Cash Flow Statements: Definition and Importance- Complete Guide

Understanding cash flow is important to run your business smoothly. Every business needs to look after its functions keenly to evaluate the money they’re making and spending. By analysing these in-n-out flows, businesses make decisions on how to make smart and better money decisions.

Assets and liabilities are the crucial components in cash flow statements. It is recommended to track the assets and liabilities to assess the long and short-term functioning of the business. These insights combined help the business to plan and manage its financial responsibility.

What is a Cash Flow Statement?

A cash flow statement is a type of financial statement that shows how much a business's cash inflows and outflows are over a specific period. It has all the details of cash earned and spent with detailed sources. The cash flow statement helps the business to understand where they are positioned financially and how they can control the inflow and outflow of the cash to develop a better financial strategy.

It is a major statement that investors, managers, and accountants look at when making decisions about a business’s financial stability.

How Cash Flow Statements Work

The purpose of a cash flow statement is to provide a better understanding of how well a business is managing its financials. It provides precise ideas of future obligations, investment opportunities for further growth, and profits for the shareholders and the business itself. To understand how it works, three main components are important:

• Cash flow from operating activities: The business’s day-to-day cash transactions are recorded. Cash earned from customers and payments made to vendors indicated whether there is more of a cash inflow or cash outflow.

• Cash flow from investing activities: This determines the cash flow through purchasing or selling long-term assets. Positive cash flow means investment, and negative cash flow means disinvestment.
• Cash flow from financing activities: In this, the cash flow statement of a business displays the net flows of cash utilised to finance the business.

How the Cash Flow Statement is used

A cash flow statement assesses the business’s liquidity for various purposes. It shows whether the cash used is affecting the flow positively or negatively. If the business maintains a positive statement, the investors and stakeholders will invest more, resulting in better operation activities and a positive financial record.

By keeping track of operation activities a business can determine how well it is doing from its central activities. A good and stable cash flow statement indicates a possible expansion in the future. Detect any negative cash flow to turn it around on time and avoid any arising financial burdens.

Importance of a Cash Flow Statement

The cash flow statement is of great importance to the business. It helps analyse the primary usage of cash and how much working capital is needed in the business. Here are some points that depict the importance of a cash flow statement.

• Decision making: By analysing the cash flow statements the businesses can make smart decisions on where to invest the money or how to generate more money.

• Growth and expansion: With cash flow statements in the picture, the businesses can determine whether they have sufficient funds to grow or should focus on developing strategies to get more cash inflow.

• Onboarding investors: When investors look to invest in a business, they consider checking the cash flow statement to assess whether it is a beneficial investment based on their cash inflows and outflows.

• Avoid negative cash flow: By tracking the cash flow statements thoroughly, businesses can avoid financial stress by managing the cash flow promptly and avoiding negative cash flow.

Format of a Cash Flow Statement

Understanding the format of cash flow statements is beneficial in evaluating all the crucial details they contain. The format of the cash flow statement is as mentioned below:

Cash flow from operating activities:

Cash flow from investing activities:

• It records the cash generated from buying and selling long-term assets.
• It records the investment made in the form of properties, equipment and securities.
• The final step includes generating the net cash from investing activities.

Cash flow from financing activities:

• It records the cash transactions among the business owners and creditors.
• It records the cash paid while restocking inventory, paying the employees, etc.
• The final step includes generating the net cash from financing activities.

In the end, the cash is added and subtracted from all three activities and the final cash flow reveals whether the business has an increased cash flow or a decreased cash flow at the end of each financial year.

How Cash Flow is Calculated

Not all financial transactions use cash; some transactions do not include cash. To determine how cash flow is calculated, there are 2 methods involved - Direct and Indirect.

Direct cash flow method

This method offers more transparency and provides detailed cash flow in the business. Cash payments to suppliers, cash received from customers, and cash paid for salaries are all totalled using the direct method. The difference between each account's starting and ending balances on the balance sheet is how you get these figures. The direct Cash flow method will enable you to calculate the net change in cash in these accounts, if any.

Indirect method

The net income must be changed from the accrual basis to the cash basis to compute cash flow using the indirect method. Many businesses prefer this method as it is less complex and not time-consuming.

Cash flow statement using indirect method -

What is Negative Cash Flow?

You have negative cash flow when your business's cash outflow exceeds its inflow. Sales are not enough to pay your bills. Rather, you require funds from loans and investments to make up the shortfall.

New businesses frequently experience negative cash flow. However, a business with negative cash flow over the long run cannot survive. If your profit margin is insufficient to pay your costs, eventually, you will run out of money.

Refer to the table below to understand the negative cash flow.

Cash flow statement

It is evident from the above statement that the company's cash flow is negative. The business suffered losses due to the costs it incurred.

Remember, cash flow is more than just a statement. This statement throws insights into your business’s financial position and growth. Duly maintain a healthy and positive cash flow to avoid a bad reputation and negative cash flow.

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