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Cash Flow Statements: Definition and Importance- Complete Guide
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A cash flow statement is a type of financial statement that shows how much a business's cash inflows and outflows over a specific period. It has all the details of cash earned and spent with detailed sources.
The three main types of cash flows are:
Cash flow decreases by transactions that indicate an increase in assets. Transactions indicating a drop in assets improve cash flow. Cash flow increases due to transactions that indicate an increase in liabilities.
Add your net and non-cash costs to the operating cash flow calculation, then deduct the working capital. A cash-flow statement has all of them.
Disclaimer: This Article is for information purposes only. The views expressed in this Article do not necessarily constitute the views of Kotak Mahindra Bank Ltd. (“Bank”) or its employees. The Bank makes no warranty of any kind with respect to the completeness or accuracy of the material and articles contained in this Article. The information contained in this Article is sourced from empaneled external experts for the benefit of the customers and it does not constitute legal advice from the Bank. The Bank, its directors, employees and the contributors shall not be responsible or liable for any damage or loss resulting from or arising due to reliance on or use of any information contained herein. Tax laws are subject to amendment from time to time. The above information is for general understanding and reference. This is not legal advice or tax advice, and users are advised to consult their tax advisors before making any decision or taking any action.
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:
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.
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:
Cash flow 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.
Cash received from customers
15,50,000
Wages and salaries
(4,00,000)
Payments made to the vendors
(3,50,000)
Income tax paid
1,75,000
Net cash from operations
9,75,000
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 -
Operating activities
Net income
3,00,000
Depreciation
30,000
Increase in accounts receivable
(10,000)
Increase in inventory
(5,000)
Decrease in prepaid expenses
10,000
Increase in accounts payable
20,000
Decrease in accrual
(5,000)
Net cash flow
3,40,000
Investing activities
Increase in investment
(40,000)
Increase in equipment
(90,000)
Net cash flow
(50,000)
Financing activities
Increase in long-term bank loan
60,000
Dividends paid
(95,000)
Net cash flow
(35,000)
Net increase in cash flow
2,55,000
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
Operations
Cash received from customers
Rs 80,000
Cash paid
Rs (50,000)
Investing
Cash received from the sale of vehicle
Rs 20,000
Cash paid for equipment
Rs (25,000)
Financing
Cash paid for loan payment
Rs (30,000)
Net decrease in cash
Rs (-5000)
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.
Read Also: Capital Gains: What It Is, How It Works Taxes & Asset Types
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