Statement of Cash Flows Made Simple
Running out of cash is the number one reason why most businesses fail.
The statement of cash flows is the least popular financial statement and also the least used amongst small business owners.
This article provides a simple guide to the statement of cash flows, breaking it down into bite size pieces that are easy to understand.
A 30,000 Foot View
Simply put, the statement of cash flows shows the net amount of cash a business brought in (or sent out) over a period of time.
If you’ve ever looked at a statement of cash flows you know the sentence above is true, but it's actually a lot more detailed as well.
This financial statement displays more than just a single number of net cash flow. It shows many numbers in many sections to inform the user not only the overall net cash flow of a business, but also where a business’ cash went over a period of time.
Let’s get a first look.
See the image below for a typical statement of cash flows:
The image to the left may look like hieroglyphics…or like a foreign language but it becomes much clearer when you understand each part.
As you can see the statement of cash flows has 3 separate parts.
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
Let’s break down each part into bite size pieces to learn what’s going on in the statement and apply this knowledge to leveling up our business finances.
Things to Note in the Heading
Two important things to identify in the heading is the company name, and the time period in which the report is displaying the data.
Note that a statement of cash flows shows financial data that occurred in a range of time in the past. This is different from a balance sheet which shows the value of certain items on a specific date.
If you happen to be reviewing the statement of cash flows for many different companies, or several different time periods, it's good to double check the headings of each of your reports before you dive in. You’ll want to make sure you’re looking at data for the right company in the proper period of time.
Part One: Cash Flow from Operating Activities
Simply put this section summarizes the net amount of cash flow the company took in or sent out from a business’ usual operations.
There are other ways cash can come in or out of a business such as getting a loan or selling stock, but those are for the other sections that we’ll review later in this article.
Looking at the image to the left, notice that this section starts with the amount of profit that will be displayed on the company’s P&L, then it goes further to make adjustments to this number to get the true amount of net cash provided by operating activities.
Now you may be asking yourself “Isn’t the amount of profit the same amount that the company’s bank account balance increased or decreased?”…
It would be simple to answer this question as a “Yes” all the time, but that is not the case. Consider the following examples:
Example 1: Putting expenses on a credit card
If a business owner uses a business credit card for business expenses, great! Get those rewards points. Those expenses are going on the P&L as regular ole’ business expenses, but do those expenses directly represent cash leaving the business bank account? Unfortunately the answer to this question is “No”, which adds complexity to the statement of cash flows.
Example 2: Paying off a credit card
On the opposite side of Example 1. Let’s say that a business owner has a business credit card that has been used in the past and is carrying a balance. This month the business owner doesn’t put any expenses on this credit card and opts to pay off the entire balance of the credit card. This credit card payment is cash leaving the business bank account, but it doesn’t represent an expense that is going to show up on the P&L for the month in question.
In exploring the first two examples we begin to see the importance and the need for the statement of cash flows. The business owner can get a lot of information from their P&L and the balance sheet, but not the entire picture.
Let’s keep exploring.
Example 3: Accrual Accounting Items
Most small business bookkeeping is performed using the cash basis method of accounting, however there are some businesses that may want to opt for the accrual method.
The accrual method is more complex and will account for several non-cash items on the P&L such as accounts receivables, and depreciation.
For accounts receivable, the accrual method will add invoices sent to customers to sales (the top line of the P&L), even though the cash has yet to be collected. The statement of cash flows accounts for invoices that haven’t been paid but are listed as “Sales” on the P&L and subtracts this amount in calculating the net amount of cash from Operating Activities
For depreciation, the accrual method will add this expense to the P&L, but depreciation is always a non-cash expense. Depreciation is nothing other than accounting for the reduction in value of your vehicles, equipment, and buildings as these things get older and have more “miles” on them. The statement of cash flows accounts for depreciation being a non-cash expense on the P&L and adds this back to the Operating Activities section of the statement of cash flow.
In the examples above we explored how the amount of profit shown on the P&L doesn’t equal the cash flow a business experiences. The statement of cash flows helps tell where the money went (or where the money came from).
Next we’ll explore cash flow from Financing Activities
Part Two: Cash Flow from Investing Activities
The second of the three main sections of the statement of cash flows is Cash Flow from Investing Activities.
This statement is more straightforward than the first one we reviewed above.
At first glance one might think that this section represents a company “buying stocks” as an “investment”, but that isn’t the case at all.
This statement displays the company’s investment in itself. The numbers in this section show the net cash flow from a company purchasing big items that it will use in the future to make more money from its everyday operations, or from selling big items it no longer needs.
Notice I’ve underlined the word “Big Items” above. When a company purchases a large item such as a vehicle or a piece of real estate, this “Big Item” is considered to be a Capital Asset. Generally speaking capital assets will not be fully written off their first year They will not fully depreciate their first year.
The expenses for these big items aren’t found on the P&L, but the cash used to pay for these items will still have to leave the business bank account. Since their is cash leaving the business bank account these large purchases will be accounted for on the statement of cash flows
Examples of cash outflows in this section are when a company buys equipment, vehicles, buildings, or land to use to expand its operations.
Examples of cash inflows in this section are when a company sells equipment, vehicles, buildings, or land that it no longer needs to use for its current operations.
A big purchase of new vehicles, new equipment, and/or real estate would lead to a large cash outflow in this section. This big cash outflow may look “bad” on paper in the short term. One thing to note is that great business leaders take a long term view of their business. They’ll often sacrifice great financial statements in the short term to win in the long term.
It’s true that business leaders don’t always win, but McDonalds wouldn’t be where it is today if the founders hadn’t decided to invest in their first restaurant. They took a chance and it paid off big.
“ “You miss every shot you don’t take.” - Wayne Gretzky” - Michael Scott
Part Three: Cash Flows From Financing Activities
The second of the three main sections of the statement of cash flows is Cash Flow from Financing Activities.
This section is fairly easy to understand as well as it shows the net cash flows from when the company receives financing of some sort such as loans or potentially issuing stock to new shareholders.
The Bottom Line(s)
The bottom few lines on the statement of cash flows is a little different than the bottom line from a P&L. The last three lines display the overall net cash flow for the business for the time period, and the beginning and ending cash balances for the same time period.
Key Takeaways
In reviewing the explanations above you can see that a company could have a great looking P&L from a highly profitable year, but on the statement of cash flows they could have invested heavily in equipment or paid a lot of dividends to the owners leading to an overall decrease in their bank account balances.
Here you can see why the P&L isn’t the be all end all of financial statements. There’s more going on in the background and the statement of cash flows helps readers understand more details about the company in question.
We Simplify This Statement for Our Clients
Our clients are busy small business owners. Time is of the essence so they need financials they can read on the fly that are as straightforward as possible.
At Shoff Accounting we offer small business owners many types of accounting services, and custom financial reports is one that is very popular.
Our custom reports compress the statement of cash flows into one section that's easy and fast to read. See the example below:
The compressed statement of cash flows is one of many ways our custom reporting system helps our clients review and understand their business financials in a flash.
If you’d like to start receiving financial statements for your business that you can get the information you need fast click the link below to schedule a call with Jonathan Shoff, the founder of Shoff Accounting.