How to Prepare a Cash Flow Statement
Introduction to Cash Flow Statement
The cash flow statement is an essential part of financial reporting that provides a detailed account of a company’s cash inflows and outflows over a specific period. Unlike the income statement, which records income and expenses based on accrual accounting, the cash flow statement focuses solely on actual cash transactions. This makes it a vital tool for assessing a business’s liquidity, solvency, and long-term financial health.
What is a Cash Flow Statement?
A cash flow statement is a financial document that summarizes the amount of cash and cash equivalents entering and leaving a company. It breaks down the analysis into three main categories:
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
Together, these sections provide a complete picture of how a company generates cash to fund its operations, pay debts, and support investments.
Importance of a Cash Flow Statement
The cash flow statement is one of the three core financial statements used by businesses, alongside the income statement and balance sheet. Here are several reasons why the cash flow statement is crucial:
Liquidity Assessment: It helps determine whether the company has enough cash to meet its short-term obligations.
Financial Planning: Businesses use it for budgeting, forecasting, and strategic decision-making.
Investor Insight: Investors analyze it to assess the viability and sustainability of a business.
Creditworthiness: Lenders evaluate the cash flow statement to decide whether to extend credit.
Cash Flow vs. Profit
It’s a common misconception that a profitable business automatically has a healthy cash flow. However, this isn’t always the case. A company might show profits on its income statement while struggling to pay bills due to poor cash management. The cash flow statement highlights these discrepancies, helping managers make better financial decisions.
Who Uses a Cash Flow Statement?
Business Owners: To manage daily operations and ensure sufficient working capital.
Accountants and Auditors: To analyze and validate financial performance.
Investors and Shareholders: To assess the risk and return profile of investments.
Lenders and Credit Agencies: To determine a company’s ability to service debt.
Step-by-Step Guide to Preparing a Cash Flow Statement
Step 1: Gather Financial Information
You’ll need:
Income Statement (Profit & Loss Statement)
Comparative Balance Sheets (beginning and end of the period)
Additional details on transactions (e.g., asset purchases, loan repayments)
Step 2: Start with Net Income
Begin with the Net Income from the Income Statement. This is the starting point for the Operating Activities section.
Step 3: Adjust for Non-Cash Items
Add back non-cash expenses that reduced net income:
Depreciation & Amortization
Losses on sale of assets
Subtract non-cash gains:
Gains on sale of assets
Step 4: Adjust for Changes in Working Capital
Analyze changes in current assets and current liabilities from the balance sheets:
Increase in current assets (e.g., accounts receivable) → Subtract from cash
Decrease in current assets → Add to cash
Increase in current liabilities (e.g., accounts payable) → Add to cash
Decrease in current liabilities → Subtract from cash
Step 5: Calculate Net Cash from Operating Activities
Combine the net income, non-cash adjustments, and working capital changes to get Net Cash Provided by (or Used in) Operating Activities.
Step 6: Determine Cash Flows from Investing Activities
Include:
Cash outflows for purchasing long-term assets (e.g., equipment, property)
Cash inflows from selling long-term assets or investments
Note: These are actual cash movements, not accounting entries.
Step 7: Determine Cash Flows from Financing Activities
Include:
Cash inflows from issuing shares or taking loans
Cash outflows from repaying loans or paying dividends
Step 8: Calculate Net Increase or Decrease in Cash
Add the totals from:
Operating Activities
Investing Activities
Financing Activities
This gives the net change in cash during the period.
Step 9: Add Beginning Cash Balance
Take the cash balance at the beginning of the period (from the previous balance sheet).
Step 10: Compute Ending Cash Balance
Add the net change in cash to the beginning balance to arrive at the ending cash balance, which should match the cash reported on the ending balance sheet.
