Understanding the Cash Flow Statement

The Cash Flow Statement (aka- The Statement of Cash Flows) is a business’s financial statement that summarizes the amount of cash and equivalents entering and leaving the company. It is a measure of how well the company generates cash to pay its obligations and fund its operating expenses.  

For investors and lenders, this is the most valuable statement to understand where the money is coming from and how the money is being spent. This allows the reader of the statement to conclude whether the company is financially fit or not. The statement shows how much cash is available to pay expenses and debt, including future debt.

The Structure of the Cash Flow Statement

The components of the Cash Flow Statement are:

  1. Cash from operating activities
  2. Cash from investing activities
  3. Cash from financing activities
  4. Disclosure of noncash activities is sometimes included when prepared under the accepted policies of accounting principles.

Cash From Operating Activities

The first section of the Cash Flow Statement includes cash from operating activities. This is the income produced by the business during the daily sales of its products or services.

 These operating activities might include:

  • Receipts from sales of goods and services
  • Interest payments
  • Income tax payments
  • Payments made to suppliers of goods and services used in production
  • Salary and wage payments to employees
  • Rent payments
  • Any other type of operating expenses

It is important to understand that no matter what the business is, this activity is from the way the company makes money. 

How Cash Flow Is Calculated

The balance sheet and Profit and Loss Statements use non-cash items to calculate net income on the P&l and assets and liabilities on the balance sheet. Because of this, these items must be recalculated to determine the cash flow from operations.

As a result, there are two methods of calculating cash flow: the direct method and the indirect method. 

Direct Cash Flow Method

This method adds up all the various types of cash payments and receipts, including cash paid to suppliers, cash receipts from customers, and cash paid out in salaries. These are calculated by taking the difference between the starting and ending balances and determining the net increase or decrease. 

Indirect Cash Flow Method

Many businesses utilize the accrual accounting method where revenue is recognized when its earned and not when it is received. The indirect method makes adjustments to add back non=operating activities that do not affect the company’s operating cash flow. For example, depreciation is the amount deducted from the value of an asset (for age and use) that has previously been accounted for and is not a cash expense, so this is added back.

Accounts Receivable and Cash Flow

Changes to the balance of an accounts receivable account must be reflected, whether it is a net increase or decrease(AR), on the cash flow statement. A net decrease reflects cash coming into the company, whereas an increase to accounts receivable must be deducted from net sales, and does not represent revenue (it is not cash). 

Inventory Value and Cash Flow

An increase in inventory, on the other hand, signals that a company has spent more money to purchase more raw materials. If the inventory was paid with cash, the increase in the value of inventory is deducted from net sales. A decrease in inventory would be added to net sales. If inventory was purchased on credit, an increase in accounts payable would occur on the balance sheet, and the amount of the increase from one year to the other would be added to net sales.

The same logic holds true for taxes payable, salaries payable, and prepaid insurance. If something has been paid off, then the difference in the value owed from one year to the next has to be subtracted from net income. If there is an amount that is still owed, then any differences will have to be added to net earnings.

Cash From Investing Activities

This includes any sources and uses of cash from a company’s investments. A purchase or sale of an asset, loans made to vendors or received from customers, or any payments related to a merger or acquisition is included in this category. In short, changes in equipment, assets, or investments relate to cash from investing. 

Usually, cash changes from investing are a “cash-out” item, because cash is used to buy new equipment, buildings, or short-term assets such as marketable securities.. However, when a company divests an asset, the transaction is considered “cash in” for calculating cash from investing.

Cash From Financing Activities

Cash from financing activities includes the sources of cash from investors or banks, as well as the uses of cash paid to shareholders. Payment of dividends, payments for stock repurchases, and the repayment of debt principal (loans) are included in this category.

Changes in cash from financing are “cash in” when capital is raised, and they’re “cash-out” when dividends are paid. Thus, if a company issues a bond to the public, the company receives cash financing; however, when interest is paid to bondholders, the company is reducing its cash.


From this CFS, we can see that the cash flow for the fiscal year 2017 was $1,522,000. The bulk of the positive cash flow stems from cash earned from operations, which is a good sign for investors. It means that core operations are generating business and that there is enough money to buy new inventory. The purchasing of new equipment shows that the company has the cash to invest in inventory for growth. Finally, the amount of cash available to the company should ease investors’ minds regarding the notes payable, as cash is plentiful to cover that future loan expense.

Negative Cash Flow Statement

Of course, not all cash flow statements look this healthy or exhibit a positive cash flow, but negative cash flow should not automatically raise a red flag without further analysis. Sometimes, negative cash flow is the result of a company’s decision to expand its business at a certain point in time, which would be a good thing for the future. This is why analyzing changes in cash flow from one period to the next gives the investor a better idea of how the company is performing, and whether or not a company may be on the brink of failure or success.

Balance Sheet and Income Statement

As we have already discussed, the cash flow statement is derived from the income statement and the balance sheet. Net earnings from the income statement are the figure from which the information on the CFS is deduced. As for the balance sheet, the net cash flow in the CFS from one year to the next should equal the increase or decrease of cash between the two consecutive balance sheets that apply to the period that the cash flow statement covers. For example, if you are calculating cash flow for the year 2019, the balance sheets from the years 2018 and 2019 should be used.

The Bottom Line

A cash flow statement is a valuable measure of strength, profitability, and the long-term future outlook for a company. The CFS can help determine whether a company has enough liquidity or cash to pay its expenses. A company can use a cash flow statement to predict future cash flow, which helps with matters of budgeting.

For investors, the cash flow statement reflects a company’s financial health since typically the more cash that’s available for business operations, the better. However, this is not a hard and fast rule. Sometimes, a negative cash flow results from a company’s growth strategy in the form of expanding its operations.

By studying the cash flow statement, an investor can get a clear picture of how much cash a company generates and gain a solid understanding of the financial well-being of a company.

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