Organizations have multiple sources of income and expenses, making it essential to monitor these areas and gauge cash flow.
By regularly performing a cash flow statement analysis, businesses can determine whether they are operating in a deficit or maintaining profitability. It also pinpoints areas where companies can reduce costs and generate more revenue to improve their operations.
3 Elements of a Cash Flow Statement
Businesses have multiple forms of income and expenses, creating various elements to consider when making a cash flow statement. Generally, there are three primary cash flow statement components, including-
1. Operating Activities
Cash flow derived from operating activities refers to the amount of capital entering or leaving a business through daily operations. In other words, it is the income generated from operations plus any applicable depreciation or amortization, known as non-cash items. These non-cash items reduce the accounting profits and therefore need to be considered when calculating cash flow.
Measuring the cash flow from operating activities is essential as it ensures the inflow of cash from standard operations outweigh the expenses. Otherwise, the company would be running on a deficit and faces the risk of going under.
2. Investing Activities
Cash flow from investing activities includes expenses from acquiring large assets, such as property, equipment, and facilities. It also includes income generated from the sale of similar assets. However, the majority of investing activities' cash flow consists of outflow from making investments.
3. Finance Activities
Cash flow from finance activities refers to the inflow from selling bonds and stocks and the outflow to investors, shareholders, and bondholders. However, most finance activities' cash flow consists of outflows as most companies rarely issue their stocks and bonds.
How to Calculate Cash Flow
Generally speaking, cash flow is calculated by adding or deducting a business's net income by the expenses and transactions occurring within a specific accounting period. These adjustments are made to consider non-cash items, from assets to liabilities, which are not included in income statements but impact a company's overall cash flow.
With all of the cash flow statement components considered, there are several ways businesses can calculate their cash flow, including-
Direct Cash Flow Method
The direct cash flow method totals all cash payments and receipts from suppliers, customers, and payroll. These values are calculated using the starting and ending balances from business accounts to determine the positive or negative differences.
Indirect Cash Flow Method
The indirect cash flow method first deducts a company's net income from their income statement, as it is typically created on an accrual basis. This means that income is only noted when earned, not received.
Therefore, the net income does not accurately portray the actual cash flow from operating activities without the appropriate adjustments from revenue before interest and taxes.
This method also adds non-operating activities that do not affect a business's operating cash flow. For example, non-cash items, such as depreciation, are not considered to be cash expenses but they still impact the value of an asset that is already accounted for. For this reason, it needs to be added to the net sales to calculate cash flow accurately.
Accounts Receivable and Cash Flow
Every change that occurs in accounts receivable (AR) between accounting periods must be considered when calculating cash flow. A decrease in AR means that there was an influx of cash due to customer payments. This difference is then added to the net sales to formulate cash flow.
On the other hand, an increase in AR would be deducted from the net sales, as this income is considered to be revenue, not cash.
Inventory Value and Cash Flow
Increased inventory shows that a business has invested in raw materials. If the supplies were purchased with cash, the amount would be deducted from the net sales. On the other hand, a decrease in inventory would imply an increase in sales, and the amount would be added to net sales.
However, if the inventory were purchased using credit, the increase in accounts payable (AP) would be recorded on the balance sheet. Then the increased amount from each year would be added to the net sales.
This same procedure is used for taxes payable, salaries payable, and prepaid insurance. Once a financial obligation is paid off, the difference is subtracted from the net income. Anything owed must also be added to the net revenue.
Negative Cash Flow Statement
While all businesses wish to have a positive cash flow, management should further analyze their financials before worrying about a negative cash flow statement.
There are instances where negative cash flow occurs because of business expansion and investments. Although acquiring assets often requires significant funds, it implies a business is confident enough in their financial stability to invest in their future. Therefore, businesses should analyze discrepancies in their cash flow statement before raising a red flag.