A very important metric that every business owner should be well aware of is the metric of managing once cash flow. Cash flow helps you understand how you are using your funds as well as help you allocate your capital resources appropriately.
For a new business owner learning how to manage their cash flow is a skill of a lifetime, hence we have written this blog to help business owners learn in detail about how to manage their cash flow.
In this blog, we will be talking about the following points.
- What is a cash flow.
- benefits of cash flow statements.
- Methods of cash flow statement.
- Preparation of cash flow statement
- Example of cash flow statement.
- Interpretation of cash flow statement.
- Conclusion
What is a cash flow
A cash flow statement is a financial statement that shows the inflows and outflows of cash and cash equivalents for a business over a specific period, usually a year. It provides a summary of the company’s cash transactions, including its operating, investing, and financing activities.
The cash flow statement is divided into three sections:
1. Operating activities: This section shows the cash inflows and outflows related to the company’s core business operations. This includes cash received from customers, payments made to suppliers and employees, and taxes paid.
2. Investing activities: This section shows the cash inflows and outflows related to the company’s investments. This includes cash spent on purchasing or selling property, plant, equipment, or other long-term investments.
3. Financing activities: This section shows the cash inflows and outflows related to the company’s financing. This includes cash received from issuing stocks or bonds or borrowing money, as well as cash paid for repurchasing stocks or paying off loans.
Benefits of Cash Flow Statement
Benefits of cash flow statement
A cash flow statement is an essential financial statement that provides information on a company’s cash inflows and outflows. By analyzing cash flows, investors and creditors can assess a company’s ability to generate cash and meet its financial obligations. Here are some benefits of a cash flow statement:
Provides a Clear Picture of a Business’s Financial Health: The cash flow statement helps business owners and investors to evaluate the liquidity of a business. By understanding the cash inflows and outflows of a company, investors can determine if a business has enough cash on hand to pay its debts and fund its operations.
Helps in Decision Making: The cash flow statement can also help business owners to make important financial decisions. For example, by analyzing the cash flow statement, business owners can determine the feasibility of capital expenditures or decide whether to pursue new investments or financing opportunities.
Monitors Business Performance: By analyzing a company’s cash flow statement, you can determine its operational efficiency, profitability, and liquidity. It provides insights into the company’s performance over a while, allowing you to identify trends and make informed decisions.
Improves Cash Management: A cash flow statement helps businesses improve their cash management by identifying areas where cash inflows can be increased or cash outflows can be reduced. This can lead to better financial performance and increased profitability.
Methods of Cash Flow Statement
Methods of cash flow statement
There are two main methods of preparing a cash flow statement: the direct method and the indirect method.
Direct Method
The direct method involves tracking all cash inflows and outflows from operating activities and presenting them in a cash flow statement. This includes the cash received from customers, cash paid to suppliers, salaries paid to employees, and other operating expenses.
To calculate the cash flow statement using the direct method, you will need to calculate the following:
- Cash flow from operating activities:
Cash Inflow: This includes cash received from customers, interest and dividends, and other operating income.
Cash Outflow: Cash paid for inventory, operating expenses, interest and taxes, and other operating expenses. - Cash flow from investing activities:
Cash Inflow: This includes cash received from the sale of investments and property, plant, and equipment.
Cash Outflow: Cash paid for the purchase of investments and property, plant, and equipment. - Cash flow from financing activities:
Cash Inflow: This includes cash received from debt or equity securities issuance.
Cash Outflow: Cash paid for debt repayment and dividends.
Indirect method:
The indirect method, on the other hand, starts with the net income figure from the income statement and adjusts for non-cash items and changes in working capital to arrive at the cash flow from operating activities. Non-cash items include depreciation and amortization, while changes in working capital include changes in accounts receivable, accounts payable, and inventory.
Preparation of Cash Flow Statement
Preparing a cash flow statement requires accurate tracking of all cash inflows and outflows during the period. Businesses can use accounting software to automate this process or do it manually using spreadsheets. The steps involved are:
- Gather financial data: Collect financial data for the period for which you will be calculating the cash flow statement (usually monthly, quarterly, or annually).
- Identify cash inflows and outflows: Determine the sources and uses of cash for the period, including operating, investing, and financing activities. Start with the beginning balance of cash on hand for the period. This is the amount of money the company had at the beginning of the period.
- Calculate cash flows from operating activities: Use the indirect method to calculate cash flows from operating activities. This involves adjusting net income for non-cash items such as depreciation and changes in working capital.
- Calculate cash flows from investing activities: Determine the cash flows from investing activities, such as buying or selling property, plant, and equipment or investing in securities.
