Whether you’re a working professional, business owner, entrepreneur, or investor, knowing how to read and understand a cash flow statement can enable you to extract important data about the financial health of a company.
If you’re an investor, this information can help you better understand whether you should invest in a company. If you’re a business owner or entrepreneur, it can help you understand business performance and adjust key initiatives or strategies. If you’re a manager, it can help you more effectively manage budgets, oversee your team, and develop closer relationships with leadership—ultimately allowing you to play a larger role within your organization.
Not everyone has finance or accounting expertise. For non-finance professionals, understanding the concepts behind a cash flow statement and other financial documents can be challenging.
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 business’s cash during a specified period, known as the accounting period. It demonstrates an organization’s ability to operate in the short and long term, based on how much cash is flowing into and out of the business.
The cash flow statement is typically broken into three sections:
Operating activities
Investing activities
Financing activities
Operating activities detail cash flow that’s generated once the company delivers its regular goods or services, and includes both revenue and expenses. Investing activities include cash flow from purchasing or selling assets—think physical property, such as real estate or vehicles, and non-physical property, like patents—using free cash, not debt. Financing activities detail cash flow from both debt and equity financing.
Based on the cash flow statement, you can see how much cash different types of activities generate, then make business decisions based on your analysis of financial statements.
Ideally, a company’s cash from operating income should routinely 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 note that cash flow is different from profit, which is why a cash flow statement is often interpreted together with other financial documents, such as a balance sheet and income statement.
HOW CASH FLOW IS CALCULATED
Now that you understand what comprises a cash flow statement and why it’s important for financial analysis, here’s a look at two common methods used to calculate and prepare the operating activities section of cash flow statements.
Cash Flow Statement Direct Method
The first method used to calculate the operation section is called the direct method, which is based on the transactional information that impacted cash during the period. To calculate the operation section using the direct method, take all cash collections from operating activities, and subtract all of the cash disbursements from the operating activities.
Cash Flow Statement Indirect Method
The second way to prepare the operating section of the statement of cash flows is called the indirect method. This method depends on the accrual accounting method in which the accountant records revenues and expenses at times other than when cash was paid or received—meaning that 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.
Essentially, the accountant will convert net income to actual cash flow by de-accruing it through a process of identifying any non-cash expenses for the period from the income statement. The most common and consistent of these are depreciation, the reduction in the value of an asset over time, and amortization, the spreading of payments over multiple periods.