Our CEO often says, "cash flow is the oxygen of any business," which begs the important question - just how well is your business breathing? When conducting an investment analysis of a business, there are three key financial statements that must be considered: A profit and loss (P&L) statement, balance sheet, and the cash flow statement. These three statements are interdependent of one another, and are mandatory in determining the complete financial health of a business.
Previously, we covered How to Read a Profit and Loss Statement, and How to Read a Balance Sheet. Now, it's time for the third installment in our blog series. Here, we reveal how to achieve cash flow forecasting with these industry best practices...
What Is a Cash Flow Statement?
Simply put, a cash flow statement is a financial statement that summarises a business' net amount of cash, together with the cash-equivalents, that are coming in and out. These amounts are determined through a financial breakdown of the business' key activities (operating, investing, and financing).
If after you've paid all of your assets' expenses, and are still generating income on this, then you've successfully generated a positive cash flow. On the other hand, if the income you've generated is less than the total of all your expenses, then you've generated a negative cash flow.
The Cash Flow Statement Terms You Need to Know
In the same way a profit and loss (P&L) statement and balance sheet are structured differently in accordance with the elected accounting package, a cash flow statement can also vary depending on the nature of your business and its unique requirements.
However, regardless of the accounting package you're using, any statement of cash flow comprises three universal types of activities: Operating Activities, Investing Activities, and Financing Activities.
1. Operating Activities
The cash flow from operating activities (CFO) is a direct indication of exactly how much money your company is generating when it's business-as-usual; this is the first section of a cash flow statement. This amount refers to the net cash generated from both the selling and manufacturing of a product or service.
There are two types of CFO methods: Indirect, and direct. When analyzing a standard cash flow statement, and subsequently forecasting your financial state, the indirect method occurs where noncash items are first added to the net income in order to result in a cash basis. In best practices, this is otherwise referred to as the cash method of accounting.
On the other hand, the direct CFO method doesn't modify any report (i.e. there is no cash basis); instead, it simply utilises the true cash inflows and outflows from a business' operations.
This section consists of the following entries: Receipts from customers, payments to suppliers and employees, cash receipts from other operating activities, and finally, net cash flows from operating activities.
2. Investing Activities
When it comes to reporting the cash flow from investing activities, which is the second section of your cash flow statement, you need to be able to report the cash your company generates from either the purchase and/or sale from its investment activities.
Generally, these investment activities embody capital expenditures, which is the purchase of property, plant, and equipment (PP&E), along with proceeds from the sale of other businesses, marketable securities such as bonds and stocks, and proceeds from a business' sale of PP&E.
This section consists of the following entries: Proceeds from sale of property, plant and equipment, payment for property, plant and equipment, other cash items from investing activities, and finally, net cash flows from investing activities.
3. Financing Activities
Cash flow from financing activities (CFF) is the final section of a cash flow statement, which displays the total net cash flows used in order to fund a business.
Here, classic CFF examples include, but are not limited to, refinancing loans, paying debt, bank loans and dividends, and issuing stocks to raise capital.
This section consists of the following entries: Other cash items from financing activities, and finally, net cash flows from financing activities.
We hope this guide has helped you to better understand how a cash flow statement works. To learn more about forecasting your financial state, discover our Best Practices: How to Read a Balance Sheet guide here (in case you missed it).
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