The Cash Flow Statement is a financial statement that offers a view of where cash is coming into the business and where it is being spent.
What does a cash flow statement look like, and how can we read it to better understand the working of the business? This blog explains everything you need to know about the cash flow statement, with examples for better understanding!
Table of Contents
What is a Cash Flow Statement (CFS)
A cash flow statement helps summarize the movement of cash and cash equivalents in and out of the business.
It shows how much cash is coming into the business and from which source. It also shows where this cash is being spent, and the final amount of cash left with the business at the end of the accounting period.
It is one of the three main financial statements used to understand how a business is performing. The other two are the Income Statement and Balance Sheet.
While the Income Statement provides insight into the profits and losses of the business, the Cash Flow Statement gives a deeper look into how the money that was earned is being spent.
Why Should Founders Know CFS
Founders are responsible for making most, if not all decisions pertaining to the business. As long as a founder is fully aware of his business’s financial position, making these decisions is easy.
Cash Flow is the single most important factor that determines a business’s success. If inflow of cash is not more than the outflow of cash, the business runs at a loss – if this persists for a while, the business is likely to collapse.
Learning how to read your business’s Cash Flow Statement is very important, especially for businesses in nascent stages. Startups and small businesses have very high expenses, and this shows on the Cash Flow Statement.
Being able to read and understand your business’s Cash Flow Statement means you will be able to pinpoint where your business is spending too much, or too little money. Once you’ve pinpointed the problem, you’ve already solved half of it!
How Cash Flow Statement Works
A Cash Flow Statement is divided into three categories.
- Cash from operations
- Cash from investing activities
- Cash from financing
Each of these categories has cash inflows and outflows, shown as additions and deductions. Let’s take a deeper look into each category.
Cash from Operations
This is the cash that a business generates or uses from regular day-to-day operations. For example, the cash that Razor Bakery generates by selling baked goods will be its cash from operations.
When cash from operations is positive, the business has generated more cash than it spent, and vice versa if cash from operations is negative.
Cash from Operations is calculated by adding non-cash items and changes in working capital to the net income for the accounting period.
Let’s break that down.
Net income is the total money earned by the business by selling goods or services.
Non-cash item is any expense that does not include actual cash being exchanged. A good example is depreciation. Depreciation is the reduction in the value of an asset over time. There is no actual cash being lost, but it is still counted as an expense.
To understand changes to working capital, let’s first understand what working capital is.
Working capital is current liabilities deducted from the current assets of the business. Current Assets are the most liquid assets of the business, like cash and cash equivalents. Current Liabilities are the most liquid liabilities of the business, like accounts payable.
Read more: Balance Sheet
Changes to working capital would be any cash item that increased or decreased the working capital over the accounting period.
For example, let’s say Razor Bakery purchased a cookie-baking oven for Rs 20 lakh in cash. The oven is an addition to the business’s fixed assets, and the money spent would be a deduction from current assets.
Since there is a deduction to current assets and no change to the current liabilities side, this would be recorded as a change to working capital.
Any transaction that causes an equal change on both the current assets and current liabilities side would not be recorded as a change to working capital.
For example, let’s say Razor Bakery received cash from accounts receivable. There would be an addition to cash (current asset) and the exact same value deducted from accounts receivable (current liability). Since the net effect of the transaction is zero, it will not be counted as a change to working capital.
Importance of Cash from Operations
Cash from operations is an important metric to understand the basic functioning of your business.
Every business relies on sales of goods or services to fund its operations – without a reliable stream of revenue from sales, no business model is sustainable. Positive cash from operations is crucial to any business’s survival.
Cash from Operations is a more realistic view of how much cash your business is actually generating – net income as shown on the balance sheet does not include non-cash items and changes to working capital.
Cash from Investing Activities
Through the course of business, money is also spent on making investments in the growth of the business. This could include buying fixed assets, acquiring other valuable businesses, and investments in marketable securities like equity and bonds.
For example, Razor Bakery wants to sell its old cookie-baking oven to make room for the new one. The sale of this machine would be included as an addition to the cash from investing activities section of the cash flow statement.
Let’s say Razor Bakery also wants to start selling beverages with its baked goods – it then chooses to acquire a popular beverage business. This acquisition would be included as a deduction in this section.
This would be included as a capital expenditure or capex. Generally, capex is a negative cash flow, since purchase of fixed assets means that cash is flowing out of the business.
Importance of Cash from Investing Activities
Investing activities ensure the future growth of your business – when Razor Bakery decided to buy the beverage business, it took a step towards expansion and reaching a wider market.
Buying a new cookie-baking oven is also an investment into the future of the business because it will help Razor Bakery bake more cookies in less time – improving efficiency and increasing profitability.
It is normal for new startups to have a very high capex, resulting in a significantly negative balance in the cash from investing activities. This is because new businesses are spending a lot of money on starting operations.
Cash from Financing
This category includes the flow of cash from funding the company – capital invested by banks, the founders, and other investors.
Items under this category could include
- Long-term debt
- Payment of dividends
- Repayment of long-term debt
- Issuance of equity
Additions to this category include transactions that cause an inflow of capital into the business, regardless of the source.
Deductions from this category are essentially how much it costs to acquire this capital.
For example, if Razor Bakery decides to take a term loan from XYZ Bank, it will be an addition to this category. Meanwhile, monthly interest payments towards this loan would be a deduction from this category.
It is interesting to see how much money the business has to spend and how much it costs to get that money – especially for young startups when revenue from sales is usually not enough to keep the business running.
Wondering what’s the best way to manage your business’s money?
You’re at the right place.