How to Read & Understand A Cash Flow Statement
Whether, you’re a working professional, business owner, an entrepreneur or an investor, knowing how to read and understand a cash flow statement can enable you to extract important data about the financial health of the company.
If you’re an investor, the information can help you better understand whether you should invest in a company or not. If you are a business owner or entrepreneur, it can help you understand business performance and make strategies. If you’re a manger, it can help you more effectively manage budgets.
Not everyone has finance or accounting expertise. For non-financial professionals we at “B4INVESTING” help you understand the concept behind a cash flow statement and other financial documents. To facilitate this understanding, here’s everything you need to know about how to read and understand a cash flow statement.
What is a Cash Flow Statement?
The purpose of a cash flow statement is to provide a detailed picture of what happened to a company’s cash during a specific period. It demonstrates an organization’s ability to operate in short and long term, depending upon how much cash is coming in and going out of the business.
The cash flow statement is divided in three parts:
- Operating activities: the detail cash flow that’s generated once the company deliver its regular goods and services, it includes both revenue and expenses.
- Investing activities: it includes cash flow from purchasing or selling assets; like real estate or vehicles or patents—using free cash, not debt.
- Financing activities: it includes detail cash flow from both debt and equity.
Based on the cash flow statement, you can see how much cash different types of activities generate then make business decisions based on the analysis. Ideally, a company’s cash from operating income should always exceed its net income, because a positive cash flow speaks to a company’s ability to remain solvent and grow its operations. It’s important to remember that cash flow statement is different from profit statement, it is therefore always interpreted together with balance sheet and profit &loss statement.
How is Cash Flow Statement Calculated?
After understanding the basics of cash flow statement, let’s look into two common methods of calculating and preparing a cash flow statement:
- Cash Flow Statement Direct Method:
The Direct Method is based on the transactional information that impacted the cash during a specific period. To calculate, we take all cash collections from operating activities and subtract all the cash disbursement from the operating activities.
- Cash Flow Statement Indirect Method:
The Indirect Method is based on the accrual accounting method in which the accountant records revenues and expenses at times other than when cash was paid or received i.e. these accrual entries and adjustments cause the cash flow from operating activities to differ from net income. Instead of organizing transactional data like the direct method, the accountant starts with the net income number found from the income statement and makes adjustments to undo the impact of the accruals that were made during the period. Identifying any non-cash expenses and making adjustments; like depreciation etc.
How to Interpret a Cash Flow Statement?
Financial document is made to give an insight about the financial health of an organization. Cash Flow Statement can reveal what phase a business is in: whether it’s rapidly growing startup or a mature and profitable company. It also reveals if a company is going through transition or in a state of decline. Using this information an investor might decide that a company with uneven cash flow is too risky to invest in, or they might decide that a company with positive cash flow is primed for growth. Similarly, a department head might look at a cash flow statement and understand how their particular department is contributing to the health and wellbeing of the company and accordingly adjust their activities.
Cash flow also impact the internal decisions like budgeting, or the decision to hire or fire an employee. Cash flow can be either POSITIVE or NEGATIVE.
Positive Cash Flow:
It indicates that a company has more money flowing into the business than out of it over a specific period. This is an ideal situation because having excess cash allows company to reinvest in itself and its shareholders, settle debts and find new ways to grow business. Positive cash flow does not necessarily translate into profit as it can because of the loan taken to operate the company.
Negative Cash Flow:
Having negative cash flow means your cash outflow is higher than the cash inflow during a period, it doesn’t necessarily mean profit is lost. It may be caused by expenditure and income mismatch, which should be addressed as soon as possible. It can also be due to expansion or investment for future growth.
Hence it is necessary to analyze change in cash flow from one period to another, which can indicate how a company is performing overall.
The Bottom Line:
A cash flow statement is a valuable measure of strength, profitability and long term future outlook of a company. It can determine whether a company has enough liquidity or cash to pay its expenses. It helps in prediction and budgeting. For investors its reflection of the company’s financial condition. But this is not the only document that should be taken into consideration. The balance sheet and profit & loss statement should be analyzed in tandem as well.
But, Be Careful!!!