Example Summary Format
Cash Flows from Operating Activities:
Net Income XX
Adjustments:
+ Depreciation XX
– Gain on Sale of Equipment (XX)
Changes in Working Capital:
– Increase in Accounts Receivable (XX)
+ Increase in Accounts Payable XX
Net Cash from Operating Activities XX
Cash Flows from Investing Activities:
– Purchase of Equipment (XX)
+ Sale of Investments XX
Net Cash from Investing Activities (XX)
Cash Flows from Financing Activities:
+ Proceeds from Loan XX
– Dividends Paid (XX)
Net Cash from Financing Activities XX
Net Increase (Decrease) in Cash XX
Beginning Cash Balance XX
Ending Cash Balance XX
Common Mistakes in Cash Flow Statement Preparation
1. Confusing Cash Flow with Profit
Mistake: Treating net income as cash flow.
Why it’s wrong: Net income includes non-cash items (e.g., depreciation) and accruals. Cash flow reflects only real cash movement.
Fix: Always adjust net income with non-cash items and working capital changes.
2. Incorrect Classification of Activities
Mistake: Misclassifying cash flows between operating, investing, and financing activities.
Examples:
Placing loan repayment under operating instead of financing.
Treating the purchase of equipment as operating instead of investing.
Fix: Learn and apply correct activity classification rules.
3. Ignoring Non-Cash Transactions
Mistake: Including non-cash transactions like issuing shares for assets or depreciation in cash flow.
Fix: Exclude non-cash transactions—they do not affect cash and should be disclosed in the notes.
4. Incorrect Handling of Depreciation and Amortization
Mistake: Forgetting to add back depreciation/amortization in the indirect method.
Fix: Always add these non-cash expenses back to net income in operating activities.
5. Overlooking Changes in Working Capital
Mistake: Ignoring changes in current assets and liabilities like inventory, receivables, and payables.
Fix: Analyze comparative balance sheets to properly reflect these changes in the operating section.
6. Double Counting or Omitting Cash Flows
Mistake: Recording the same cash flow in two sections or missing them entirely.
Fix: Cross-check entries with other financial statements for accuracy and completeness.
7. Incorrect Treatment of Dividends
Mistake: Confusing dividends paid with dividends received:
Dividends paid → Financing activity
Dividends received → Operating (or Investing) activity (depends on accounting policy)
Fix: Follow accounting standards and your reporting framework (IFRS or GAAP).
8. Not Matching Cash Flow with Balance Sheet
Mistake: Ending cash balance in the cash flow statement doesn’t match the cash on the balance sheet.
Fix: Ensure the calculated ending cash equals the balance sheet cash at period-end.
9. Neglecting Foreign Exchange Effects (if applicable)
Mistake: Ignoring currency exchange gains/losses on cash if operating internationally.
Fix: Include a line item for foreign exchange impact on cash.
10. Using the Wrong Method
Mistake: Mixing up the direct and indirect methods or using components of both.
Fix: Stick to one method (most use the indirect method) and format it consistently.
Advanced Techniques in Cash Flow Management
1. Cash Flow Forecasting
Cash flow forecasting involves predicting future cash inflows and outflows, which helps businesses plan ahead.
Techniques:
Short-term Forecasting (Weekly/Monthly): Focus on the immediate cash position for smooth day-to-day operations.
Long-term Forecasting (Quarterly/Annually): Helps with strategic planning, capital investment, and large expenditure forecasting.
Key Benefits:
Proactively identifying cash shortages.
Avoiding last-minute borrowing or unnecessary credit.
Tools:
Spreadsheet models for detailed cash flow forecasts.
Cash Flow Management Software (e.g., Float, Pulse, etc.) for real-time updates.
2. Optimizing Working Capital
Efficient management of working capital (the difference between current assets and current liabilities) is crucial for maintaining liquidity.
Key Techniques:
Inventory Management: Avoid overstocking to free up cash; use Just-in-Time (JIT) systems.
Accounts Receivable Management: Shorten payment terms or offer early payment discounts.
Accounts Payable Management: Extend payment terms (without harming supplier relationships) to keep cash longer.
Tools:
Cash Conversion Cycle = Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) – Days Payables Outstanding (DPO).
