It’s vital for companies and investors to understand cash flow: the money coming into a company and leaving it. To understand this metric at a glance, companies will prepare a cash flow statement. This financial document is a summary of the entity’s cash flow over a specific accounting period. It shows cash and cash equivalents as they enter and leave a business, painting a picture of financial health. 

A cash flow statement is one of the big three financial documents companies rely on to understand financial health, alongside the balance sheet and income statement. Alone, the cash flow statement is a marker of financial health. Together with the other financial statements, it provides context for the financial stability, reliability, efficacy and profitability of a company. Needless to say, it’s an important document for companies and investors alike. 

Filing a cash flow statement

What Determines Cash Flow?

While the concept of cash flow is the measure of funds in and out, it’s much more nuanced than it seems. At its core, cash flow comes down to three sources, each with its own impact on the business’ finances:

  • Operational cash flows. This is cash spent or received as the result of normal business operations. Examples include revenue from sales or payment for materials. 
  • Investment cash flows. This is cash that’s spent or received via investment activities. Examples include buying inventory or the purchase of marketable securities.
  • Financing cash flows. This is cash that’s received as the result of debt payments to the company or paid out as repayment against debt.

Companies need to account for each source to calculate cash flow. The actual calculation occurs via one of two methods: direct or indirect. 

  • Direct method simply involves accounting for all cash inflow and outflows, and subtracting the end period account balances from the beginning balances to measure the net gain or loss. 
  • Indirect method takes net income off a company’s balance sheet, since the accrual basis of accounting recognizes revenue and payment at the point of origination, not transaction. Then, the company adds back in non-cash expenses and adjusts for working capital.

No matter which method a company uses, the final cash flow figure is an important metric that can determine profitability for the period. But, equally as important are the attributing figures used to find it. It’s why companies (and investors) need to probe the balance sheet beyond the sum totals. 

What’s on a Cash Flow Statement?

Cash flow statements break out into the three categories mentioned above: operational, investment and financing. Within each section is a summary of the most important contributing factors to the company’s cash inflow and outflows.

  • Operations. These figures can include net income and adjustments to reconcile it to net cash, depreciation and amortization, changes in assets and liabilities. It’s summed up in the net cash provided by operating activities. 
  • Investment. These figures can represent capital expenditures and proceeds from the sale of assets. The final number is the net cash used for investing activities. 
  • Financing. These figures can include proceeds from issuing debt or dividends paid. The sum total is net cash provided by financing activities. 

Each section of the cash flow statement will detail the most important contributors to inflows and outflows, to show how they affect the sum total for each section. The cash flow statement distills down into a net increase or loss based on cash at the beginning of the period vs. cash at the end of the period. 

Negative Cash Flow Statement

If the bottom line total on the balance sheet comes out negative, it’s considered a “negative cash flow statement.” While this may raise concern from investors, it’s not necessarily a bad thing. For example, a company may have significant cash outflows as it finances a new venture or completes an acquisition. This is why companies issue cash flow statements alongside income statements and balance sheets—to add context. That said, negative cash flow always deserves further investigation to ensure it’s not indicative of a trend or looming insolvency. 

Predicting Future Cash Flow

From a business standpoint, the cash flow statement is useful for budgeting and predicting future cash flow. Companies can look back at previous accounting periods to examine the cash flow statements and identify trends. This helps with forward-looking assumptions and sets expectations. It also paints a clear picture of strength and weakness in cash flow. For example, a company may have strong operations inflows, but weighty investment outflows that hamper healthy cash flow. 

On the investor side, shareholders can use the balance sheet to better-understand how a company manages its cash flow. Struggles with cash flow may indicate a rocky picture of financial health. Conversely, a strong cash flow statement can give investors optimism—even if a company currently carries debt on its balance sheet. Strong, healthy cash flow can solve a lot of problems!

Learn to Read a Cash Flow Statement

Every investor needs to learn how to read a cash flow statement, and to identify the different segments of cash flow and what they mean. This will help you make the right decisions for your portfolio to gain financial freedom. To learn more about building weath through your investments, sign up for the Liberty Through Wealth e-letter below!

Distinguishing cash inflows and outflows, and understanding their impact on the financial health of the business is the key to making smart investment decisions about a company. Even more important, the ability to juxtapose a cash flow statement with an income statement and balance sheet will unlock real insight into the trending financial health and stability of a company.