A cash flow statement is part of the financial statements that present a source of cash receipts and disbursements of the company during the reporting period. This report includes three subsections, cash flow from operating, investing, and financing activities.
Operating activities refer to the company’s daily core business activities. Investment activities are related to the acquisition or disposal of long-term assets. Meanwhile, funding activities related to capital injection or repayment.
The cash flow statement is one of three critical parts of the financial statements. The other two are the balance sheet and the income statement. Investors use it to evaluate the short-term viability of a company, especially its ability to pay debts.
Cash flow statement formulas and components
Net cash flow = Net operating cash flow + Net investing cash flow + Net financing cash flow
For instance, from the case of the cash flow statement above, company X posted a negative net cash flow value of IDR213 billion in 2019. The figure then moves to cash and cash equivalents accounts in current assets in the balance sheet. And ending cash and cash equivalent for 2019 is IDR49 (IDR262-IDR213).
Ending cash and cash equivalents = Net cash flow + Initial cash and cash equivalents
Cash flow from operating activities
This section reports cash inflows and outflows from the company’s core business. Its components consist of money from selling goods or providing services to customers, expenses related to the supply of products and services, income tax expense, and investment in working capital.
Investors usually monitor this part carefully. That provides the best picture of how great companies make money from their main activities. Positive operating cash flow is preferable because it shows the company’s ability to support future operational growth. Conversely, if cash flow from operations is not enough, they need external financing to develop the business.
In the indirect method, you can calculate it by adding net income, depreciation and amortization expenses, and changes in working capital.
Depreciation and amortization don’t represent cash outflows because the company does not actually pay them. It is an accounting estimate of the value of assets lost during the reporting period. Therefore, you need to add it back to net income to generate actual cash flow.
Cash flow from investing activities
Investment activities are related to the acquisition or disposal of long-term assets such as property, factories, and equipment. Long-term investments are also included in this section.
In this section, you will find capital expenditure (CAPEX). Capital expenditure drags large cash outflows and is usually a significant component in this section, causing negative investment cash flows.
But, negative net cash flow from investments is not always bad because it can show business is growing. High capital expenditure tends to lead to greater production capacity in the future.
Cash flow from financing activities
Cash flow from financing activities, including any transactions with company owners and creditors. Examples are the issuance or repurchase of company shares, issuance or settlement of debt securities, and payment of dividends.
Positive numbers show more money coming into the company than flowing out. Companies may raise capital to finance capital expenditure, either through the issuance of shares or debt securities.
When the numbers are negative, it might mean the company is paying debt, buying back shares, making dividend payments, or a combination of the three.
Note in classifying accounts
Classifying accounts in each section will vary between companies and depends on the nature of their operations. For example, revenue from machinery sales is operating activities for machine manufacturers. But, it is an investment activity for other companies.
Preparing cash flow statements
Two approaches to present cash flows are direct and indirect methods. Under the indirect method, the operating activities section of the cash flow statement starts with net income. Then, you need to add it with non-cash components, such as depreciation and amortization expenses. Finally, you add the results with the change in working capital (excluding cash and cash equivalents and short-term debt accounts).
Why should we add the change in working capital? Working capital represents the difference between current assets and current liabilities. The increase in liabilities means more cash flow, while the rise in assets drained the company’s cash.
Take a simple example: accounts receivable and accounts payable. The company records account receivable when it has sent the goods to the customer but hasn’t received cash payments. Therefore, when the number goes up, more money is owed to the customer.
In contrast, accounts payable represent the money owing to suppliers for inputs that have been sent. I mean, the company hasn’t paid cash to suppliers for input. If the accounts payable rises, more money is still in the company’s hands because it has not paid to the supplier.
Next, under the direct method, you need to group cash receipts and payments. The company will divide the statement of operating cash flows into accounts such as cash from the sale of goods, money received from interest income, cash paid to employees and suppliers, etc. The process is more complicated than the indirect method.
The importance of cash flow statements
The cash flow statement is the most widely watched part besides the balance sheet and income statement. That shows the company’s ability to make money and provides valuable insights into liquidity, solvency, and corporate financial flexibility.
Having ample cash allows companies to quickly react and adapt to financial difficulties or investment opportunities. And, there is the phrase “Cash is King.”
Higher net income is not the same as more money coming in.
Financial statements generally use an accrual basis. A profitable company can fail to adequately manage cash flow because high net income doesn’t always mean a lot of money.
You need to confirm the income statement with a statement of cash flows. The company might report large profits but lack of cash because most sales are still in the hands of customers. In this case, the company recognizes revenue in the income statement and doesn’t report it as cash inflows, but rather in the accounts receivable account.
Positive operating income is ideal but does not apply to all companies.
Ideally, for an established company, the primary source of cash flow is from operating activities rather than investing or financing activities. That shows the company has successfully exploited its primary business.
But, for a growing company, operating cash flow is usually negative. The company is developing and, therefore, often posts revenues less than expenses. Hence, the primary source of cash inflows is from financing activities, for example, by issuing shares or bonds.
When it has grown and reached a mature stage, it should generate positive cash flow from operating activities. And that should exceed capital expenditure and payments to debt and equity capital providers. The inability to do so can lead to business failure and mistrust of the company.