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Understanding cash flow: the money that goes into and leaves a business is vital for businesses and investors. To understand this metric at a glance, companies will prepare a cash flow statement. This financial document is a summary of the entity’s cash flows over a specific accounting period. It shows cash and cash equivalents as they enter and leave a business, painting a picture of financial health.

A statement of cash flows is one of the three major financial documents that businesses rely on to understand financial health, alongside the balance sheet and income statement. On its own, the cash flow statement is a marker of financial health. Along with other financial statements, it provides a context for the financial stability, reliability, efficiency and profitability of a business. Needless to say, this is an important document for businesses and investors.

What Determines Cash Flow?

Although the concept of cash flow is the measure of cash inflows and outflows, it is much more nuanced than it looks. In his heart, cash flow comes from three sources, each with its impact on the company’s finances:

  • Operational cash flow. It is money spent or received in the course of normal business operations. Examples include income from sales or payment for materials.
  • Investing cash flow. This is cash spent or received through investing activities. Examples include buying stocks or buying marketable securities.
  • Funding of cash flow. This is cash received as a result of debt payments to the business or paid as debt repayment.

Businesses must consider each source when calculating cash flow. The actual calculation is performed using one of the following two methods: direct or indirect.

  • Direct method simply involves recording all cash inflows and outflows and subtracting end of period account balances from starting balances to measure net gain or loss.
  • Indirect method removes net income from a company’s balance sheet, since accrual accounting recognizes income and payments at the point of origin, not transactions. Then the business adds non-cash expenses and adjusts working capital.

Regardless of which method a business uses, the final cash flow figure is an important metric that can determine profitability for the period. But, equally important are the attribution numbers used to find it. That’s why businesses (and investors) need to look at the balance sheet beyond the totals.

What’s on a cash flow statement?

The cash flow statements fall into the three categories mentioned above: operational, investment and financing. In each section is a summary of the main factors contributing to the company’s cash inflows and outflows.

  • Operations. These figures may include net income and adjustments to reconcile it with net cash, depreciation and amortization, changes in assets and liabilities. It is summed up in net cash provided by operating activities.
  • Investment. These figures can represent capital expenditures and proceeds from the sale of assets. The final figure is the net cash used for investing activities.
  • Funding. These figures may include the proceeds of debt issuance or dividends paid. The total sum is the net cash provided by financing activities.

Each section of the cash flow statement will detail the most important contributors to inflows and outflows, to show how they affect the total sum for each section. The cash flow statement results in a net increase or loss based on cash at the beginning of the period compared to cash at the end of the period.

Negative cash flow statement

If the total at the bottom line of the balance sheet is negative, it is considered a “negative cash flow statement. “While this may cause investor concern, it is not necessarily a bad thing. For example, a company may have large cash outflows when financing a new business or making an acquisition. That is why companies publish cash flow statements alongside income statements and balance sheets, to add context. That said, negative cash flow always deserves further investigation to ensure that it is not indicative trend or impending insolvency.

Predict future cash flows

From a business perspective, the cash flow statement is useful for budgeting and forecasting future cash flows. Businesses can look back on previous accounting periods to review cash flow statements and identify trends. This helps with forward-looking assumptions and sets expectations. It also paints a clear picture of the strength and weakness of cash flow. For example, a business may have large inflows of operations, but large investment outflows that hamper healthy cash flow.

On the investor side, shareholders can use the balance sheet to better understand how a company manages its cash flow. Cash flow difficulties can indicate a difficult picture of financial health. Conversely, a strong cash flow statement can give investors optimism even if a company is currently carrying debt on its balance sheet. A strong and healthy cash flow can solve many problems!

Learn how to read a cash flow statement

Every investor should learn to read a cash flow statement and identify the different cash flow segments and their meanings. This will help you make the right decisions so that your portfolio gains financial freedom. To learn more about building wealth through your investments, subscribe to Freedom through wealth e-letter below!

Distinguishing between cash inflows and outflows and understanding their impact on the financial health of the business is the key to making sound investment decisions for a business. Most importantly, the ability to juxtapose a cash flow statement with an income statement and balance sheet will give you a real insight into the financial health and stability of a business.

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