The written records of a company's business activities are called its financial statements. One of these is a cash flow statement. But what is the purpose of a cash flow statement?
We look at its definition, its purpose, how important it is and finally, how to interpret a cash flow statement.
Definition Of A Cash Flow Statement
A cash flow statement is one of the most important financial documents that a company produces. It provides excellent insight into the health of the business.
Typically the cash flow statement offers insight into how financially healthy a company is in a given period.
This period is known as the accounting period and the cash flow statement is not the only essential financial document that demonstrates how well a business is doing.
They are one of many financial statements which show the business activities and financial performance of an organization. Other financial statements include balance sheets, income statements, and statements of changes in equity.
What Is The Purpose Of A Cash Flow Statement?
To understand the part that a cash flow statement plays we need to know what is the purpose of a cash flow statement.
The purpose of a cash flow statement is to provide information on the cash inflow and outflow of a business for a particular reporting period.
The information in this statement is further divided into operating, investing and financing activities.
This knowledge is used to understand the way that an organization generates cash and how it uses its funds. Cash flow is not readily apparent from an income statement particularly if it is prepared under the accrual basis of accounting.
How Important Is Cash Flow?
The cash flow statement complements the income statement and the balance sheet of a business. It conveys how a company generates its income in order to pay its debts, fund its operating costs and finance its investments.
For investors the cash flow statement shows how the business is run, where its cash is coming from and how it is spent.
It can demonstrate how financially stable the company is and allow those looking to invest in the business to discern whether to proceed with investment.
The three components of a cash flow statement show how its operating, investing and financing activities generate and utilize cash flow.
This section of a cash flow statement shows the sources and uses of cash flow in relation to the operating activities of the business.
Income is generated via the selling of goods or services and the cash outflow covers some operating expenses.
Money from operations typically includes any changes in accounts payable, cash accounts receivable, depreciation and inventory.
These will include cash receipts from sales of goods and services, rent, interest payments, income tax payments and wages.
This component of a cash flow statement deals with the sources and uses of cash by a business in its investments.
This could include buying assets, loans received from customers, loans made to vendors or money paid as part of an acquisition or merger.
Buying fixed assets such as plant, equipment or property is also included in the investing activities section of a cash flow statement.
So any changes in investments, assets or equipment that relate to cash from investing activities are included in this section.
The financing activities of a business are included in this third section of a cash flow statement. It deals with the sources of cash from banks or investors and includes cash payments to shareholders.
Also included in this section are loans repaid, stock repurchases, debt issuance, equity issuance and dividends paid.
As well as the operating, investing and financing cash activities of a business the cash flow statement will show the amount of income tax, interest and other financing activities that did not involve using cash.
Interpreting A Cash Flow Statement
When looking at a cash flow statement it is important to view it from a business perspective. The cash flow statement will tell you what the status of a business is and its current phase.
For example, it might be a start-up, a well established business or an organization in decline.
Depending on how you look at the cash flow statement it can be interpreted for various purposes. An investor will look at the cash flow statement to decide whether the company looks healthy and is a good investment.
Various departments within a business may look at the cash flow statement to see how their section of the business is performing and contributing to the overall financial health of the company.
They may adjust their activities depending on what they see in the cash flow statement. Cash flow can also influence the budgeting decisions of an organization including the hiring or firing of employees.
How Cash Flow Is Calculated?
In essence, a company's cash flow is interpreted as being either negative or positive. If it is negative this means that cash outflow is greater than the cash coming into a business during a given period.
Although this doesn't necessarily mean there is a loss of profit. A company may be investing heavily in expansion and this could have a short term negative impact on cash flow.
Positive cash flow means that there is more money coming in than is spent in a reporting period.
This is a good thing and means the business can invest in its future through asset purchase, debt repayment or other ways of growing the company.
However there is no direct correlation between positive cash flow and profitability. A business can be profitable and still have negative cash flow or have positive cash flow but not be profitable.
Cash flow statements are just one of a few financial statements that it is useful to understand when you are in business.
We hope you have enjoyed our guide to what is the purpose of a cash flow statement and that it has helped you.
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