- Calculate cash flows from financing activities: Determine the cash flows from financing activities, such as taking out or repaying loans, issuing or buying back shares, paying off debt, or paying dividends to shareholders.
- Calculate the net change in cash: Calculate the net change in cash for the period by adding and subtracting the cash inflows and outflows from Operating. Investing and Financing activities.
- Determine the ending cash balances: Calculate the ending balance of cash for the period by adding the net change in cash to the beginning balance of cash.
- Prepare the cash flow statement: Present the cash inflows and outflows for each category and the net change in cash in a cash flow statement. The statement should include a reconciliation of the beginning and ending cash balances.
Example of Cash Flow Statement
Examples of cash flow statement
Let’s prepare Cash Flow Statement for Excel Ltd by using Direct Method and Indirect Method:
Excel Ltd
Cash Flow Statement
For the Year Ended March 31, 2023 (in Rupees)
Using Direct Method:
Cash inflows from operating activities:
Cash received from customers: 5,00,000
Cash paid to suppliers: 3,00,000
Salaries paid to employees: 1,00,000
Total cash inflows: 5,00,000
Total cash outflows: (4,00,000)
Net cash inflow from operating activities: 1,00,000
Cash inflows from investing activities:
Sale of equipment: 10,000
Purchase of equipment: (30,000)
Net cash outflow from investing activities: (20,000)
Cash inflows from financing activities:
Issuance of long-term debt: 50,000
Repayment of long-term debt: (20,000)
Payment of dividends: (10,000)
Net cash inflow from financing activities: 20,000
Net increase in cash: 1,00,000 – 20,000 + 20,000 = 1,00,000
Cash and cash equivalents, the beginning of the year = 85,000
Cash and cash equivalents, end of year = 1,85,000
Using the Indirect Method:
Net income: 1,00,000
Adjustments for non-cash items:
Depreciation expense: 20,000
Changes in working capital:
Increase in accounts receivable: (30,000)
Decrease in accounts payable: 10,000
Increase in inventory: (5,000)
Net cash inflow from operating activities: 95,000
Cash inflows from investing activities:
Sale of equipment: 10,000
Purchase of equipment: (30,000)
Net cash outflow from investing activities: (20,000)
Cash inflows from financing activities:
Issuance of long-term debt: 50,000
Repayment of long-term debt: (20,000)
Payment of dividends: (10,000)
Net cash inflow from financing activities: 20,000
Net increase in cash 95,000 – 20,000 + 20,000 = 95,000
Cash and cash equivalents, the beginning of the year = 85,000
Cash and cash equivalents, end of year = 1,80,000
As you can see, the main difference between the two-method is the way they report cash flow from operating activities.
Interpretation of Cash Flow Statement
Interpreting a cash flow statement involves analyzing the sources and uses of cash for the period in question. Review and analyze the cash flow from operating, investing, and financing activities.
- Operating Activities: Positive cash flow from operating activities is generally a good sign, as it indicates that the company is generating cash from its main business activities. Negative cash flow from operating activities may be a cause for concern, as it suggests that the company is not generating enough cash to cover its operating expenses.
- Investing Activities: Positive cash flow from investing activities may indicate that the company is investing in its future growth, while negative cash flow from investing activities may indicate that the company is divesting assets or reducing its investments.
- Financing Activities: Positive cash flow from financing activities may indicate that the company is accessing capital to support growth, while negative cash flow from financing activities may indicate that the company is paying down debt or returning capital to shareholders.
Assess the net change in cash: The net change in cash shows the overall change in the company’s cash balance for the period. A positive net change in cash is generally a good sign, as it indicates that the company is generating more cash than it is using. A negative net change in cash may indicate that the company is experiencing cash flow problems or is using cash to fund operations or investments.
Conclusion
In summary, a cash flow statement is like a bank statement for a company. Just like how a bank statement shows all the money coming in and going out of your account, a cash flow statement shows all the money coming in and going out of a company’s account. By accurately reviewing and assessing the cash flows, businesses can find opportunities to improve their financial performance and promote growth. Whether you’re a small business owner or a large corporation, the cash flow statement is a valuable tool that can help you achieve your financial goals. As the company gets bigger manually maintaining its cash flow may get difficult, to solve this problem a lot of companies opt for accounting software.
There are a lot of accounting software like ProfitBooks which you can use to manage your cash flow. The plus side of using ProfitBooks is its easy interface and “forever free plan”
To know more visit the website and sign in for your “forever free plan” today!
Also Read:-
How to manage cash flow in a small business
30 cost-cutting ideas to survive cash flow crunch
10 cash flow mistakes that can kill your business
Difference between cash & accrual accounting method
Top 10 free accounting for small businesses.
