What is a Cash Flow Statement? Definition and Importance
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A cash flow statement documents in detail all company income and debt over a specific period of time. It reflects the short-term viability of a company by indicating whether it has enough cash on hand to pay its employees and debts. If it does, then the company is considered to have a “positive” cash flow.
Here’s What We’ll Cover:
How Do You Calculate Cash Flow?
How Is Cash Flow Different from Income Statement?
Why Cash Flow Statement Is Important
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Types of Cash Flow
The cash flow statement (also referred to as a “statement of cash flows”) is broken down into three sections:
Operating Activities
Cash flow operating activities are the costs directly associated with the production and sale of a company’s product, and the income generated by those sales. These costs include:
- Purchase of raw materials
- Building Inventory
- Advertising
- Payments to vendors
- Payroll and employee benefits’ payments
- Dividends from company investments
- Interest received or payed
- Income taxes & deferred taxes
- Income from sales of products or services
- Depreciation and amortization
- Sale of non-current assets
Investing Activities
Investing Activities in accounting refers to cash spent on:
- Long term investments (for example, purchase or sales of stocks and bonds)
- Properties and equipment (purchases or sales of)
- Loan payments (but not interest. Interest on bank loans would go under ‘Operating Activities’ above)
- Money loans
- Costs related to payments for merger and acquisitions
Although a business can generate cash flow by selling properties and equipment, those specific costs are not an indication of a profitable business.
Financing Activities
Financing activities refer to:
- Incoming cash from investors and shareholders
- Incoming cash from issuing debt (for instance, bonds)
- Outgoing cash in the form of dividends
- Repurchasing of stock
- Proceeds from employees exercising stock options
- Capital lease (a large expense, such as a building that is being accounted for over a number of years).
How Do You Calculate Cash Flow?
There are two methods to calculate cash flow. Each have a different approach to the way “Operating Activities” are calculated.
Cash Flow Calculation: Direct Method
The accounting department of a company adds up all payments and receipts.
This is the universally recommended way to calculate cash flow because the expenses and income are so detailed. That detail can help a company to better make financial decisions.
Cash Flow Calculation: Indirect Method
The accounting department takes net income and then makes adjustments to remove costs related to non-operating activities.
This is considered an easier method to calculate than direct, because of the way accounting departments typically record transactions.
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How Is Cash Flow Different from Income Statement?
An income statement is concerned with revenues, gains, expenses and losses in both the operating and non-operating activities of the business during a specific period of time. It does not deal directly with cash.
A cash flow statement is concerned with showing the cash coming in and going out of a business as it relates to operating, investing and financing activities – also during a specific period of time.
Is Cash Flow a Profit?
Cash flow is not profit.
Profit is what a company has left over after all expenses have been paid.
Cash flow is the available cash a company has on hand at any given time (which is based on income and expenses). A cash flow statement will indicate whether a company is viable, meaning it can continue operating and making profits.
Why Cash Flow Statement Is Important
If a company is able to continuously generate more cash (than it is spending), then it can use that cash to:
- Increase size of dividend payments to investors
- Attract shareholders
- Reinvest in the business
- Buy stock
- Reduce Debt
- Acquire other companies
A cash flow statement is considered to be one of the four most important financial statements a company can generate when doing a financial analysis, the other three being:
- Balance sheet
- Income statement
- Statement of Changes in Equity
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