income but isn't actually a cash outflow, so this needs to be addressed within the cash flow statement.

Either way, the operating cash flow should be the same between the direct and indirect method, because the goal is always to show money leaving or entering a business over a given period.

After that, determine cash flows associated with investing activities, which involve the purchase or sale of any assets like securities or real estate.

Creating the next section of a cash flow statement involves calculating any cash that went in or out of a business as a result of financing, for example, issuing equity or taking on debt.

Once you have calculated the aforementioned amounts, you can combine the totals of operating, investing, and financing cash flows to determine the overall cash flow during the period in question. You can also compare this number to the starting balance or other previous periods to see how cash flow has changed.

FAQs