When it comes to handling your small business accounting, there are a few key financial statements you will need to generate on a regular basis. Not only do these reports share vital information about your business with interested parties (shareholders, potential lenders, and creditors, to name a few), but you can also use them to get a good sense of whether your business is financially healthy or headed for trouble. Let’s take a look at one of these standard financial reports: the cash flow statement.
What is Cash Flow?
Before we can get into the cash flow statement, first we need to make sure we know what cash flow itself is. As the name would suggest, cash flow is the money (cash) that flows into and out of your business. Having good cash flow is crucial to keeping your business up and running, and also looks good in the eyes of potential investors and lenders/creditors. It also can allow you to pay off debt and expand your business.
The cash flow statement (also known as the statement of cash flows) is a good consolidated indicator of a business’s cash inflow and outflow. It breaks down these cash flows into three distinct categories: operating activities, investing activities, and financing activities.
Activities Reported on the Cash Flow Statement
Each of the three categories on the cash flow statement deserves a closer look, starting with operating activities. This section of the report deals with items found on your income statement: accounts like Accounts Payable and Accounts Receivable, inventory, wages payable, and income taxes payable.
A quick sidebar on reporting operating activities: when your cash flow statement is being prepared using the indirect method (more on this method in an upcoming post), you’ll first need to take the net income from your income statement and make some adjustments to it. This needs to be done because the income statement is created using the accrual method of accounting, whereas the cash flow statement utilizes the cash basis. There are certain non-cash transactions (such as those dealing with depreciation, as well as gains or losses on the sale of assets) which have to be accounted for in the operating activities section by making adjustments.
The next section deals with investing activities. These would be any activities involving the purchase or sale of long-term investments, such as property or equipment. Other long-term assets that can show up in this section include furniture and fixtures, land, and company vehicles.
Third, we have financing activities. Entries in this section have to do with transactions occurring in your long-term liability and stockholders equity accounts. This would include notes payable, retained earnings, and payment of dividends.
Why Does the Cash Flow Statement Matter?
You’ve probably realized by now how vital a role the cash flow statement can play in analyzing your company’s finances. We’ve already mentioned its importance to outside parties like lenders and investors, but within your own company, it’s also a great tool for your own accounting department (or accounting person – if you’re reading this, that’s probably you!) because it can help determine whether there’s enough cash flow to cover upcoming expenses like payroll.
It can also be useful to compare the cash reported under the operating activities section with the net income reported on the income statement: if the cash reported is consistently higher than net income, that’s a good sign (the business is bringing in more cash than it’s using), and if not, then that’s a red flag that merits some further investigation.