What is a cash flow statement and how do you make one?

A cash flow statement is a financial statement that summarizes the cash flowing in and out of a company during a specified time period. It is an important measure of how a company generates and manages its cash, which translates into cash available to fund operations and pay debt.

The cash flow statement, together with the income statement and balance sheet, is one of the key financial statements used to measure a company's position. It presents a comprehensive picture of a company's strength and profitability, providing critical information for investors, creditors, and management.

Why do you need a cash flow statement?

A cash flow statement is necessary because net income is typically viewed using accrual-based accounting. This type of accounting gives a picture of a business's finances based on when activities are completed versus when cash outlays are made. A company with a profitable income statement but insufficient cash flows is not likely to be a profitable investment, as it will not have the necessary cash to continue operations.

The cash flow statement shows a company's ability to generate cash, which is crucial in understanding the profitability and viability of any company.

Comparing changes in cash flow from one period to the next sheds important information about the company's direction.

Creating a cash flow statement

To create a cash flow statement, organize all cash transactions under the following three primary sections.

• Cash from operating activities. Record cash expended and received from the company's main line of business. Typically, this is the most telling category, since it shows whether the company's core business is generating enough cash for sustainability.
• Cash from investing activities. Record cash changes in assets or equipment, or general monetary investments.
• Cash from financing. Record cash changes related to investors, loans, or dividend payments made.

Additionally, you may need to use notes or an attachment to disclose certain non-cash activities which are part of a full snapshot of the company's position, such as acquiring an asset by assuming a liability.

Direct and indirect methods

The direct or indirect method may be utilized to prepare the cash flow statement. Under either method, the investing activities and financing sections are identical. The difference between the two methods impacts the operating activities section only.

For the direct method, simply list all cash payments and receipts from operations, such as receipts from the sale of goods or services, payments to suppliers, salary, rent, and other operating expenses.

For the more commonly used indirect method, begin with net income as a starting point and make the necessary balance sheet adjustments to arrive at an accurate cash flow figure. The following are some of the most common adjustments to net income when calculating cash flow:

• Depreciation. A non-cash expense on the income statement, depreciation is added back to net income for cash flow purposes.
• Accounts receivable. Increases in accounts receivable are deducted from net income, as no cash has been received for these sales. Conversely, decreases to accounts receivable are added back to net income, because they represent cash received.
• Payables. Increases in payables are a non-cash accrual and are added back to net income.
• Inventory. If purchased with cash, an increase in inventory would mean a cash outlay that reduces net income.

Below is an example of a cash flow statement prepared using the indirect method. Although earnings are $250,000, not all of that amount is available for use, as the bottom line shows.

Cash flow statement

Company ABC

Month ended Jan. 31, 2021

Cash flow from operations

Net earnings

$250,000

Additions to cash

Depreciation

$7,500

Increase in accounts payable

$24,000

Increase in Taxes Payable

$8,000

Subtractions from cash

Increase in accounts receivable

($35,000)

Increase in inventory

($40,000)

Net cash from operations

$214,500

Cash flow from investing activities

Purchase of equipment

($12,000)

Net cash from operations

($12,000)

Cash flow from financing activities

Notes payable

$16,000

Dividends Paid

($900)

Net cash from operations

$15,100

Cash flow for month ended Jan. 31, 2021

$217,600

A properly created cash flow statement is an important bridge between the income statement and balance sheet and provides critical information for all decision makers.