A cash flow statement breaks down the various types of inflows and outflows of cash (and cash equivalents) that a business experiences. It can help you and other stakeholders clearly see how your business earns or spends cash, and it can provide valuable insight into your company financials. It also can help you spot business trends that can improve your overall business decision-making.
There are two main methods for preparing a cash flow statement to consider: the direct method and the indirect method. While the indirect method is more common, the better choice between the two will depend on how much detail you need to include in your statement and how much time you are willing to devote to the process. (See below for further discussion about choosing the right method.)
So, how do you prepare a cash flow statement that will provide the most benefit for your business? Here are the essential things to know in order to put an effective statement together.
Cash Flow Statement Overview
What time period your cash flow statement covers is entirely up to you. Some companies prepare statements annually—covering their full fiscal year—while others prepare them quarterly or even monthly. The frequency you choose should depend on how your business will use the statement and whether more regular reporting will provide a greater benefit.
It’s also important to understand which types of financial transactions should be reflected in the statement—and which should not. Only inflows and outflows of cash and cash equivalents should be accounted for in the cash flow statement. Noncash transactions that do not directly affect cash receipts—such as depreciation or bad debt write-offs—should not be included.
What Is Included in Your Cash Flow Statement?
There are three types of cash flows you will want to break out in order to gain the most value and insight from your cash flow statement:
- Operating activities cash flow. This is the money your business generates and spends on typical, day-to-day operating activities, such as selling products and services or paying rent and employees.
- Investing activities cash flow. This is the money spent on and generated from market securities, long-term assets, and other financial instruments over the reporting period. It could be from buying or selling major equipment or property, for example.
- Financing activities cash flow. This is the money that moves between a company and its owners, investors, and creditors, such as by issuing equity or debt.
You also may want to include an “other activities” section for any types of cash flow that don’t fit into these three main activities. Each section should include line items that break out the various types of cash flow pertaining to that activity.
Preparing Your Cash Flow Statement
Before you start working on your statement, determine whether the indirect method or the direct method makes the most sense, given your needs. Keep in mind that the method you select will only affect the operating activities section of your statement—as the investing and financing activities sections will look the same regardless of the method used.
Each method has its advantages and disadvantages. The indirect method is more common, for example, because it’s generally simpler and less time-consuming to perform. But the direct method provides greater detail about your company’s cash situation and, in turn, potentially valuable insights.
Indirect Method Steps
The indirect method is based on accrual accounting—which means revenues and expenses are counted when they are incurred, not when money actually changes hands. Most companies use the accrual method, which is partly why this method is so popular.
For the operating activities section of the cash flow statement, the indirect method involves first showing the company’s net income (which should be found easily on your company income statement). You then show any noncash inflow or outflow adjustments that need to be made in order to calculate the total operating activities cash flow. Common adjustments, for example, include:
- Depreciation (which must be added back to the net income because it does not count as cash flow)
- Accounts payable
- Accounts receivable
- Inventory expenses (which must subtracted from the net income because they are considered a cash outflow)
Direct Method Steps
The direct method relies on cash basis accounting—meaning revenues and expenses are counted when actual cash receipts and payments are made during the reporting period.
The direct method generally takes more time and number-crunching because you are subtracting actual cash outflows from inflows rather than simply adjusting the net income. Common line items using the direct method include:
- Customer receipts
- Payments to suppliers
- Payments to employees
- Interest and dividends received
- Income tax payments
While breaking out each type of cash receipt or payment takes time, this method offers more detail and visibility into your company’s finances. For example, it can show how much cash was spent during the reporting period on employee payroll or merchandise—or the exact dollar value of customer sales—rather than having those individual cash flow sources grouped together in “net income.”
That said, there are additional potential complexities to choosing the direct method. For one, since most companies use accrual accounting, the indirect method more naturally fits with their current accounting practices. Moreover, the Financial Accounting Standards Board (FASB) requires companies using the direct method to also provide a “reconciliation” that shows how their net income would be adjusted to net cash (essentially using the indirect method) on a separate schedule.
Most accounting standard-setting entities (including FASB) prefer the direct method, though, because of the higher level of insight it provides. If you choose to go the direct method route, you’ll want to start regularly tracking your cash inflows and outflows in the way you’ll be reporting it—so that putting together the cash flow statement won’t be too much of a burden.
You can use accounting software such as Intuit QuickBooks, Zoho, or FreshBooks to keep tabs on your cash flow and more easily assemble the cash flow statement.
How to Use Your Cash Flow Statement
So, how do you make the most of the cash flow statement once it’s prepared?
It can be used in multiple ways and presented to different types of interested parties. For example, you should use it internally to better understand how and when your business generates and spends cash. In turn, it can be invaluable for making budgeting decisions and predicting your cash situation in the future.
You also can give it to creditors looking to gauge your company’s liquidity and overall financial health when determining whether to provide financing, and how much. And you can give it to prospective and current investors looking to evaluate your company’s financial well-being and determine its worthiness as an investment.
As you look to grow and evolve your company, preparing a cash flow statement can be a great way to help yourself and other interested parties evaluate how your business is performing from a cash perspective—and ultimately make better business decisions.
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