One of the most important aspects of running your business is managing cash flow, or the money that comes in and goes out of your business.
In a perfect world, you'd always have more money flowing in than flowing out. But most businesses face cash shortages from time to time when they're waiting on clients to pay invoices but need to pay employees and suppliers in the meantime.
In times like that, it's helpful to know how to make a cash flow statement.
What is a cash flow statement?
A cash flow statement, also known as a statement of cash flows, is a financial statement that provides a detailed look at how a business's cash increased and decreased over a specific period. You can prepare a cash flow statement quarterly or annually, but preparing it monthly is more useful for keeping track of your cash position before a cash crunch turns into a cash crisis.
The cash flow statement is broken down into three sections:
- Operating activities. These are revenues and expenses generated as the business delivers its regular products and services.
- Investing activities. These include buying and selling assets and other investments.
- Financing activities. These include cash from debt financing, such as taking out a loan or line of credit and paying it back. It also includes equity financing, such as capital contributions from and distributions paid out to shareholders.
Direct vs. indirect cash flow method
There are two common methods for creating a cash flow statement: the direct and indirect methods. The main difference lies in how the statement presents the cash flows from operating activities.
The direct method shows all the company's gross cash receipts and gross cash payments. On the other hand, the indirect method backs into cash flow by starting with the company's net income and adjusting it for any non-cash transactions included in that figure.
Most businesses prefer the indirect method because it's easier to use.
How to make a cash flow statement
If you use accounting software, the program can likely generate a cash flow statement for you. However, you can also easily create your own by following these steps.
Step 1: Start with your beginning cash balance
Start with the amount of cash you have at the beginning of the period. For example, if you're preparing a cash flow statement for January 31, you'll start with the reconciled balance in your bank account on December 31, plus any cash on hand, if applicable.
Step 2: Calculate cash flows from operating activities
To calculate your cash flows from operating activities using the indirect method, start with your net income for the period. Then you add back non-cash expenses and losses and subtract non-cash gains. Examples of non-cash activities include:
- Depreciation and amortization expense
- Gains or losses from sales of assets
Next, you need to adjust net income for the changes in asset accounts that affect cash. These accounts include:
- Accounts receivable
- Prepaid expenses
- Accounts payable
- Deferred revenue
This is where creating a cash flow statement can be confusing because you have to think about how the changes in these accounts impact cash.
For example, if your accounts receivable increased by $5,000 from December 31 to January 31, you have $5,000 of revenue in your net income number that didn't impact your cash balance. Therefore, you have to back out $5,000 from your cash flow from operating activities.
For another example, say your accounts payable account decreased by $10,000. This means you paid cash for $10,000 of expenses that aren't reflected in your net income figure. So you have to back that amount out of your cash flow from operating activities.
Step 3: Calculate cash flows from investing activities
In the cash flows from investing activities section, you need to adjust cash flow for any investment gains and losses and purchases or sales of fixed assets.
For example, say you paid cash for a piece of equipment that costs $15,000 and received $2,000 from selling a used business vehicle. In that case, your cash flows from investing activities will be negative (-$13,000).
Step 4: Calculate cash flows from financing activities
In the cash flows from financing activities section, you must adjust cash for any debt or equity financing transactions that did not impact cash. For example, say took out a $40,000 business loan and paid out $10,000 in distributions to shareholders. In that case, your cash flows from investing activities will be $30,000.
Step 5: Calculate the net increase or decrease in cash
The final step in creating your cash flow statement is a simple math problem:
Beginning cash + cash flow from operating activities + cash flow from investing activities + cash flow from financing activities = net increase (or decrease) in cash
You can check your work by taking your beginning cash plus the increase (or minus the decrease) in cash for the period and comparing the result to your ending cash balance. If the two numbers don't agree, you've likely made a mistake somewhere in the operating, investing, or financing section.
Interpreting a cash flow statement
The bottom line of your cash flow statement will show you whether your cash flow is positive or negative. If you have a positive cash flow, you have more money coming into your business than going out. But keep in mind that this doesn't automatically mean your business is profitable. You may only have positive cash flow because you took out a loan or shareholders invested additional money into the business.
Likewise, negative cash flow for one period isn't necessarily a red flag if you're investing in future growth. It's important to analyze changes in cash flow from one period to another and see how the company is performing overall.