Different types of cash flow statements
- Cash Flow from Operating Activities (CFO)
What it is: Cash generated or spent through a company’s regular day-to-day business operations.
Examples: Cash received from sales, and cash paid for salaries, rent, inventory, and taxes.
- Cash Flow from Investing Activities (CFI)
What it is: Cash used for or received from buying and selling long-term assets and investments that support the business.
Examples: Buying or selling property, plant, and equipment (PP&E), or investing in other companies.
- Cash Flow from Financing Activities (CFF)
What it is: Cash moving between a company and its owners (equity) or lenders (debt), helping fund business growth.
Examples: Issuing or buying back shares, taking loans, repaying debt, or paying dividends.
By adding together these three sections, you get the net change in cash, showing whether the business generated or used cash overall during the period.
Importance of a cash flow statement
The cash flow statement is an important financial document that gives a clear picture of a company’s financial health and is vital for planning its future growth. Key points it highlights include:
- Quality of earnings: The cash flow statement helps assess the reliability of a company’s earnings. For example, if net income is high but cash from operating activities is low, it may suggest that earnings are not as strong as they appear. Strong cash flow from operations generally indicates high-quality earnings.
- Investor insight: For investors, the cash flow statement provides valuable information about a company’s overall performance. It shows how effectively the company generates cash, which is essential for sustaining operations, funding growth, and delivering returns to shareholders.
Structure of the cash flow statement
A cash flow statement provides insights into the inflow and outflow of cash within an organisation over a specific period. Here is a detailed look at the details present in a cash flow statement:
Operating Activities
This part of the cash flow statement shows how cash comes in and goes out from a company’s main business. It tells us whether the company can run itself without borrowing. Cash comes in from sales, interest, and dividends. Cash goes out for payments to suppliers, employee salaries, rent, electricity, and taxes.
If a company has positive cash flow from operations, it means it can cover its expenses. Negative cash flow may suggest problems in managing day-to-day finances.
Investing Activities
This section tracks cash spent or received from long-term investments that affect the company’s growth. Cash comes in when the company sells assets, sells parts of the business, or collects loans. Cash goes out for buying equipment, investing in securities, or acquiring other businesses.
High spending on assets (capex) can show expansion, but spending too much without enough operating cash can create money problems. Selling assets often to raise cash may indicate financial trouble.
Financing Activities
This section shows how a company raises money or pays it back through loans or shares. Cash comes in from issuing shares or borrowing money. Cash goes out to repay loans, pay dividends, or buy back shares.
Raising money this way can help a company grow, but too much borrowing without revenue growth is risky. Regular dividends and share buybacks show that the company is financially strong and focused on rewarding shareholders.
Objectives of cash flow statement
The cash flow statement plays a key role in assessing financial health and cash management. Its main purposes include:
- Check Liquidity and Solvency: See if the company has enough cash to pay short-term bills and long-term debts.
- Track Cash Generation: Show how much cash comes from main business activities, buying/selling assets, and borrowing or raising money through shares.
- Spot Cash Flow Trends: Identify patterns in money coming in and going out to help plan for the future.
- Assess Cash Management: Check how well cash is handled, finding extra cash for investment or gaps that need funding.
- Support Financial Planning: Help forecast future cash needs and control spending.
- Connect Income and Cash: Explain why net profit may differ from actual cash flow, including non-cash items or accounting adjustments.
- Inform Stakeholders: Give investors, lenders, and management a clear picture of the company’s financial health to guide decisions.
By fulfilling these objectives, the cash flow statement provides insights into cash availability, helps evaluate the ability to generate funds, and aids in making well-informed financial decisions.
Format of a cash flow statement
The cash flow statement is always organised around three main activities, though the way operating cash flow is calculated can differ (direct or indirect method).
- Cash Flow from Operating Activities (CFO): This shows the cash generated or used by the company’s regular day-to-day business. Using the common indirect method, it starts with net profit and adjusts for non-cash items like depreciation and changes in working capital (e.g., stock, receivables, payables).
- Inflows: Cash from sales, interest received, dividends received.
- Outflows: Payments to suppliers, wages, taxes, rent, utilities.
- Cash Flow from Investing Activities (CFI): This shows cash spent or received from long-term investments and assets, reflecting the company’s growth activities.
- Inflows: Cash from selling property, plant, equipment (PP&E), or investments.
- Outflows: Cash spent on buying PP&E, investing in securities, or giving loans to others.
- Cash Flow from Financing Activities (CFF): This shows cash coming in or going out from borrowing, repaying debt, or dealing with shareholders, showing how the company funds itself.
- Inflows: Cash from issuing shares or borrowing loans/bonds.
- Outflows: Repaying loans, paying dividends, buying back shares.
How is a cash flow statement organised?
