How Is a Cash Flow Statement Prepared?

What is a cash flow statement?

A cash flow statement is a report that states how much money your business has earned and spent over a certain period. Cash flow statements also show you how much money you have on hand, as well as cash equivalents, like bank deposits, short-term investments and other assets that can be converted into cash. This does not include credit items, like invoices you’ve sent but haven’t yet received payment on or bills that you’ve received but haven’t yet paid.

“A cash flow statement is a great tool to give business owners insight into where their actual cash is spent, since most businesses are run on an accrual basis,” said Katie Thomas, a certified public accountant and corporate controller at Upward Projects restaurant group.

How is a cash flow statement prepared? 

The easiest way to create a cash flow statement is to use small business accounting software to generate it as a report. If you don’t like using accounting software, or your program doesn’t have this option, you can use free cash flow statement templates available online.

Wherever you choose to get the basic format for your cash flow statements, it’s important to decide whether you will use the direct method or the indirect method for the calculation.

Indirect method

Many businesses use the indirect method because it’s simpler. Starting with your company’s net income statement (i.e., profit and loss statement), you add or subtract the increases or decreases, using the line items from the balance sheet. Keep in mind that a company’s income statements are done on an accrual basis, so only earned revenue (not received earnings) is considered.

The indirect method includes nonoperating activities that don’t affect a business’s operating cash flow. Depreciation, for example, isn’t a cash expense, but it is used to calculate cash flow.

Direct method

The direct method uses gross cash receipts and gross cash payments to prepare cash flow statements. This includes money paid to suppliers, receipts from customers, interest and dividends received, cash paid out or received, interest paid and income taxes paid.

The direct method is more time-consuming because, unlike the indirect method, it requires you to track operating cash receipts and payments for every transaction. You also must reconcile your cash flow statement with your income statement. Learn more about what’s included in a cash flow statement below.

What is the purpose of a cash flow statement?

A cash flow statement allows you to see the financial status of your company —  specifically, whether you’re bringing in enough money to pay the bills.

For instance, if a cash flow statement indicates you have a deficit, you may need to make some changes to increase your cash flow, such as raising prices or shortening your payment terms. Or, if you have a cash surplus, you may decide now is a good time to buy new equipment.

Additionally, a cash flow statement, along with your balance sheet and income statement, is often required by banks or investors when you seek financing. Using your cash flow statement, the lender can determine if your business is fiscally sound and will be able to repay the loan or investment. [Review this roundup of cash flow problems and how to solve them.]

What is included in a cash flow statement?

A cash flow statement has three parts: operating activities, investing activities and financing activities.

Operating activities

The operating activities section of the cash flow statement shows how much cash you have coming in and going out as part of your daily business operations within a specific period. It includes money you spend on materials and payroll, as well as money you bring in from sales. 

Investing activities

The investing activities section shows the amount of cash you’ve earned or spent on long-term investments within a specific period. In addition to stocks and bonds, investments can include the buying or selling of large assets, such as buildings, property or equipment.

Financing activities

The financing activities section shows how your business raises its capital and pays back its debts. Anything associated with loans or the issuing or buyback of stocks is included in this section.

What are the limitations of a cash flow statement?

A cash flow statement is a good tool for examining your past financial decisions, but it doesn’t help you predict your business’s future.

“A cash flow statement is historically based,” said Katie Swanson, a certified public accountant, certified valuation analyst and founder of Change Collaborative. “It does not help a business look forward to manage cash today, next week or a month from now. Business owners are concerned with the ongoing operations of their business, not what happened last year.”

Swanson also noted that business owners who don’t have a background in accounting may find it hard to understand cash flow statements.

“The information is not presented in a way that makes sense to non-accountants,” she said. “Therefore, the information is difficult for small business owners to use when making decisions.”

How is cash flow calculated?

The easiest way to calculate cash flow is to run a cash flow report in your accounting software. If you plan to calculate it manually, you’ll need your balance sheet and income statement.

Cash flow statements are made up of two main parts: operating cash flow and financing cash flow.

Operating cash flow

Operating cash flow comes from the daily work within your business. It is made up of your net profit or loss and changes in assets and liabilities between periods. In its simplest form, operating cash flow comprises the following parts: 

Operating cash flow = net income + depreciation + other noncash charges – increase in net working capital 

Financing cash flow

Financing cash flow is made up of changes in your bank debt, shareholder debt and other long-term debt between periods. You can use this equation to calculate financing cash flow: 

Financing cash flow = cash from equity/debt issuance – (dividends + repurchase of debt/equity)

Net cash flow

In a cash flow statement, the goal is to measure your operating cash flow and financing cash flow. This simple formula leads to your net cash flow: 

Net cash flow = operating cash flow + financing cash flow

Operating cash flow and financing cash flow both fluctuate over the short term, depending on the needs and performance of the business. Over the long term, however, cash flow must be positive if the business is to survive.

How do accounts payable and accounts receivable relate to cash flow?

It’s vital to understand the difference between accounts receivable and accounts payable, because both affect your cash flow. Accounts payable refers to the money your company owes its suppliers, and accounts receivable are what your customers owe you. 

To calculate the amount of cash flow affected by your accounts payable, subtract the current period’s dollar amount for accounts payable from the last period. If the difference is a positive amount, your cash flow has increased by that number within that period. If the number is negative, it means cash flow has gone down by that dollar amount.

For accounts receivable, the calculation is the same. However, when the difference is a positive number, this is considered the use of cash and represents the dollar amount by which your cash flow has decreased. A negative number represents how much your cash flow has increased.

Mike Berner contributed to this article. Source interviews were conducted for a previous version of this article.