Cash flow statement in layman terms is a statement of a company’s cash flow in a particular period. The word cash flow refers to the flow of cash into or out of the business. In simple words if flow of cash is more in to the business we can conclude that the business is financially doing well. Cash flow in to or out of a business is created basically by three mechanisms which are operations, investing and financial activities. Understanding cash flow statement is important in order to estimate liquidity, solvency of business and financial flexibility.
Financial statements provide complete information about a company’s finances. Balance sheet provides information about what a company owns and what a company owes. Income statement shows how much money has been made and how much has been spent. The cash flow statement connects the strings by actually tracking how much cash has entered and how much has left in a specific period of time.
An ideal approach to understand critical aspects of the cash flow statement would be to understand its components, analysis and impact on decision-making. We will cover each aspect in detail which enable you to conceptually understand the cash flow statement.
Key Components of the Cash Flow Statement
Cash flow statement is divided mainly in to three sections which are actually the modes in which a business can generate cash which are operating activities, investing activities and financing activities. We will cover each section starting with the operating activities.
Operating Activities
In layman terms cash flow for operating activities provides the information about where the cash is coming from and where it is going. From this part of the cash flow statement information about efficiency in utilizing the capital for business operations can be estimated.
- Cash Inflows: Cash inflow obtained from selling goods and services, recurring amount from royalties, fee charged for services, commissions in sales or products and other cash flows which are basically obtained from business operations are included in the cash inflow due to operating activities.
- Cash Outflows: The outward flow of cash for suppliers, business operating expenses, salary for employees, interest payments on debt, income tax etc. are included cash outflows for operating activities.
- Net Cash Provided by Operating Activities: Net cash provided by operating activities can be calculated by difference of cash inflows and cash outflows related to core business operations. However, the most widely method is to add net income from the Income statement, adjustments in the working capital and non-cash items like depreciation.
Net cash provided = Net Income + Adjustment in working capital + non-cash items
Investing Activities
Cash flow from Investing activities simply refers to the cash flow resulting from buying or selling assets. Buying and selling of assets can provide a lot of information about how a business plans to expand or grow in future.
- Cash Inflows: Inward cash flow from sale of property, plant, and equipment, sale of investments is considered positive cash flow or cash inflow from investing. Selling assets creates positive cash flow for investing activities.
- Cash Outflows: Cash flow outward for purchasing assets like property, land, equipment, investments, and loans given to others is included in the cash outflow. Buying assets creates a negative cash flow for investing activities.
- Net Cash Used in Investing Activities: Net cash used in investing activities is simply the difference between cash outflow and cash inflow related to acquiring or diluting any kind of asset or investment which will give returns in future. It is really helpful in estimating a company’s future moves regarding expansion and financial health. If a company’s net cash used in investing activities is negative it means that the company is investing in creating assets and if the value is positive this means that the company is selling or capitalizing on investments for strategic reasons.
Financing Activities
Cash inflow and outflow refers to the flow of cash into or out of the organisation from financial activities which include issuing equity, borrowing funds, repayments of burrowed funds, paying dividends to shareholders or repurchasing the company shares.
Net cash used in financial activities is also just the difference between the cash inflow and cash outflow due to the company’s financial activities related to the business operations and expansion.
Net Increase (Decrease) in Cash and Cash Equivalents
Net increase or decrease in cash and cash equivalents is defined as the total cash used operating activities, investing activities, and financing activities which describes a company’s overall position regarding cash for the period for which the statement is being prepared. Cash and Cash Equivalents at the Beginning and End of the Period
Cash equivalents in layman terms refer to assets that are equivalent to cash at hand. These are assets which can be converted into cash within a time period of 90 days. These include any asset that can be liquified into cash within 90 days.
Importance of the Cash Flow Statement
Liquidity Assessment
In simpler terms cash flow statement provides a complete view regarding a company’s cash flow which is directly correlated to a company’s ability of maintaining liquidity and meeting short-term obligations.
Financial Health
Cash movement is an extremely important parameter for estimating a company’s financial health. This parameter is an exclusive feature of cash flow statement and is not provided by the Balance sheet and Income statement.
Investment Decisions
Cash flow statement is the statement to which investors and financial analyst usually refer in order to evaluate a company’s financial stability and potential for growth in future to make investment decisions.
Operational Efficiency
Net cash flow from operating activities is used in evaluating the operational efficiency of a business and cash flow statement is used for this purpose. It is analysed and reviewed frequently by management and stakeholders.
Analyzing the Cash Flow Statement
Cash Flow from Operating Activities
If your company is doing well in operations and is generating cash while satisfying its short-term obligations this means that you are effectively using the working capital and your cash flow is positive.
Cash Flow from Investing Activities
Negative value of cash flow from investing activities indicates that a company is investing in creating assets to plan for the future but excessive cash outflow can impact the current liquidity of a company.
Positive cash flow from investing activities indicates that a company is actually selling assets to create cash flow and hence is a concern as any company would sell assets to maintain operations when it is not generating cash from business operations.
Cash Flow from Financing Activities
If a company is taking debt from the market or is providing equity to raise money to either finance its operations or expand its presence cash is actually coming into the company and hence cash flow would be positive.
Negative Cash Flow: Could suggest that the company is repaying debt, paying dividends, or repurchasing shares, which might impact its liquidity.
Cash goes out of the company when it is repaying creditors, paying dividends to shareholders, or purchasing its shares from the shareholders, hence the cash flow would be negative. Reducing debt improves financial health but excessive cash outflow can impact liquidity.
Free Cash Flow (FCF)
Free cash flow can be understood as the cash flow available to repay debt, pay dividends, and invest in growth opportunities after taking care of expenses. It is cash flow from operating activities minus the capital expenditures. A positive free cash flow reflects that your business is financially flexible however a negative free cash flow that you are either struggling to make ends meet or are just able to make ends meet in your business.
Cash flow statement is an amazing tool to evaluate operating efficiency, capital management and financial health of a business. Cash flow statement not only helps in tracking the cash flows but also helps in making strategic adjustments to ensure stability and solvency of any business. Analysing cash flow statement is must have skill whether you are an investor, analyst or a business owner.
