Cash Flow Statements || Preparation of Financial Statements || Bcis Notes

Cash Flow Statements

Cash flow statement is a financial statement that provides aggregate data regarding all cash inflows a company receives from its ongoing operations and external investment sources. It also includes all cash outflows that pay for business activities and investments during a given period.

A company’s financial statements offer investors and analysts a portrait of all the transactions that go through the business, where every transaction contributes to its success. The cash flow statement is believed to be the most intuitive of all the financial statements because it follows the cash made by the business in three main ways—through operations, investment, and financing. The sum of these three segments is called net cash flow.

How Cash Flow Statements Work

Every company that sells and offers its stock to the public must file financial reports and statements with the Securities and Exchange Commission (SEC).1 The three main financial statements are the balance sheet and income statement. The cash flow statement is an important document that helps open a wind interested parties’ insight into all the transactions that go through a company. There are two different branches of accounting—accrual, and cash. Most public companies use accrual accounting, which means the income statement is not the same as the company’s cash position. The cash flow statement, though, is focused on cash accounting.

Profitable companies can fail to adequately manage cash flow, which is why a cash flow statement is a critical tool for companies, analysts, and investors. The cash flow statement is broken down into three different business activities: operations, investing, and financing.

Why do you need cash flow statements?

So long as you use accrual accounting, cash flow statements are essential for three reasons:

They show your liquidity which means you know exactly how much operating cash flow you have in case you need to use it. So you know what you can afford, and what you can’t.
They show you changes in assets, liabilities, and equity in the forms of cash outflows, cash inflows, and cash being held. Those three categories are the core of your business accounting. Together, they form the accounting equation that lets you measure your performance.
They let you predict future cash flows. You can use cash flow statements to create cash flow projections, so you can plan for how much liquidity your business will have in the future. That’s important for making long-term business plans.

Statements of cash flow using the direct and indirect methods

In order to figure out your company’s cash flow, you can take one of two routes: The direct method, and the indirect method. While generally accepted accounting principles (GAAP) approve both, the indirect method is typically preferred by small businesses.

The direct method of calculating cash flow

Using the direct method, you keep a record of cash as it enters and leaves your business, then use that information at the end of the month to prepare a statement of cash flow. The direct method takes more legwork and organization than the indirect method—you need to produce and track cash receipts for every cash transaction. For that reason, smaller businesses typically prefer the indirect method.

Also worth mentioning: Even if you record cash flows in real-time with the direct method, you’ll also need to use the indirect method to reconcile your statement of cash flows with your income statement. So, you can usually expect the direct method to take longer than the indirect method.

The indirect method of calculating cash flow

With the indirect method, you look at the transactions recorded on your income statement, then reverse some of them in order to see your working capital. You’re selectively backtracking your income statement in order to eliminate transactions that don’t show the movement of cash.

Since it’s simpler than the direct method, many small businesses prefer this approach. Also, when using the indirect method, you do not have to go back and reconcile your statements with the direct method.