(Lower cycle = more efficient working capital management.)
3. Dynamic Cash Flow Management
Dynamic cash flow management adjusts strategies in real-time based on cash flow performance, aligning with business objectives and market changes.
Techniques:
Scenario Planning: Create best, worst, and base-case scenarios to anticipate cash flow changes.
Cash Flow Stress Testing: Simulate adverse conditions (e.g., revenue downturns, supply chain disruptions) to ensure the company can weather financial shocks.
Benefits:
Greater flexibility in decision-making.
Improved ability to pivot business strategy during economic downturns.
4. Cash Flow-Based Budgeting
Instead of relying solely on traditional profit-based budgeting, companies can integrate cash flow considerations into the budgeting process.
Techniques:
Zero-based Budgeting (ZBB): Start from scratch each period to allocate resources based on cash availability.
Cash-Based Budgeting: Focus on cash inflows and outflows rather than accounting accruals for a more realistic budget.
Benefits:
Helps identify which expenses are critical.
Prevents over-expenditure based on projected revenues that may not materialize.
5. Cash Flow Hedging
Cash flow hedging involves using financial instruments to minimize the impact of cash flow volatility, particularly for companies dealing with foreign exchange fluctuations, interest rate changes, or commodity price swings.
Techniques:
Forward Contracts: Lock in prices for future purchases or sales (useful for hedging foreign exchange or commodity price risks).
Interest Rate Swaps: Swap fixed interest payments for variable ones to adjust debt servicing costs.
Currency Swaps: Exchange future cash flows in different currencies to hedge against currency risk.
Tools:
Use derivatives, like options and futures, to mitigate risks related to fluctuations in cash flow.
Interpretation of Cash Flow Statement for Startups and SMEs
1. Monitor Cash Flow from Operations:
A negative operating cash flow is common for startups in early stages, especially those investing heavily in growth.
If the operating activities consistently show negative cash flow, consider revising your revenue model or expense management.
2. Efficient Working Capital Management:
Accounts receivable and inventory management are key areas. Slow receivables can hurt cash flow, and excess inventory ties up cash that could be used elsewhere.
3. Strategic Investing Decisions:
Excessive spending on capital expenditures can drain cash quickly. Ensure that any major purchases (e.g., equipment, real estate) align with your strategic goals.
Consider leasing rather than purchasing assets, especially in the early stages when cash flow is tight.
4. Financing Activities to Fuel Growth:
Reliance on equity financing (e.g., angel investment or venture capital) is typical in startups. However, keep an eye on the dilution of ownership.
Be cautious with debt financing in the early stages—only take on debt if you have a clear plan for repayment and can generate enough revenue to cover the debt servicing costs.
Common Cash Flow Challenges for Startups and SMEs
Unpredictable Revenue: Many startups experience fluctuating revenues, which can lead to cash flow instability. Forecasting cash flows and securing funding in advance can mitigate this risk.
Delayed Payments: Clients paying late can disrupt cash flow. Consider offering early payment discounts or enforcing stricter payment terms.
High Overheads: Startups often have high fixed costs. Look for areas where cost-cutting can be implemented without affecting operations.
Underestimating Capital Needs: Underestimating the capital required to reach critical milestones can lead to cash shortages. Thorough financial planning and accurate forecasting are essential.
The Difference Between a Balance Sheet and a Cash Flow Statement
| Feature | Balance Sheet | Cash Flow Statement |
|---|---|---|
| Definition | Shows a company’s financial position at a specific point in time. | Summarizes cash inflows and outflows over a period. |
| Purpose | Measures assets, liabilities, and equity. | Tracks liquidity and actual cash movement. |
| Time Frame | Static – represents a snapshot at a single date. | Dynamic – covers a specific time period (monthly, quarterly, annually). |
| Main Components | Assets, Liabilities, Equity | Operating, Investing, Financing activities |
| Focus | What the company owns and owes. | Where the cash comes from and where it’s spent. |
