You've got the business idea down. You've printed those business cards, and you've spun up a beautiful website. People are buying your product or loving your service. Expansion is always the dream, but before you can begin planning the worldwide takeover, some basics need to be covered – like cash flow.
You're probably thinking, ‘we make money, and sometimes spend it.’ What's the big deal? Keeping track of how you're spending and what you're spending money on is imperative to long-term business success. If you want to see your new business grow, this is one of those things you've got to be mindful of, no matter if you're mowing lawns or developing the world's next great software.
What is a cash flow statement?
A cash flow statement (CFS) is the financial statement summarizing your movement of cash and cash equivalents (CCE) that come in and go out. The CFS measures how you're managing money to pay debts and fund your operating expenses.
How the Cash Flow Statement Is Used
The cash flow statement shows how your business operations are running, where your money comes from, and where the money goes. The CFS helps creditors determine available cash (you've heard the term "liquidity") for the company to fund operating expenses and pay debts. If you've dreamed of getting investors on board, the CFS is the first place they'll look to see if you're on solid ground.
Structure of the Cash Flow Statement
This is basic with a few main components:
- Cash flow from operating
- Cash flow from investing
- Cash flow from financing
- Disclosure of non-cash activities (included under generally accepted accounting principles (GAAP)
Cash from Operating
This is the cash you're making from your product or service and the expenses of running a business. This is the biggest bucket because it includes things like:
- Misc. operating expenses
- Income tax payments
- Interest payments
- Employee salaries and costs
- Receipts from sales of goods and services
- Payments made to suppliers
- Any other type of operating expenses
If you've got a trading portfolio or an investment company, receipts from the sale of loans, debt, or equity is included because it's considered a business activity.
Any changes you've made in cash, inventory, or accounts receivable or payable go here, too.
Cash from Investing
This bucket includes anything related to any investments like purchases or sales of assets, vendor loans or received from customers, or any payments related to mergers and acquisitions (M&A). Any changes in assets, equipment, or investments, go here. (Yes, equipment is considered an investment.)
These changes are considered cash-out items because cash is used to buy things like buildings, new equipment, or short-term assets. When a company divests an asset, the transaction is considered cash-in due to calculating cash from the investment.
Cash from Financing
This is any source of income from banks or private investors and cash paid to shareholders, including dividends, stock repurchases, and repayment of debt principal (loans).
Changes in cash from financing are cash-in when capital is raised and cash-out when dividends are paid. If you issue a bond, the company gets cash financing. When interest is paid, the company reduces cash. Although interest is a cash-out expense, it's reported as an operating activity—not financing.
How Cash Flow Is Calculated
This is straightforward: there are two methods for calculating cash flow: the direct method and the indirect method.
Direct Cash Flow Method
This is the easiest method for small businesses, and it adds up payments and receipts, including supplier costs, customer receipts, and salaries. Most companies use the accrual basis accounting method, recognizing revenue when earned instead of received.
Keep in mind: this can cause a disconnect between real net income and actual cash flow because not all transactions involve real cash.
Indirect Cash Flow Method
Cash flow is calculated by adjusting net income due by adding or subtracting differences in non-cash transactions. Non-cash items appear as changes to the balance sheet's assets and liabilities. Your accountant (we can help with this) must identify any increases and decreases in asset and liability accounts. These need to be added back to or removed from your net income figure to determine what's currently accurate.
Accounts receivable (AR) changes on the balance sheet from one period to the next must be reflected:
If AR decreases, customers pay off their accounts, which is added to net earnings.
An AR increase must be deducted from net earnings because the amounts represented are in revenue; they're not cash.
What about inventory changes?
If inventory goes up, this is deducted from net earnings. A decrease in inventory means you'd add to net earnings. Credit purchases are reflected in accounts payable on the balance sheet, and the increase from one year to the next is added to net earnings.
The same goes for:
- Taxes Payable
- Prepaid Insurance
If something's been paid off, the difference owed from one year to the next must be subtracted from net income. Any differences will be added to net earnings if an amount is owed.
Limitations of the Cash Flow Statement
Negative cash flow doesn't mean the house is on fire – yet. Poor cash flow can mean you've expanded the company, which took a lot of money.
The Fight of the Century: Cash Flow Statement vs. Income Statement vs. Balance Sheet
The cash flow statement measures company performance. The CFS can be calculated from the income statement and the balance sheet due to net earnings but have nothing to do with the CFSs investing or financial activities sections.
Your income statement includes depreciation expense, which doesn't show an associated cash outflow, but gives the cost allocation of an asset over its life. The CFS measures actual inflows and outflows.
The balance sheet reports the net cash flow on the CFS, which equals the net change in the line items on the balance sheet, excluding cash and cash equivalents and non-cash accounts.
What's the Difference Between Direct and Indirect Cash Flow Statements?
Using the direct method, cash inflows and outflows are known amounts using cash payments and receipts.
Using the indirect method, cash inflows and outflows don't have to be known due to net income or loss from the statement, then modifies the figure using the balance sheet.
So, What's Included in Cash and Cash Equivalents?
Cash and cash equivalents are a single line item, and these report the value of business assets that are cash or convertible into cash within 90 days. (These include petty cash or currency. While cash equivalents include commercial paper, Treasury bills, and short-term government bonds.)
Why this stuff matters
The cash flow statement is critical if you're planning on growing the business. It provides details about spending, helps maintain optimal cash balance, and can be super useful for short term planning (Trust us, they will want to see these numbers immediately.) The CFS also shows your liquidity and helps predict future budgeting!