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Understanding Financial Statements: Part 3 – Cash Flow Statements

7 mins read

This article explains what Cash Flow Statements are, as they are important financial statements to be aware of.

Can you imagine being lost at sea, and the sick feeling of not knowing what direction you were going? Not knowing what is going on with your business’s financials would likely feel the same way, and it’s not worth the risk of finding out for certain! This is why having a statement of cash flows is vital to steer your business in the right financial direction. Cash Flow Statements (CFS) are one of the 3 key financial statements and measures financial performance, specifically reporting on the cash which a business generates and spends during a specific time period (monthly, quarterly, and annually).

A CFS summarizes all cash/cash equivalent amounts and how they flow in and out of a business, acting as a bridge between the income statement and balance sheet. Similar to the other key financial statements, a CFS ensures a business’s financials are going in the right direction, meaning how well a business controls its cash positions and manages to generate revenue to fund operating expenses and pay debt obligations.

Three Sections of CFS:

Operating Activities: Revenue-generating activities that aren’t investing or financing. Any cash flows from current assets and current liabilities.

Investing Activities: Cash flows from the acquisition and disposal of long-term assets/investments not included in cash equivalents.

Financing Activities: Changes in cash flows that result in the size and composition of the contributed equity capital or borrowings of the entity (i.e., bonds, stock, dividends).

Pro Tip: A CFS does not include futures of incoming and outgoing cash that has been recorded as revenues and expenses.

CFS Classifications:

Operating Activities

Includes any sources and uses of cash from business activities (how much cash is generated from a company’s products or services).

    • Direct: Operating cash flows are presented as a list of cash flows; cash in from sales, cash out for capital expenditures, etc.
    • Indirect: Operating cash flows are presented as a reconciliation from profit to cash flow

Typically changes made in cash, accounts receivable, depreciation, inventory, and accounts payable are reflected in cash from operations, which more specifically include:

    • Receipts from sales of goods and services
    • Interest payments
    • Income tax payments
    • Payments made to suppliers of goods and services used in production
    • Salary and wage payments to employees
    • Rent payments
    • Any other type of operating expenses

Investing Activities

Includes any sources and uses of cash from a business regarding equipment, assets, or investments relating to cash from investing. This typically includes cash flows associated with activities such as:

    • buying or selling property, plant, and equipment (PP&E), other non-current assets, and other financial assets
    • loans made to vendors or received from customers
    • payments relating to a merger or acquisition

Pro Tip: The only time that income from an asset is accounted for in CFS calculations is when the asset is sold. Changes in cash from investing are a “cash-out” as the cash is used to buy new equipment, buildings, or short-term assets such as marketable securities. However, when a company divests, the transaction is considered “cash-in” for calculating cash from investing.

Financing Activities

This type of activity typically includes cash flows associated with borrowing and repaying activities such as:

    • bank loans
    • issuing and buying back shares
    • payment of a dividend is also treated as a financing cash flow

Pro Tip: Changes in cash from financing are “cash-in” when capital is raised and “cash-out” when dividends are paid. Thus, if a company issues a bond to the public, the company receives cash financing. However, when interest is paid to bondholders, the company is reducing its cash.

Example of a Cash Flow Statement

This example of a Cash Flow Statement comes from a stock analysis of Amazon. Keep in mind, not all CFS look as healthy as this example or exhibit a positive cash flow. Poor cash flow is sometimes the result of a company’s decision to expand its business at a certain point in time, which would be a good thing for the future. Analyzing changes from one period to the next gives a clearer picture of how the company is performing.

What Is the Difference Between Direct and Indirect Cash Flow Statements?

The difference lies in how the cash inflows and outflows are determined. Using the direct method, actual cash inflows and outflows are known amounts. The cash flow statement is reported in a straightforward manner, using cash payments and receipts.

Using the indirect method, actual cash inflows and outflows do not have to be known. The indirect method begins with net income or loss from the income statement, then modifies the figure using balance sheet account increases and decreases, to compute implicit cash inflows and outflows.

Now that you understand what a CFS is and that it is a valuable measure of strength, profitability, and future outlook of a company, this brings us to the conclusion of our Understanding Financial Statements series.

If you have any questions or need further support, please reach out to a BIG Representative or your business’s accountant.

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