As mentioned above, a cash flow statement is divided into three main sections: operations, investing, and financing. These are outlined as follows:
Cash flows from operations (CFO)
The first section covers cash flows from operating activities (CFO) and includes transactions from the company’s core business operations. This section starts with net income and adjusts all non-cash items to reflect cash-based operational activities. In simple terms, it is the cash version of a company’s net income.
This section reports the cash inflows and outflows related to the company’s primary business activities, such as purchasing and selling inventory, paying employee salaries, and other operational expenses. Transactions like investments, debts, and dividends are excluded from this section.
Companies need to generate enough positive cash flow from operations to fund growth. If they cannot generate sufficient cash, they may need external financing for expansion. Having a firm grasp on the working capital cycle can help businesses manage cash flow more efficiently.
For example, accounts receivable is a non-cash account. If accounts receivable increase during a period, it indicates higher sales, but no cash was received at the time of the sale. The cash flow statement deducts these receivables from net income because they do not represent cash. This section may also include accounts payable (debts yet to be paid), depreciation, amortisation, and prepaid items recorded as revenue or expenses without corresponding cash flow.
Cash flows from investing (CFI)
The second section of the cash flow statement covers cash flows from investing activities (CFI). This includes investment gains and losses, as well as cash spent on property, plant, and equipment. Analysts often review this section to track changes in capital expenditures.
An increase in capital expenditures usually reduces cash flow. However, this may not always be negative, as it can signal that the company is investing in its future operations. Companies with high capital expenditures are often those experiencing growth.
Positive cash flows in this section, such as from the sale of equipment or property, are generally considered favourable. However, investors typically prefer companies to generate cash flow primarily from operations rather than selling assets.
Cash flows from financing (CFF)
The third section of the cash flow statement focuses on cash flows from financing activities (CFF). This section outlines how much cash is used or generated through business financing and tracks the financial interactions between a company and its owners or creditors. Cash flow here typically arises from debt or equity, such as the sale of stocks and bonds or bank loans. These figures are usually reported annually in the company’s 10-K report.
Analysts use the CFF section to see how much cash a company has distributed via dividends or share buybacks. This section is also helpful in understanding how a company raises capital for its operational growth. Cash obtained or repaid through capital-raising efforts and loans is recorded here.
A positive cash flow from financing indicates more cash is coming into the company than going out. Conversely, a negative number suggests the company is repaying debt, making dividend payments, or buying back shares.
How to prepare a cash flow statement?
Here's a step-by-step guide to preparing a cash flow statement:
1. Operating activities
- Start with net income from the income statement.
- Adjust for non-cash items like depreciation and amortization.
- Account for changes in working capital such as receivables, payables, and inventory.
2. Investing activities:
- List cash flows from buying and selling long-term assets.
- Include investments in securities or loans made by the company.
3. Financing activities:
- Record cash flows from issuing or repurchasing stock.
- Include cash from borrowing or repaying loans and bonds.
- Note dividends paid to shareholders.
4. Calculate net cash flow
- Sum all cash flows from operating, investing, and financing activities.
- Determine the net increase or decrease in cash for the period.
5. Reconcile with financial statements
- Ensure the ending cash balance reconciles with the balance sheet.
- Verify that net cash flow matches the change in cash reported on the balance sheet.
6. Finalise and analyse
- Review the cash flow statement for insights into liquidity and financial health.
- Use the statement to assess the company's ability to generate cash and manage its cash resources effectively.
Understanding capital structure and cost of capital can also influence a company’s financial management and its approach to funding growth while managing risk.
How is the cash flow statement used
A cash flow statement shows how money comes into and goes out of a business. It is important for checking liquidity, financial health, and the ability to pay debts. It helps investors and managers see if a company can generate cash, run its operations, invest in growth, and plan for the future. Unlike profits shown in the accounts, it tracks the actual cash from operating, investing, and financing activities, giving a clearer picture of the company’s finances.
Example of a cash flow statement
To understand how a cash flow statement works, let’s take a simple example of a small business “ABC Traders” for the financial year ending 2023. A cash flow statement shows how much cash the business earned, spent, and saved across three main areas: operations, investments, and financing.
- Operating activities: ABC Traders earned Rs. 10,00,000 by selling goods and services. Out of this, it spent Rs. 6,00,000 on salaries, rent, and other day-to-day expenses. This leaves a net cash flow of Rs. 4,00,000 from operating activities. A positive amount here means the business is running smoothly and earning well.
- Investing activities: The company spent Rs. 1,00,000 to buy a new delivery van. Since this is money spent on a long-term asset, it is recorded as a negative cash flow. This shows the business is investing to expand or improve operations.
- Financing activities: ABC Traders also repaid a loan of Rs. 50,000. This payment is shown as a cash outflow under financing, which includes money borrowed, repaid, or distributed as dividends.
