Note: this article is part of our guide to cash flow management.
There are a handful of documents that can provide you with insights into the health of your company. One of those documents is the cash flow statement, which essentially tracks all the money coming in and going out of a business at any point in time.
Having a clear understanding of how to create, read, and use a cash flow statement can make it easier to manage your company’s cash flow. As your startup scales, your chief financial officer (CFO), accountant, and other members of the finance team can use the cash flow statement to help inform their strategic decisions to increase your cash inflows and lower outflows.
Even companies with healthy profits may face cash flow issues that could make it difficult to sustain the business if they don’t have the necessary amount of cash.
What is the purpose of a cash flow statement?
The purpose of a cash flow statement, also known as a statement of cash flows or SCF, is to provide a summary of how much cash or cash equivalents (short-term investments like money market funds or treasury bills that a company could quickly convert to cash) is flowing through a company over a specific period.
Like the income statement, the cash flow statement shows a change in funds over time, while the balance sheet is a snapshot of a company’s finances on a specific date such as the end of a month, quarter, or year.
For companies that use accrual accounting, the cash flow statement can provide a window into the exact cash position of a company and how it’s changing, without including accounting non-cash costs that can skew the appearance of the cash position on other financial documents.
If a company has more money going out than coming in over time, it has a “negative cash flow” during the cash flow statement period. That may indicate an issue for the company, but for growing startups a negative cash flow may simply show that the company is investing back into the business and may not yet be profitable. In a company’s early days, the founders may be more focused on building business momentum than generating a profit for the business.
A company with positive cash flow typically has more liquidity than a company with a negative cash flow. Tracking your cash on hand and burn rate is particularly important to maintaining the health of your company during a period of market cooling like the one we may be entering. You can use the information on a cash flow statement to calculate a company’s free cash flow, which is another metric investors consider when assessing the health of a company.
Cash flow statements are also one of the documents necessary to perform a spend analysis of your company, a process that can help identify supply chain inefficiencies, reduce procurement costs, and otherwise set the company up for success. Low or negative cash flow could be a sign that the company needs to make changes—whether that’s decreasing costs or increasing prices—to improve the company’s profit margins and lower cash outflows relative to inflows.
How to read a cash flow statement
Typically, a cash flow statement will have three sections, each of which may show cash coming and cash going out during a period of time. While each section is connected, the expenses and revenues that appear in one do not appear in others.
- Operating activities: This section includes revenues and expenditures and shows cash flow created through the company’s business delivering goods or service as well as the expenses associated with producing or providing them. These might include payment for products, income tax payments, accounts payable, and accounts receivable. Under U.S. Generally Accepted Accounting Principles (GAAP), interest payments and receipts also appear in this section.
- Investing activities: This section shows cash flows that the company generates via buying or selling assets with cash-based transactions. This includes CapEx on things like property, plant & equipment, real estate, or vehicles.
- Financing activities: Cash flows in this section result from the company’s financing activities, including both debt and equity
If the ending balance on the cash flow statement is higher than the starting balance, that means that the company is profitable, while the opposite means that the company is not profitable. The more cash a company has, the more flexibility it has in its operations, and the more likely it is to be able to pay current and future bills.
Keep in mind that the data on a balance sheet and an income statement can appear significantly different, due to several factors such as the company’s approach to revenue recognition, or a reliance on assets with high upfront costs that depreciate over time.
What can you learn from a cash flow statement?
Typically, business owners use this statement, along with other financial documents such as the company’s balance sheet and income statement, to get a full picture of the company’s financial performance and overall health.
Cash flow statements can also give you insight into actions to improve a company’s cash flow or liquidity. For example, moving to align your billing cycles with your net payment terms could help avoid the cash crunch that comes with poor cash flow management.
2 methods used to produce a statement of cash flow
Businesses typically use one of two different methods to produce their cash flow on operating activities. When done correctly, both methods should result in the same ending balance.
Indirect cash flow method
This method uses the company’s net income statement as a starting point and calculates cash based on operating activities and adds back in any non-cash expenses booked during the period, such as depreciation or amortization.
Direct cash flow method
This method itemizes all cash expenses and inflows using receipts and invoices. This method provides a more detailed look at where your cash is going and may be more useful for planning purposes, but it can also be more time consuming.
How to prepare a cash flow statement in 5 steps
The steps to create a cash flow statement are relatively straightforward. For very small companies, there may be some months or quarters where there is no cash flow from operating or investing activities. Depending on the size of a company and the complexity of the business, its cash flow statement could fit on just one page, or span multiple pages with dozens of line items.
Step #1: Determine your starting balance
Since the cash flow statement looks at the change in a company’s cash position over a specific period, you’ll need to choose a starting date for that period. Your starting balance will be the amount of money the company had on hand on that date.
Step #2: Calculate cash flow from operating activities
This is typically the first section in a cash flow statement. Using either the direct or indirect method discussed above, subtract expenses, like rent, inventory, and insurance, and add in revenues recorded during the period covered by the cash flow statement. If you provided services in January, for example, but got paid in February, the revenue would appear in the cash flow statement in February.
Step #3: Calculate cash flow from investing activities
This section is where you record any transactions involving assets (aside from those using debt and equity). If your company bought real estate or a patent, for example, or sold vehicles or equipment, you would include those under cash flow from investing activities.
Step #4: Calculate cash flow from financing activities
If your company issued equity or used debt during the cash flow statement period, this is the section where you would include that.
Step #5: Determine your ending balance
Once you’ve calculated the cash flow from operating activities, investing activities, and financing activities, you can use that information to figure out the ending cash flow for the reporting period. Simply add up the cash flow from each of the three sections (including negative numbers) and subtract that from the starting balance.
The difference between your starting balance and the ending balance are your net cash flows. Negative net cash flows mean the company is losing money, while positive net cash flows mean the company is profitable.
Why does my business need a cash flow statement
In addition to providing useful insights that you can use to shape strategy, your company may also need a cash flow statement to show others evaluating the business. Potential lenders, investors, partners, and acquirers typically all use company cash flow statements when conducting due diligence on a company.
While you can get a sense of a company’s ability to pay its bills using a quick ratio, the cash flow statement provides a more nuanced look at an organization’s cash position. The cash flow statement can also surface potential issues, such as overspending or low profit margins.
Track and control your cash flow with Ramp
While manually building a cash flow statement is a helpful exercise, it’s also timely and inefficient. Luckily you don’t need to be an accounting whiz or Excel expert to build one or us it to manage your software.
Using expense management and accounting software like Ramp, makes this process fast and reliable. The digital transformation or accounting tools and the advent of finance automation makes it easy for you to level up your finance function and scale your business more effectively.
Ramp can centralize the records of your company’s transaction, making expense recognition and the creation of financial documents much easier. Automating expense management and recognition can also make your accounting team more efficient, freeing up team members to focus on more high-value projects.
Click here to learn more about how Ramp can save you time and money by removing the stress of cash flow management.