Cash is the lifeblood of any business. Without adequate cash flow, companies cannot pay employees and suppliers, invest in growth, or navigate challenging economic times. That’s why reviewing a company’s cash flow statement is so important for assessing its financial health.
In this article, we’ll explain what the cash flow statement is, its key components, and why it provides valuable insights that the income statement and balance sheet do not.
What is the Cash Flow Statement?
The cash flow statement records the actual flow of cash into and out of a business over a set period, usually quarterly and annually. It has three sections:
- Cash Flow from Operations
- Cash Flow from Investing
- Cash Flow from Financing
The net amount of cash at the end of the reporting period can be compared to the cash balance at the beginning of the period to understand if more cash is entering or leaving the business.
Cash Flow from Operations
The cash flow from operations section outlines the amount of cash generated from the company’s core business operations. This includes cash earned from sales of products and services, minus cash paid out for operating expenses like inventory, employee wages, rent, etc.
The cash flow from operations is often considered the most important section because it represents the viability of the company’s core business model for generating cash. If this number is consistently negative, it is a major red flag.
This section can be calculated using two methods:
Direct Method – Lists actual cash transactions from operating activities like receipts from customers or payments to vendors.
Indirect Method – Starts with net income from the income statement, then adjusts for non-cash items like depreciation to arrive at cash from operations.
Most companies use the indirect method because net income is readily available. While less intuitive than the direct method, it is easier to prepare.
Cash Flow from Investing
This section outlines the amount of cash used for or provided by investing activities. Common examples include:
- Cash used to purchase new property, plants, equipment
- Cash used to acquire other companies or investments
- Cash received from sale of assets like property or equipment
Reviewing this section helps determine where a company is allocating cash for growth initiatives. Increased investment may foreshadow expansion plans or new products.
Cash Flow from Financing
The financing section summarizes the cash flow from raising capital or borrowing funds and repaying debt. For example:
- Cash received from issuing new shares or bonds
- Cash received from new loans
- Cash paid out as dividends to shareholders
- Cash paid to repay loan principal
Analyzing financing activities helps gauge a company’s ability to access credit and manage debts. Taking on more debt financing may indicate aggressive expansion plans.
Conclusion
While the income statement and balance sheet provide snapshots of a company’s profitability and financial position, the cash flow statement offers crucial insights on cash entering and leaving the business.
Reviewing the cash flow statement, particularly the cash from operations section, helps assess a company’s financial health and management of cash flow. This is critical for sustaining operations, investing in strategic initiatives, and navigating downturns.