How to Read a Cash Flow Statement

If you don’t understand how to read financial statements, the numbers and columns scattered across the pages can seem like an unsolved puzzle, broken into hundreds of meaningless pieces. Yet, with some basic knowledge, those pieces can tell you a brilliant story about where your business has been and where it is going.

Most introductory business or accounting classes only cover two basic financial statements: the balance sheet and the income statement. Balance sheets are a quick snapshot of an organization’s financial position (assets, liabilities, and equity); and an income statement shows the profitability of operations over a period of time. While these financial documents are vital to understand, most classes never touch or only skim the surface of one of the most telling financial statements, the cash flow statement. Here are some tips on how to understand this vital statement:

What is a cash flow statement?

What is a cash flow statement? A statement of cash flows, of course...seriously though, it’s pretty simple; a cash flow statement reconciles the income statement and balance sheet to look specifically at cash transactions. A cash flow statement doesn’t necessarily cover all business incomes and expenses (since some exchanges come from credit), but still tells a valuable story about your business.

Cash transactions come from many different business operations. These operations are broken down into separate categories, which can result in positive or negative amounts of cash flow. These categories include:

Operating Activities

This section covers normal business activities that are paid for in cash, such as buying and selling products or services. Think of the normal operations at your business core.

Investing Activities

This section includes the cash buying and selling of any asset that produces income for a business. Things like buying materials to make products, or selling an older piece of equipment or another line of business would be included in Investing Activities. These are often known as capital transactions.

Financing Activities

Not to be confused with Investing Activities, financing activities cover cash transactions within a company and its creditors. An example of this is when a company pays out dividends to its investors. If a company has negative cash flow in this section it could represent paying out cash dividends to investors, which is typically a good thing, but it could also represent the company paying interest on previous debt. This is an example of why it’s important to understand where your numbers are coming from and what they represent because a positive or negative doesn’t tell you anything unless you know where it’s coming from.

Most organizations have many different cash transactions across all lines of operation, so it’s important to know where your cash is going. Once a business can identify how much cash they do or don’t have on hand, it can reassess its strategy in areas like financing, payments, and investing.

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What a Cash Flow Statement Isn’t

The cash flow statement does not tell you about profits or losses, because those calculations are made up of other non-cash items on the income statement. Although cash flow is important to analyze, a cash flow statement is not a reliable metric for overall financial well-being of a company.

Large accrual-based accounts that can greatly distort a company's financial well-being, such as accounts payable and accounts receivable, are not taken into account on a statement of cash flows.

Breaking it Down

Now that we’ve determined what goes into a cash flow statement, let’s take a look at an example. We’ll it break down into 5 main parts:

1. Net income
2. Operating Cash Flow
3. Cash Flow from Investment Activities
4. Cash Flow from Finance Activities
5. Final Cash Amount

1) Net Income

This number is conceived and brought over from the income statement. It represents your “profit” or “bottom line” after paying all expenses from total sales. Net income often includes accrual accounts, or non-cash accounts, so that’s why it’s at the start of your cash flow statement. From here, net income will be adjusted into “net cash” to represent only cash transactions.

2) Operating Cash Flow

Often, the “cash flow from operations” section can be the most useful area for small business owners to analyze. Your regular day-to-day cash business transactions will be recorded in this section (for example, depreciation, paying credit cards, or changes in accounts receivable).

3) Investment Cash Flow

This section deals with what your business is investing in, not to get confused with what others are investing in you (that comes in Finance Cash Flow). These investments include anything that grows your business. This can include things from buying new equipment to merging or acquiring another business. This can be useful to determine if a big chunk of cash has been received or spent on some sort of investment activity. Often times companies with low or negative cash flows are investing in better facilities or operations for the future (remember, it’s important to understand the story behind the positive or negative number).  Altogether, this section results in your net cash flow from investing activities.

4) Finance Cash Flow

This section is critical to understanding how a company deals with debt. Borrowing cash, repaying cash, and raising capital are all included here. Positive inflows to this section would include funding activities like bank loans, venture capital fundraising, or selling company shares. Outflows of cash would include activities like paying dividends or repurchasing company stock.

If a company has high positive cash flow from financing, it likely means it is taking on debt for further business operations.

5) Final Cash Amount

A cash flow statement concludes with a couple bottom-line numbers. First, by summing each of the previous categories, you’ll be able to determine a net increase or decrease in cash for the period you’ve been looking at. The next line combines the starting amount of cash with the net change in cash, resulting in your ending amount of cash for that period in time. When it comes to making decisions, the size and sign of these numbers is less important than understanding the story that they convey.

Making Decisions

All financial statements contain vital information for your business. However, unlike balance sheets and income statements, a statement of cash flows tells a brilliant story about where your business is spending and receiving cash, and isn’t as concerned with bottom-line numbers. Understanding each line of a cash flow statement is the best way to understand your cash’s story, but positive and negative numbers can hint to certain things. Remember that a negative net cash flow shouldn’t concern you if you know your business is healthy. This could often mean that you’re investing heavily in new sources of assets or income to keep your business moving forward. However, if those investments don’t pay off, you could be spending too much on growth and should keep an eye on your negative cash flow.

Positive cash flows also aren’t necessarily good or bad. It could mean you’ve taken out loans or raised capital that will need to be paid back later. Conversely, you could be running at high profit margins and raking in the dough! A careful understanding of each section of the cash flow statement can help you determine how a positive number is being produced.

Understanding and using cash flow statements to make educated decisions for your business could be the difference between IPO and bankruptcy. Luckily, Decimal is here to help. Our proprietary software combined with a personal bookkeeper makes viewing up-to-date financial statements easy and understandable. Let Decimal help your small business or non-profit flourish by scheduling a demo today.