All businesses must prepare financial statements regularly to understand their economic standing. A cash flow statement is one key report that businesses prepare to handle their accounting. Whether you’re just starting in the business sector or you’re a seasoned executive in a successful corporation, you should recognize the importance of a cash flow statement. In this article, we explain what a cash flow statement is and outline eight reasons it is an essential part of running a successful business.
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What is a cash flow statement?
A cash flow statement is a financial statement that portrays how businesses spend their cash. The statement includes detailed information about a business’s cash inflow and outflow, meaning it keeps track of the amount of money that flows in and out as a result of business handling. Having cash available is a base requirement for businesses to stay solvent and avoid bankruptcy.
Cash flow statements break down this flow of money into three different sections of cash-related activity:
Operating activities
This section of the cash flow statement details operating costs and profit items that are also found on an income statement, such as accounts receivable and payable, inventory, wages payable and income taxes payable. The operating activities section focuses on a business’s main activities, like selling or buying merchandise and services.
Investing activities
This section includes information about the business’s purchase or sale of long-term investments, such as property, buildings, vehicles, furniture or equipment. The investing activities section provides further details about a company’s assets.
Financing activities
This section outlines all cash transactions from long-term liability and stockholder equity accounts, including notes payable, retained earnings and dividend payments. The financing activities section reflects the company’s net cash flow, taking stock purchases and debt financing into consideration.
An example of how cash flow is calculated
A cash flow statement can play a crucial role in analyzing a business’s finances. Not only is it an important report for internal stakeholders, but it can also help external ones, like lenders and investors, determine whether a company is successful and worthy of investment. Here is a basic example of how cash flow is calculated:
If Barry starts his small business with $10,000 in savings and an additional $15,000 loan from a private lender, he starts out with $25,000 total to fund his venture. He spends the entire amount getting his business off the ground during his first year. Over a short amount of time, though, Barry’s business becomes highly profitable, and he brings home $55,000 total in revenue from operating activities, such as sales, in the first year.
Some of this revenue has been made through $5,000 in credit transactions, though. To determine Barry’s cash flow position—or how much cash he currently has—he must take his operating activities, investing activities and financing activities into account. Because Barry spent $10,000 of his own money to start his company and is currently $15,000 in debt to a private lender, he must subtract the outflow sum of $25,000 from his total revenue to get an accurate picture of his cash inflow.
With this, it is evident that Barry only made a total of $30,000 in profit during his first year in business. However, because Barry made $5,000 of his revenue through credit transactions that still remain unpaid, he only has $25,000 in cash on hand. This is a positive cash flow, which is good news for Barry. This calculation, which takes all cash-related activity into account, can help Barry and his team make informed business decisions in the future.
8 reasons why a cash flow statement is important
Cash flow statements can help businesses navigate the need for positive cash-related activity. Here are eight reasons why a cash flow statement might be useful for your company:
Insight into spending activities
Cash flow statements give a holistic picture of the different payments companies make that aren’t typically reflected in a profit and loss statement. For instance, if your company took out a loan and is paying it back, those payments wouldn’t be included in a profit and loss statement. Comparatively, this information would be included in a cash flow statement, providing insight into the actual cash your business spent. If you want to know where your business is spending money, a cash flow report can give you a precise portrait of outflow.
Short-term planning
Cash flow statements are especially useful to companies when it comes to short-term planning. All companies must stay solvent to avoid bankruptcy and meet obligations, such as paying wages, operating costs and more. Because cash flow statements provide a detailed report on how much cash a business has on hand at a given time, they can help financial managers project the cash flow in the near future and keep track of spending to meet specific, short-term goals.
A better picture of cash planning results
Businesses typically create cash plans to follow to ensure their ventures are successful. Despite this, however, there are times when businesses aren’t able to execute their cash plans perfectly or meet the objectives identified during the planning period. A cash flow statement can help companies analyze whether their cash planning was effective by allowing readers to compare projected cash flow numbers to actual cash flow results. Companies can use this information to make more accurate projections in the future.
Ability to increase cash inflow
When businesses have data regarding their current inflow and outflow, they can focus on creating cash from activities other than earning profits. While profit inevitably helps to create cash, there are other ways to do so, and sometimes these methods can be more lucrative overall. For instance, if a company’s employees find that they’re spending a lot of money on inventory, they can try to create excess cash by optimizing operations, such as using inventory efficiently to collect receivables faster.
Improved knowledge of cash balance
Business owners and stakeholders need to know the optimal amount of cash they need to operate successfully. This is one of the most important things a cash flow statement can accomplish—with such a statement, companies can analyze whether they have an excess or deficit of funds. If a company has an excess of cash, they can invest that money, and if they are in a deficit situation, they can turn to external lenders or investors to reach their optimal cash balance.
Working capital analysis
Working capital is defined as the funds that are currently available to businesses—the amount of cash, deposits or other reserves kept on hand to manage operational and day-to-day expenses. Cash flow statements can help business executives, investors and other stakeholders analyze the working capital movement within a given company. This analysis makes it easier for a business to improve its operations in order to preserve cash and improve inflow numbers.
Long-term planning
Similar to short-term planning, cash flow statements can help financial managers plan for the long term. A company’s growth is dependent on accurate financial planning, and a cash flow statement can help managers identify specific, implementable changes. These changes could very well situate the business within a solid financial position over time. In essence, a cash flow statement helps financial managers understand what activities a company needs to prioritize.
Crisis management
Because a cash flow statement gives business stakeholders insight into whether they have a shortage or excess of cash on hand, the report can help with crisis management. If a manager can project a potential cash shortage in a company’s future, they may be able to come up with ways to help the company overcome such a challenge ahead of time. This can make an enormous difference in a company’s ability to reach its goals.
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