Cash Flow Statement: Meaning, Importance, Examples, Structures, How to prepare it, Advantages and Disadvantages

The cash flow statement is an essential financial report that records a company’s cash inflows and outflows during a specific time frame. It is divided into three sections - operating, investing, and financing activities and offers a clear picture of a business’s liquidity and cash management within the business environment. This statement supports decision-making by helping stakeholders evaluate short-term financial health, plan operations, and assess investment potential. Prepared using either the direct or indirect method, it highlights cash-based transactions but does not include non-cash items. Compared to the fund flow statement, it gives a more immediate, cash-oriented view suited for the dynamic nature of today’s business environment.

What is a cash flow statement?

A cash flow statement is one of the primary financial statements that businesses and investors use to gauge a company's financial performance and health. It provides detailed insight into how a company receives and uses cash in a specific period. The statement encompasses cash activities across three categories: operating, investing, and financing.

By analysing a cash flow statement, stakeholders can gauge a company's liquidity, its ability to cover expenses, pay dividends, and reinvest into business growth. Furthermore, understanding the cash flow statement can also shed light on how effective the company is at utilising its cash resources. For startups that need to manage their cash prudently, exploring startup business loans can provide crucial financial support in the early stages.

Different types of cash flow statements

A cash flow statement is a financial document that provides a detailed summary of a company’s cash inflows and outflows over a specific period. It is divided into three main sections: operating activities, investing activities, and financing activities.

1. Operating activities: Includes cash generated from core business operations, such as sales and payments to suppliers.
2. Investing activities: Reflects cash spent on or received from the purchase and sale of assets, like equipment or investments.
3. Financing activities: Encompasses cash flows from transactions with the company’s investors, such as issuing shares or paying dividends.

By analysing these sections, stakeholders can assess the company's liquidity, financial health, and long-term viability.

Importance of a cash flow statement

For any business to succeed in a competitive business environment, maintaining adequate cash is essential. This ensures it can repay loans, purchase goods, and invest for growth. A shortage of cash, even in a profitable business, can lead to insolvency. The cash flow statement plays a vital role in managing this aspect effectively. Here's how:

• Tracks actual cash spending: It provides a detailed view of the company’s cash transactions, including payments to creditors and expenses not shown in other statements, like inventory purchases, equipment buying, or extending credit to customers.
• Maintains the right cash balance: The statement helps assess whether the business is holding too much or too little cash. Excess funds can be invested or used to expand inventory, while shortfalls highlight the need for additional financing.
• Highlights cash generation methods: Beyond profits, it draws attention to other cash-generating actions, like negotiating better deals, reducing costs, or speeding up customer payments, that boost liquidity.
• Supports short-term financial planning: By analysing past cash inflows and outflows, businesses can better prepare for upcoming obligations. This insight helps prevent cash shortages, manage debts, and even strengthens the case when applying for bank credit.

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: Records cash generated from primary business operations, such as sales revenue, payments to suppliers, and salaries to employees.
• Investing activities: Highlights cash flows related to investments in assets, like property, equipment, or securities, as well as proceeds from asset sales.
• Financing activities: Tracks cash flows from sources like loans, equity issuance, or dividends paid to shareholders, reflecting how the company funds its operations and expansion.
• Net cash flow: Summarises the overall cash position by combining cash flows from operating, investing, and financing activities, indicating whether there was a net increase or decrease in cash during the period.
• Supplementary information: Includes additional details to enhance understanding, such as non-cash transactions, exchange rate effects, and significant investing or financing events.

Objectives of cash flow statement

The cash flow statement plays a key role in assessing financial health and cash management. Its main purposes include:

• Measuring cash generation: Analysing how much cash is produced from daily operations to ensure there is enough to cover expenses and financial commitments.
• Monitoring cash usage: Tracking how cash is allocated for investments and financing activities, such as acquiring assets or repaying loans, to determine the effectiveness of financial decisions.
• Assessing liquidity and solvency: Ensuring there is sufficient cash available to meet short-term payment obligations and financial responsibilities.
• Identifying cash flow patterns: Recognizing trends and fluctuations in cash flow over time to support better financial planning and decision-making.
• Reviewing cash management strategies: Evaluating how efficiently cash is handled, including inflows and outflows, to enhance financial operations.
• Supporting financial analysis: Offering a clear picture of cash sources and utilization, helping investors, lenders, and stakeholders assess financial stability and performance.

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

A cash flow statement is divided into three main sections, each showing different types of business cash movement. Here's a brief overview in simple pointers:

• Operating activities: This section covers cash earned or spent during core business operations. It includes transactions like sales receipts, employee salaries, rent, tax payments, and inventory costs. It starts with net income and adjusts for non-cash items to show true operational cash flow.
• Investing activities: It reflects cash movement related to buying or selling assets such as property, plant, or equipment. A key component here is capital expenditure (CapEx), which indicates long-term investments. Negative cash flow in this section is common during growth phases.
• Financing activities: This section tracks cash exchanged with lenders and investors. It includes proceeds from loans or equity and outflows like dividend payments or debt repayments. It reveals how a business funds its operations and expansion.

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

The cash flow statement is a pivotal financial tool used to evaluate a company's financial performance. It offers insights into the sources and uses of cash, aiding in decision-making regarding investments, financial planning, and business operations.

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	Cash Flow Statement	Fund Flow Statement
Purpose	Shows inflows and outflows of cash during a specific period.	Shows the sources and uses of funds, indicating changes in financial position.
Focus	Focuses on liquidity and cash management.	Focuses on the overall financial health and working capital of a business.
Components	Operating Activities, Investing Activities, Financing Activities.	Sources of Funds (like equity, loans), and Application of Funds (like asset purchase, debt repayment).
Time period	Typically covers a short-term period (monthly, quarterly, annually).	Usually covers a longer period (annually).
Basis	Based on actual cash inflows and outflows.	Based on changes in working capital and fund balances.
Objective	To assess the company's ability to generate and manage cash efficiently.	To analyze changes in financial structure and fund flow between two balance sheet dates.
Nature of transactions	Only cash-based transactions are considered.	Both cash and non-cash transactions affecting funds are considered.
Types of activities	Classified into Operating, Investing, and Financing Activities.	Classified into Sources and Applications of Funds.
Financial indicators	Provides insights into cash liquidity and operational cash generation.	Provides insights into the financial stability, capital structure, and fund management.
Key analysis	Cash position at the beginning and end of the period.	Working capital movement between two balance sheet dates.
Method of preparation	Prepared using direct or indirect method.	Prepared by analyzing changes in non-current assets, non-current liabilities, and working capital.
Regulation	Required by accounting standards (like IFRS and GAAP).	Not mandated by accounting standards but useful for internal management analysis.

Understanding and managing cash flow is critical for businesses. The cash flow statement provides valuable insights, helping businesses make informed decisions and maintain financial stability. Explore the business loan from Bajaj Finance for financial support in managing your business's cash flow.

Advantages of cash flow statement

Here are some of the advantages of cash flow statement:

1. 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.
2. Effective cash management: It aids in managing cash by identifying periods of surplus or shortage.
3. Performance evaluation: The statement helps assess the company’s operational efficiency and ability to generate cash from core activities.
4. Investment insights: Investors use it to gauge a company’s ability to generate returns and manage debts.
5. 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. 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.