You don't have to have an accounting degree to make wise business decisions. Entrepreneurs running a start-up, corporate department managers, and small business owners need enough bookkeeping knowledge to understand basic financial statements. Financials help you keep a watchful eye on the financial strength and performance of your organization. And, they help you spot potential problems early enough to make adjustments to your purchasing and spending habits before they become detrimental to success. Financial statements also provide a snapshot of business activities to share with lenders, board members and investors.
Understanding the Statement of Cash Flows, sometimes simply called cash flow statements, is essential for anyone who makes financial decisions for a company. After reading this article, you will know what goes into a Statement of Cash Flows.
Let's get started.
Statement of Cash Flows Fundamentals
The Statement of Cash Flows provides a single document of revenue (cash generated) and expenditures for a given period of time. The statement may cover a month, quarter, year or other defined period of time. This financial document creates a bridge between the Balance Sheet and the Income Statement, showing exactly how cash moves in and out of a business.
Three Key Transaction Categories
Revenue-generating transactions (assets) and expenditure transactions (liabilities) are broken into three categories: Operating transactions, investment transactions and financing transactions. Transactions represent both incoming (positive) and outgoing (negative) business activities. The primary goal of creating a Statement of Cash Flows is to accurately determine the actual cash or cash equivalent on hand at a particular point in time.
To get started, we'll look at what type of activity goes into each category.
Operating transactions represent adjustments to asset and liability balances during the predetermined period. This category lists the beginning net income balance (pulled from the most recent P&L) and adjustments for prepaid liabilities (like payroll taxes and business insurance), accrued expenses not paid, but due, and money in transit. Money in transit includes items like bank drafts still in process. Anything that is not an investing or financing activity falls into this category.
Investment transactions included generated income and capital expense items. For example, you would list income or expenses related to acquiring or selling equipment and the purchase of stocks and bonds. Proceeds of marketable securities sales would also belong in this category.
Cash flow financing transactions change the size, scope or composition of an organization. They may involve equity, debt and dividend activities. Financing activities fund the company. The cash flow statement is a way to gauge a company's financial strength, and financing activities are key metrics in that process.
Lenders (and potential investors) may use this information to calculate risks based on a company's financial health. Cash flow from financing activities demonstrates activities between creditors, owners, partners, investors and the business. Some activities create positive cash flow, while others have a negative effect.
Positive Effect Transaction may include items such as:
- Selling equity or stock to investors
- Securing a loan from a lender
- Issuing bonds
Negative Effect Transactions may include items such as:
- Paying dividends
- Stock buybacks
- Debt reduction payments
A company taking on new debt or initiating stock buybacks are not automatically signs of distress. But negative effect transactions can cause investors to take a closer look at what triggers certain activities. It is important to note here that even a positive net cash flow can be a red flag if the company is already dealing with heavy debt as interest rates rise and debt serving costs escalate.
Investors and lenders often use a standard formula to evaluate the financial health of a company before approving a loan or investment proposal. Buy adding incoming cash from issuing debt or equity, debt reduction payments and stock buybacks together; then, subtracting all outflows from financing activity, you reach a net cash flow from financing activity total.
In the chart above, even though the net cash for the period represented is a negative number, the company appears to be healthy because the majority of the shortfall is created by debt reduction, company stock purchases and dividend payments. These are "good" indicators because reducing debt improves valuation. Likewise, paying dividends promptly demonstrates the company is transparent and responsible to their stakeholders.
Here's an example using real numbers that explains the Cash Flow from Financing (CFF) formula in more detail.
Let's say Company XYZ spends $1 million for stock buybacks, $10 million on dividend payments and $1 million for long-term debt reduction between March 1st and March 31st. During the same period, the company has a $2 million cash inflow from long-term debt proceeds.
The CFF formula would look like this:
$2,000,000 - ($1,000,000 -$10,000,000 - $1,000,000) = -$10, 000,000
At first glance, the above example sure looks like a company hemorrhaging cash! And, would most likely trigger a deeper dive to see what is driving the negative cash flow! However, as stated earlier, the closer look at each category demonstrates the outflow was according to best practices that improve financial health.
Key Take Aways
Financial statements are written documents that demonstrate business activities, and the overall performance of an organization. The cash flow statement is a financial document that conveys how well (or, how poorly) a company generates revenue, funds its operations and investments, and pays recurring, short-term, and long-term debt. The Statement of Cash Flows is one of the three major financial records every business leader needs to know how to interpret and leverage to inform financial business decisions.