Cash is king. Pehr G Gyllenhammer, CEO of Volvo, said that in the aftermath of the stock market crash of 1987. The phrase now surfaces in times of investor crises. It also alludes to a company’s mastery of cash flow. Monitoring cash inflows and outflows, gives you a sense of how well you are doing. In accounting, you monitor money with the cash flow statement (CFS). This statement shows the effectiveness of a company’s management of revenue and expenses. Overall it is a measurement of financial health.
This article is an exclusive on the statement of cash flows (SCF). We’ll explain:
- What a cash flow statement is
- The different types of statements: direct and indirect
- How to analyze a statement of cash flows
- The best accounting software for preparing cash flow statements
What is a Statement of Cash Flows?
In accrual accounting, earning revenue isn’t synonymous with cash in hand. That is where statements of cash flow come in. These statements show the cash reality of the business, versus the cash that you theoretically have. Put simply it is a view of the cash that literally came into the business and literally left, in any given period.
Profit & Loss Statement vs Cash Flow Statement
The profit and loss statement (P&L) gets confused with the statement of cash flow. It is very similar to the “cash from operations” section in the cash flow statement–more about this below. The profit and loss statement lines up revenue and costs for a fiscal year (quarter). It helps a business see their profitability by analyzing their revenue and/or costs. However, the profit and loss statement is missing elements like loan payments, credit card payments and owner’s draw. A cash flow statement only shows the company’s cash position, NOT profitability.
Preparing a Cash Flow Statement
Cash flow can be reported monthly, quarterly, or at the very least annually. Best accounting principles includes them as part of the month end close process. In order to create one, you will first prepare an income statement, and balance sheets for the beginning and end of the period you are looking at. How your business operates will determine your cash flow statement method.
There are two different methods of reporting: direct and indirect. The difference is in the first part of the statement, called “cash from operations.” Other areas of the statement are the same.
Direct Method: Statement of Cash Flow
In this method, your cash amount is the starting point. The direct method is used for small companies who have less transactions than a larger company. It is infinitely more useful to small business owners because it shows cash from incoming sales, outgoing expenses, investments (owner’s draw/contributions) and financing.
How to Prepare a Direct Cash Flow Statement
Direct cash flow statements consists of these main items:
- Cash from Operations = cash is generated from selling the company’s goods or services. Changes made in cash, accounts receivable, accounts payable, depreciation, and inventory are placed here. These operating activities might include:
- Receipts from sales of goods/services
- Payments made to vendors of goods/services
- Salary and wages to employees
- Interest payments
- Income tax payments
- Rent payments
- Utility Payments
- Any other payments from operations
- Cash from Investments = the exchange of cash for investments, assets, and equipment. It is outside of the main business operations of sales. These investing activities might include:
- Sales of shares
- Profits from investments
- Purchased or sold equipment
- Cash from Financing Activities = Cash transactions from raising, borrowing and repaying capital. These financing activities might include:
- Stock repurchases
- Dividend payments
- Repaying or borrowing of debt
- Non Cash Activities = These are equity conversion transactions, mainly used for large companies. These activities might include:
- A loan that was converted to stock
- Summary of Cash Flow
- A value at the beginning of the period
- A value at the ending of the period (you get this by adding the individual summaries of the main parts above)
- A value of the difference between the two. This value is reconciled with a bank statement.
Indirect Method: Statement of Cash Flows
With the indirect method you reverse create the cash flow statement, using the income statement and balance sheet. Net income is the starting point. Any accrued expenses (depreciation and amortization) need to be subtracted from the previous periods revenue to land on the net income. Then you make adjustments based on the accrual accounting net income, in cash from operations. A reconciliation to the net income has to be made because it includes non-cash items. If this isn’t done, there won’t be a realistic picture of cash.
With a large volume of transactions, indirect is the preferred method. It eliminates the listing of each individual cash item. So nearly all major U.S companies use indirect cash flow statements. It also follows GAAP principles. Unless you are a small business seeking investments, it really this method isn’t relevant.
How to Analyze a Statement of Cash Flows
Several insights can be gleaned by analyzing the statement of cash flow:
- Positive Cash Flow: A company’s liquid assets are increasing.
- Negative Cash Flow: You are burning cash or spending more than you are making, and you could go out of business.
- Free Cash Flow (FCF): This is the net operating cash flow minus capital expenditures. Shows investors that a company has enough cash flow to pay dividends.
- Summary: Gives you an overview of the change in cash.
- Investors: They can see your cash management track record.
- Creditors: Know that you have cash available to pay them back.
Best Accounting Software for Preparing Cash Flow Statements
Creating a cash flow statement in Xero or QuickBooks Online simplifies accounting. It is recommended you choose a software based on your company’s method of reporting. Here is what to expect when creating cash flow statements from each accounting software:
Xero: Auto generated cash flow statements in the direct method
- More useful for small businesses
- Shows where all the money went
- Can do indirect method statements via their report templates (currently available through their U.S. advisors only)
QuickBooks Online: Auto generated cash flow statements in the indirect method
- More useful for major corporations
- Easier for investors to understand
- Can do manual direct cash flow statements via a template download
Know Your Cash Flow
That is the jist of cash flow statements. They are a great tool to view the cash activity of a business. With these statements you can now analyze your revenue streams, major expenses, and what areas hold potential for investment. Depending on your reporting method, you can present your company’s cash position to investors. Keep in mind, the statement of cash flows looks at past cash activity. It is not a good way to see where the business will be in the future. That is cash forecasting.