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Demystifying the Cash Flow Statement

The Cash Flow statement is one of the essential financial statements for small-business owners to understand, yet a surprising number of them don't review it with their bookkeeper or accountant. In this article, I will explain what the cash flow statement is, why it's important, and how to read it.

What is the Cash Flow Statement?

Essentially, the Cash Flow statement shows all the cash inflows and outflows for a period of time, and provides a net cash increase (or decrease) for that period.

Why is the Cash Flow Statement Important?

But wait a minute, can't I get that same information by looking at my Profit & Loss (P&L) statement? And the answer is a resounding NO. Let me explain why:

When using the accrual accounting method, (refer to Cash vs. Accrual Accounting for an explanation) income and expenses appear on the Profit & Loss statement on the date of the invoice or the bill. When the related cash was received or paid can be an entirely different date. While the Profit & Loss statement is a great metric for measuring the profitability of your business, the Cash Flow statement helps you understand the health of your business, which may be very different.

Even if you are using the cash accounting method, there are still many cash transactions that you need to be aware of that won't show up on the Profit & Loss statement. For example, you purchased new chairs for your hair salon. The total cost of these chairs is stored on the Balance Sheet under Fixed Assets, and makes its way to the Profit & Loss statement over 5 year as a Depreciation Expense. By only looking at the Profit & Loss statement, you are only seeing a fifth of that purchase as an expense.

Another example is if you make payment to your shareholders. That cash comes of out the Assets section of the Balance Sheet (Cash) and equally reduces the Equity section of the Balance Sheet (Shareholder Distributions). This transaction never shows up on the Profit and Loss statement, even though the cash left the business. So if you had record sales this month, but your bank account is negative - check your Cash Flow statement:

  • Have your Receivables skyrocketed (booked sales, but invoices are still unpaid)?

  • Did your Accounts Payables or Loans Payable nosedive (you paid off a bunch of debt for expenses that appeared on a previous Profit & Loss statement)?

  • Did you give your equity section drop severely (You wrote a nice dividend check to your company owners)?

Maybe a combination of all 3?

How do I read a Cash Flow Statement?

So hopefully I've convinced you of the importance of reviewing the Cash Flow statement, but how do you read it?

The Cash Flow statement is broken into 3 sections to better help you understand which parts of your business are contributing to (or draining) your bank account: Operating, Investing, and Financing.

Operating Activities starts with your Net Income for the period as a baseline. The next line is Adjustments to reconcile Net Income to Net Cash. This sections decreases (increases) your net income by any increase (decrease) in current assets (i.e. accounts receivable, prepaid expenses, inventory, etc.). This section also decreases (increases) net income by any decrease (increase) in current liabilities (i.e. accounts payable, credit cards, short-term loans, etc.). The net cash provided by operating activities is how well your business is able to generate cash for its normal operations. Obviously, the more the better!

Investing Activities includes cash flows that will help your business generate future revenue over the long-term that do not appear on the Profit & Loss statement. Examples include purchasing or selling fixed assets like office furniture, equipment, and computers, purchasing or selling land or real estate. The investing activities section can show owners if they are spending cash on expanding their business capacity, or gaining cash through selling off fixed assets, which may hinder their ability to generate future sales. Yikes!

Financing Activities includes any cash flows from creditors or owners of the business. Examples include taking a loan, repurchasing shares from shareholders, or paying dividends to owners. The financing activities section can show how much of the cash is being sent to the owners, or being used to repay debt, which would not appear on the Profit & Loss statement and is essential for budgeting.

The final lines on the Cash Flow statement is a summary of the cash balances over the period. The Net Cash Increase for Period line totals up the net cash provided by the 3 sections. Then the report shows the cash at the beginning of period and cash at end of period. A positive cash flow for most businesses is preferred. However, in rare instances companies may be too cash-heavy and use excess reserves to pay down high-interest debt or reward shareholders.

Bottom line: Negative cash from operating activities is BAD, by depending on your business, a net cash decrease for the period may not be a terrible thing. For more on increasing operating cash flow, check out our article on 5 Tips on Increasing Cash Flow).

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