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What Is a Cash Flow Statement and Why Should You Prepare One?

Updated on January 21, 2018
Track your cash flow
Track your cash flow

What is a cash flow statement?

A cash flow statement is essentially a statement which captures the movement of cash in your business during a specified period for which it is prepared. Generally, it is prepared at the end of the year along with other financials, but it could be prepared at quarterly or monthly intervals. A cash flow statement is a snapshot of all the cash transactions that take place during the year. It does not report non cash transactions unlike the income and expenditure account or the profit and loss account. As a result, it forms an important decision making tool for managers and business owners. The health of a business can be gauged from this statement. In fact, continuous cash losses are an indicator of business or industrial sickness. A business can survive normal losses but cash losses often spell doom.

Profits arrived as per the accrual basis of accounting do not represent cash profits. This is because a profit and loss account records income earned and expenditure incurred and not income received and payments made in cash. So just because your profit earned for the year is $10,000 doesn't mean that you have $10,000 in cash from business, unless you only sell for cash and settle all expenses before the end of the year in cash. This is because sales consist of both cash sales and credit sales. Cash sales are sales for which cash is received immediately and the sale is concluded. However, in credit sales, the sale is recorded now but the cash is received at a future date. Maybe even next year or accounting period. A cash flow statement would capture only the cash sale.

Choice of Method

There are basically two ways in which cash flow statements are prepared:

  • The Direct Method
  • The Indirect Method

Both the methods give the same result. However, the manner and complexity of preparation varies. It would be more suitable for small businesses to follow the Direct Method owing to its simplicity. The Indirect Method is more complicated of the two and requires more time and details. The indirect method is usually prescribed for reporting requirements in many countries, especially for big business entities.

Direct Method

The direct method is the simplest and the most straightforward of the two. It comprises of the following components:

Cash flow from operating activities:

Essentially it captures sales made in cash during a period less all operating expenses paid in cash. Operating expenses include all expenses incurred to produce the product or service and exclude all expenses of Finance and Investment. Taxes paid on operating income are included here. The computation is as follows

  1. Cash sales
  2. Less cash operating expenses
  3. Less/Add net increase or net decrease in working capital changes.(This adjustment should be done only when cash sales figure is not available and total sales which includes credit sales also is taken)
  4. Less taxes on operating income

Cash flow from Investing Activities:

These are cash transactions involving the purchase and sale of property plant and equipment. Any taxes paid in relation to such sale or purchase are shown here. The sub total may be positive or negative. Excess purchase over sale shows negative balance and this indicates the business is in expansion mode. Excess sale is an indicator of disposal of property plant and equipment which is not a good sign.

Cash flow from Financing Activities:

These are transactions showing payment or receipt of loans, interest, dividend. Receipt of new share issues, bonds, all types of loans except loans for Investing Activities and the redemption of shares or bonds are also included. All taxes relating to Financing activities like transaction tax and dividend tax fall under this part. The sub total may be positive or negative. Positive means there is an influx of capital into the business and negative means repayments or redemption of debts. This part captures capital movement in cash.

Indirect Method

Indirect method is the same in structure as the direct method except in the case of cash flow from operating activities. The cash flow from operating activities is arrived at from the net profit or loss as indicated by the profit and loss statement in the financials. The computation is as follows:

  1. Net profit or loss as per the profit and loss statement
  2. Add back all non operating expenses (Finance and Investment expenses)
  3. Add back all non cash expenses
  4. Deduct all non operating income (Finance and Investment income or gains)
  5. Deduct all non cash income (Accrued income)
  6. Deduct net increase in working capital change or Add net decrease in working capital case respectively as the case may be.

Cash flow from the Investing and Finance income part is the same as in Direct Method.

It is essential to prepare a cash flow statement in order to track the flow of cash and funds in your business. Cash flow statements are invaluable because banks and financial institutions evaluate loan and credit proposals on the basis of cash flow statements

Perform cash analysis

Movement of cash
Movement of cash

Necessity for a cash flow statement

Cash flow statement is critical and invaluable for your business for the following reasons.

  1. It is essential to prepare a cash flow statement in order to track the flow of cash and funds in your business.
  2. Cash flow statements are invaluable because banks and financial institutions evaluate loan and credit proposals on the basis of cash flow statements.
  3. Cash flow statements are an important tool for business and performance analysis.
  4. Cash flow statement is an important tool for identification of inefficient cash management and to prevent leakage of cash.
  5. A good cash flow statement reflects the value of a business.

Prepare a cash flow statement today and take control of your business.


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