- Net cash flow: After adding all the inflows and outflows, the business had Rs. 2,50,000 remaining at the end of the year. This is its final net cash flow, which shows that the business has enough cash to meet its needs and plan ahead.
Cash flow statement examples like this help in understanding whether a business is financially healthy and managing its money wisely.
Cash flow statement vs. fund flow statement
Here’s a comparison showing the difference between cash flow and a fund flow statement:
Aspect
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Cash Flow Statement
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Fund Flow Statement
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Purpose
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Shows inflows and outflows of cash during a specific period.
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Shows the sources and uses of funds, indicating changes in financial position.
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Focus
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Focuses on liquidity and cash management.
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Focuses on the overall financial health and working capital of a business.
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Components
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Operating Activities, Investing Activities, Financing Activities.
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Sources of Funds (like equity, loans), and Application of Funds (like asset purchase, debt repayment).
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Time period
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Typically covers a short-term period (monthly, quarterly, annually).
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Usually covers a longer period (annually).
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Basis
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Based on actual cash inflows and outflows.
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Based on changes in working capital and fund balances.
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Objective
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To assess the company's ability to generate and manage cash efficiently.
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To analyze changes in financial structure and fund flow between two balance sheet dates.
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Nature of transactions
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Only cash-based transactions are considered.
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Both cash and non-cash transactions affecting funds are considered.
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Types of activities
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Classified into Operating, Investing, and Financing Activities.
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Classified into Sources and Applications of Funds.
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Financial indicators
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Provides insights into cash liquidity and operational cash generation.
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Provides insights into the financial stability, capital structure, and fund management.
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Key analysis
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Cash position at the beginning and end of the period.
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Working capital movement between two balance sheet dates.
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Method of preparation
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Prepared using direct or indirect method.
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Prepared by analyzing changes in non-current assets, non-current liabilities, and working capital.
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Regulation
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Required by accounting standards (like IFRS and GAAP).
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Not mandated by accounting standards but useful for internal management analysis.
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Advantages of cash flow statement
Here are some of the advantages of cash flow statement:
- Clear liquidity analysis: The cash flow statement provides a clear view of a company's cash inflows and outflows, offering insight into its liquidity position.
- Effective cash management: It aids in managing cash by identifying periods of surplus or shortage.
- Performance evaluation: The statement helps assess the company’s operational efficiency and ability to generate cash from core activities.
- Investment insights: Investors use it to gauge a company’s ability to generate returns and manage debts.
- Predictive value: It assists in forecasting future cash flows, supporting strategic financial planning.
Disadvantages of Cash Flow Statement
While a cash flow statement is a useful financial tool, it has its limitations. Here are some of the key drawbacks to keep in mind:
- Does not reflect actual profitability: A cash flow statement shows cash inflows and outflows, but it doesn’t give a full picture of how profitable a company is. Non-cash items like depreciation and amortisation are excluded, which means it doesn’t capture the company’s true economic performance.
- Needs support from other financial reports: You cannot rely on the cash flow statement alone to understand a company’s financial position. To get the full picture, it must be read along with the income statement and balance sheet, which provide insights into revenue, expenses, assets, and liabilities.
- Based on past data: Cash flow statements are historical in nature. They show how the company managed its cash during a previous period, not what’s happening now. While useful for forecasting, they may not always reflect current business performance in a fast-changing market.
- Can be misread or misunderstood: A negative cash flow isn’t always a bad sign, it could mean the company is investing in growth. On the other hand, strong cash inflows could be due to selling off assets, which is not sustainable. Without proper context, it’s easy to draw the wrong conclusions.
Limitations of the cash flow statement
While the cash flow statement is essential for financial analysis, it has certain limitations that should be considered:
- Excludes non-cash items: The cash flow statement does not account for non-cash transactions such as depreciation or changes in asset values, which can limit the completeness of the financial picture.
- Based on historical data: It reflects past cash movements and may not accurately depict a company's current or future financial position due to timing differences.
- Does not include future cash flows: It focuses on past and present cash flows, ignoring projections or expected changes in cash flow.
- Limited profitability assessment: It does not directly measure net income or profitability, meaning a company can have strong cash flow but low profits, or vice versa.
Despite its utility, the cash flow statement has limitations, such as not accounting for non-cash expenses. It may not fully reflect a company's financial position, necessitating supplementary analysis for a comprehensive evaluation.
Conclusion
A cash flow statement is an important financial document that helps assess whether a company has sufficient liquid cash to meet its obligations and invest in future growth, which can also influence business loan eligibility. However, it alone cannot give a complete view of the company’s overall performance. To understand the broader financial health, one must also review long-term trends using the balance sheet and income statement alongside the cash flow statement, and use tools such as a business loan EMI calculator to estimate potential repayment commitments.
