Cash Flow Statement: Understanding all the elements

At the end of the month, individuals evaluate their monthly expenditures to reflect on their financial status. This statement of their expenditures tells them how much cash in hand they have for a specific period, and accordingly will help in making their future spending decisions within their budget.

Similarly, organizations also make financial statements of their spending and earnings within a specific period. This statement reflects all types of transactions, including the ones which are made with cash or without cash. 

And this statement of transactions (spending and earning) is known as a cash flow statement. It helps an organization to make important financial decisions for the future, within a set budget.

Let’s take a detailed look at the cash flow statement and understand its significance.

Understanding Cash Flow Statement

A cash flow statement is a statement that shows the inflow (money coming to the organization) and outflow (money spent by the organization) of cash (cash in hand/ cash at bank) and cash equivalent (short term deposits/marketable securities/current investment) of the organization over a specific period. 

The cash flow statement indicates the organization’s performance and overall health in the market. It has been a mandatory part of the company’s financial report since 1987 and a companion of the balance sheet and income statement of the company. 

It is important to keep in mind that a cash flow statement only shows the firm’s liquidity, not the profitability of the firm.

Calculation of Cash Flow Statement

Cash flow is calculated by making some adjustments to the net income by adding and subtracting the revenues, credit transactions (listed on the balance sheet and income statement), and other expenses that result from the transactions that happened during a particular period.

These adjustments need to be made because non-cash items are calculated into the income statements and total assets & liabilities in the balance sheet. 

This is why many items are re-evaluated while making cash flow statements because of the non-cash transactions.

There are two methods to evaluate the cash flow method:

1. Direct Method 

This method evaluates the actual cash flow information of the organization’s operations, that represents various types of cash payments and cash receipts from the customers, paid out cash in salaries, and receipts of cash paid out to suppliers. 

These figures are evaluated by using the beginning and ending balance of the various business accounts and evaluation of net increase and decrease in the accounts. 

This method is commonly used by small firms which do their accounting on cash rather than on an accrual basis.

2. Indirect Method

This method derives information by taking the net income from the income statement and changes on the balance sheet to arrive at the amount of the cash generated by the operating activities during a particular time period. 

Both the income and balance sheet are prepared on an accrual basis. 

Operating activities are one of the key components of a cash flow statement. 

Let’s understand the basic components of a cash flow statement.

Components of the Cash Flow Statement

The cash flow statement has four components. Let’s take a detailed look into them.

• Operating Activities

This shows the main source of the organization’s income generation, which is considered to be the most important information on the cash flow statement. This section of the cash flow statement represents how much cash is generated from the organization’s core products and services. 

A positive cash flow is a sign that the organization’s financial health is good. These operating activities include:

1. Receipt from sales of goods and services.
2. Interest payments.
3. Rent payments.
4. Income tax payments.
5. Payment made to suppliers and services used in production.
6. Salary and wage payment to workers.
7. Any other type of operating expense.

In the case of an investment company or trading portfolio, debt instruments, equity instruments, and receipts from the sale of loans are also included in the operating activities.

• Investing Activities

Investment activities reflect the changes in equipment, assets, or investments relate to uses of cash from the company’s investment. These activities include investing in:

1. Equipment
2. Building
3. Land
4. Furniture & fixtures
5. Vehicles
6. Long-Term Investments

Cash changing from investing is commonly considered as “Cash Outflow” because the cash is used to buy equipment, assets, and short-term assets. When a company relieves an asset, the transaction is considered to be a “Cash Inflow”.

• Financing Activities

Any changes in loans/stock options, debt, long-term borrowing are reflected in the financing activities. These financing activities can include:

1. Short-Term/Long-Term Notes
2. Bonds Payable
3. Deferred Income Tax
4. Preferred Stock
5. Paid-in Capital Excess of Par-Preferred Stock
6. Common Stock
7. Paid-in Capital Excess of Par-Common Stock
8. Paid-in Capital from Treasury Stock 
9. Retained Earnings
10. Treasury Stock

When a company raises its capital, it is considered as “Cash-In”. On the other hand, when a company pays out the dividends or the debt is reduced. It is considered as “Cash-Out”. Financial Activities reflect how borrowing affects the company’s cash flow.

• Supplemental Information

Supplemental information often includes the primary three components of the cash flow statement. Supplemental information reflects the exchange of the company’s stocks for its bond, which did not involve cash. Supplemental information also includes the amount of income taxes and the interest rate paid.

Negative Cash Flow vs Positive Cash Flow

When the organization’s cash flow statement shows a negative number at the bottom, it shows the amount of lost cash during the accounting period. It is important to note that long-term, negative cash flow is not always a bad sign. For instance, in some months, the organization may spend heavy cash to make money in the long run by investing in equipment.

When the organization has a positive number at the bottom of the cash flow statement, that means the organization has got a positive cash flow for the period. However, keep in mind that a positive cash flow isn’t always a good sign in the long term. 

While it gives the organization more liquidity in the current time, there can also be negative reasons an organization may have that money; for instance, by taking on a huge loan to save its failing business. Hence, a positive cash flow does not mean that it is going to be positive overall.

Example of Cash Flow Statement

After understanding what a cash flow statement does, and how it is calculated, let’s take a look at an example:

In the above cash flow statement, the amount in red indicates a decrease in cash; for example, the amount (Rs. 30,000) next to “increase in inventory”, means the inventory increases by Rs. 30,000 in the balance sheet and the cash is decreased by Rs. 30,000.

The amount in black indicates an increase in cash; for example, the amount of Rs. 20,000 next to “Depreciation” means that it is an expense on the income statement. But in reality, depreciation does not decrease the cash, and that is why the company has added depreciation back in the net income. 

Uses of Cash Flow Statement

• Cash Flow Statement shows exactly how much operating cash flow an organization has, in case the organization wishes to use it on new projects. This information helps the organization to spend the money within the budget.
• Cash Flow Statement shows the changes in liability, assets, or equity in the form of cash inflows, cash outflows, and cash being held. These categories are the core of business accounting. 
• Cash Flow Statement allows the organization to predict the cash flows in the future. This future cash flow prediction gives an idea of how much liquid balance the organization will have in the future. This prediction can further help to fulfil long-term business goals.                                 

Final Thoughts

A cash flow statement is an important part of an organization’s financial statements. The cash flow statement reflects how an organization raises money and how it spends that money during the given period. 

By looking at the company’s cash flow statement, investors can get an idea of the company’s performance. A cash flow statement is an important tool that shows a company’s ability to cover its expenses.