It can be easy to get overwhelmed by all the different financial statements businesses use to track their money. The three most common ones you need to maintain are the balance sheet, income statement, and cash flow statement.
The latter illustrates your company’s incoming and outgoing money, so you can ensure you’re always financially healthy. Here’s what you need to know about cash flow statements and why they’re essential.
A cash flow statement is vital for any business because it shows you how much money is coming in and going out. It differs from the balance sheet in that it covers a specific period, whereas the balance sheet is a snapshot of your company’s financials at a particular moment. There are quite a few benefits to using a cash flow statement, such as:
Your creditors often want to see a cash flow statement before extending any credit to your business. They’ll be looking to see if you have enough cash coming in to cover your outgoing expenses and make timely repayments.
This is especially important if you’re a small business owner who is just starting. Established businesses usually have a better chance of getting approved for credit because they have a longer track record to show lenders.
It can be easy to let expenses get out of control if you’re not tracking them carefully. A cash flow statement will help you keep tabs on where your money is going so you can make necessary cuts where needed.
It is crucial in the early stages of your business when you’re trying to keep costs low. Once you have a better handle on your cash flow, you can start reinvesting some of that money back into your business to help it grow.
A cash flow statement can also be a helpful tool for monitoring your business’s overall performance. It shows how much cash is coming in and going out over time. If you see a sudden decrease in cash flow, it could be an indication that something is wrong.
Maybe you need to reevaluate your pricing strategy or cut back on expenses. Alternatively, it could just be a seasonal fluctuation. Either way, it’s important to keep an eye on your cash flow so you can make changes as needed.
What is Operating Cash Flow on your cash flow statement?
Operating cash flow (OCF) is the portion of your cash flow statement covering your day-to-day operations. Of course, it includes revenue. Revenue is the total amount of money your company has earned from sales or other activities over time.
But it also captures expenses, which are the costs associated with running your business. These include rent, salaries, marketing costs, and general overhead. Cost of sales (COGS) is a type of expense that specifically captures the costs associated with producing your product or service.
We also include some changes, such as inventory and accounts receivable. For example, if you sell a product on credit, that money won’t come in immediately. It will show up as accounts receivable on your balance sheet until the customer pays their bill.
Change in work in progress (WIP), change in other current assets, and change in accounts payables are all operating activities that impact your cash flow. These items can be positive or negative, depending on whether you’re spending or earning money. In short, your operating cash flow includes what it usually costs to keep the doors open and lights on.
Looking at the graphic above, you’ll first notice that OCF is divided into three sections. Operating cash flow includes everything in the first section. OCF is a good indicator of your business’s financial health because it shows you how much cash is coming in and going out regularly. In our example, the company has more cash coming in than going out, which is a good sign.
The second section of the cash flow statement is called free cash flow (FCF). FCF is the portion of your cash flow left over after you’ve paid for your cash outflow. It’s the money you have available to reinvest into your business or pay off debts. In our example, the company has a positive FCF, which means they have money to scale their business.
You can think of FCF as your business’s “disposable income.” It’s the money you have left over after all the bills are paid. Some subtractions from operating cash flow (OCF) to get free cash flow (FCF) include:
Depreciation and amortization: These are non-cash expenses that represent the wear and tear on your equipment and other assets. For example, if you bought a computer for your business last year, the depreciation expense would be the amount of money that computer is worth this year.
Capital expenditures: These are the costs associated with buying or improving the property, equipment, or other assets. It might include things like a new roof for your office or a new fleet of vehicles.
Changes in Intangible assets: Some businesses have intangible assets, like patents or copyrights. The changes in these assets also need to be subtracted from OCF to get FCF.
Change in investments or non-current assets: This line item covers any changes in your investments or other non-current assets. For example, if you sold some of your company’s stock, that would be reflected here.
Of course, FCF isn’t always positive. Subtracting all these items from OCF can result in a negative number. That means your business has no money left after expenses to reinvest or pay off debts. It doesn’t necessarily mean your business is in trouble, but it’s something you’ll want to keep an eye on.
Finally, we have net cash flow (NCF). This section of the cash flow statement shows you the bottom line: how much cash your business has available. Here, we simply take the operating cash flow (OCF) and add or subtract any non-operating activities. Net interest income, for example, is what you owe on your business loans minus the interest you earn on your investments.
Other items in this section include things like changes in long-term debt, changes in equity, and changes in other assets. If your company has stocks and shareholders, any changes in those will be reflected here as well. For example, dividends paid to shareholders are considered a cash outflow, meaning they would be subtracted from your company’s net cash flow.
Finally, adjustments are made for any changes in deferred taxes or other items. These items don’t necessarily fall into the operating or non-operating categories but still need to be considered when calculating your company’s net cash flow.
In our example, the company doesn’t have any of these items, so its net cash flow is the same as its operating cash flow.
That’s it! Now you know how to read a cash flow statement and all the different sections.
Note that there are two methods of calculating cash flow from operations: direct and indirect. The direct method simply lists out all the cash that came in and all the cash that went out. It uses cash receipts and payments to show the net change in cash. Conversely, the indirect method starts with net income and then adjusts for all the non-cash items.
The indirect method is more common because it’s required by GAAP (Generally Accepted Accounting Principles). However, many companies will provide both methods in their financial statements so that investors can see a clear picture of their cash flow. That’s because some items don’t show up on the cash flow statement with the direct method. They include:
Depreciation & Amortization expenses: Depreciation and amortization are non-cash expenses, meaning they don’t involve any actual cash outflow. However, they still need to be considered when calculating operating cash flow.
Unrealized Gains & Losses: Unrealised gains and losses are changes in the value of assets that haven’t been sold yet. For example, if you own a piece of land that has gone up in value, that’s an unrealized gain. An unrealized loss would be if the value of that land went down.
Accounts Receivable write-offs: A write-off is when a company decides that an invoice will never be paid and removes it from their accounts receivable.
Balance Sheet Accounts: Balance sheet accounts reconcile the different sections of the balance sheet into one number. These don’t appear on the income statement, so they must be considered separately when calculating operating cash flow using the indirect method.
The indirect method starts with net income, which is reported on the income statement. From there, add any non-cash expenses, like depreciation and amortization. This will give you your operating cash flow. Then, adjust for any changes in your balance sheet accounts. It will provide you with your final cash flow from operations.
The cash flow statement is one of your business’s most important financial statements. It shows how much cash is coming in and going out of the company, which is vital information for making decisions.
If you’re new to the business world, you might want to brush up on your accounting knowledge before diving into the cash flow statement. At Start Grow Manage, we offer courses, programs, and consulting to help small entrepreneurs grow to business owners and successful entrepreneurs.