The cash flow statement is probably the most important of your three primary financial statements. However, despite this it is probably the least understood of the three. Understanding what the line items on this statement mean and the overall significance of the numeric totals will enable you to spot many situations where a business is either in trouble, or could find itself in trouble in the future.
So What is the Purpose of the Statement? What Does it Mean?
The cash flow statement tells you whether the business is capable of generating enough cash from its operations to sustain the business. This is not the same thing as profit. Many times you will hear about profitable businesses that expand quickly and go bankrupt. The reason is insufficient cash flow to meet their obligations as they come due.
Actually, the statement tells you much more than that. It tells you what the net change was in the cash balance of the business - an increase or decrease. More importantly, it tells how how that increase or decrease came about, by disclosing information about the cash flows in three sections:
1. The operating section
2. The investing section
3. The financing section
The operating section is all about the day to day operations of the business. The cash flow statement will always contain a subtotal showing you how much cash was either generated by or used in operations. Except for a startup business, a healthy mature business should always have positive cash from operations. This means that the day to day operations are generating enough cash to pay the obligations of the business as they come due without having to resort to drastic measures like selling off assets or borrowing money.
The investing section contains transactions of a long-term capital nature that are outside the normal operations of the business and that occur infrequently such as buying new equipment or selling off old equipment. Buying or selling of marketable securities held over the long-term would also be disclosed in this section.
The financing section contains information about long-term capital transactions involving either shareholders or long-term creditors.
Understanding The Operating Section
The operating section is prepared in one of two ways by your accountant. Each way will result in different information being shown:
1. The Direct Method.
The direct method will look almost like a repeat of your income statement, except that it will not include any non-cash items. The amounts shown will also reflect the cash impact of increasesor decreases in your current assets and liabilities as explained below.
2. The Indirect Method
This the most common method used now. It starts with your net income or loss figure from your income statement and then adjusts this number for two major classes of items:
- It removes any items that are non-cash in nature, such as gains and losses as well as amortization (depreciation) of capital assets.
- It adds or subtracts the cash flow impact of increases or decreases in current assets and liabilities.