The statement of cash flows is one of the most important financial statements a business produces, yet it’s often overlooked. Unlike the other statements, the statement of cash flows focuses on what truly powers a company: cash.
By tracking how cash moves in and out of a business, this statement answers critical questions: Is the company generating enough cash from its operations to sustain itself? How is it funding its growth? Is it spending wisely on investments?
So, what is the statement of cash flows, why is it important, how is it structured, and what insights can be drawn from it?
Be sure to reinforce your learning with our free quiz at the end!
What Is The Statement of Cash Flows?
The statement of cash flows provides a detailed summary of a company’s cash movements (inflows and outflows) over a period. It usually covers a quarter or financial year and provides a snapshot of how cash was generated and used during that time.
The statement of cash flows is one of three primary financial statements, alongside the statement of financial position (balance sheet) and the statement of profit or loss (income statement).
Why Is It Important?
The statement of cash flows provides a clear view of how a business generates the cash it needs to meet its obligations, fund growth, and sustain operations.
Other reasons of importance include the following.
Links the Income Statement and Balance Sheet
The statement of cash flows starts with a company’s net profit (from the income statement) and ends with its cash at the end of the period, as presented on the balance sheet.
The statement of cash flows adjusts net profit for non-cash items (gains and expenses included in the calculation of net profit that have no impact on cash) and changes in working capital (from the balance sheet) to bridge the other primary financial statements.
After accounting for investing cash flows and financing cash flows, the net change in cash reconciles the company’s cash balances at the beginning and end of the period (see here).
This connection ensures consistency across the financial statements, providing investors and other stakeholders with a complete picture of how a company’s activities during a period impact its profitability, financial position and cash balance.
Reveals A Company’s Cash Generating Ability
The statement of cash flows details how much cash a company generates from its core business.
After net profit is adjusted for non-cash items and changes in working capital, it shows the total cash generated from a company’s operations. When this is positive and growing, the company generates sufficient funds to cover its day-to-day expenses and obligations.
When negative, it suggests that the company spent more on its day-to-day operations than it generated and may have to take on debt to cover expenses and other obligations.
The statement of cash flows also shows how effectively a company generates cash. A metric like the cash conversion ratio helps investors compare a company’s net profit to its physical, usable cash.
The cash conversion ratio (CCR) formula is as follows.
Cash Conversion Ratio = Net Cash From Operations / Net Profit
Interpretation
- CCR greater than 1: The company generates more cash than its reported net profit.
- CCR equal to 1: The company generates net profit and cash at an even rate. For every £1 of profit, the company generates £1 of cash from operating activities.
- CCR less than 1: The company generates less cash from its operating activities than its profit.
Highlights Financial Risk
For the savvy investor, the statement of cash flows can reveal potential red flags before they appear on any other financial statement and manifest in real life.
For example, an increasing trend of borrowing appears on the statement of cash flows (in the financing activities section) before it negatively impacts a company’s profits and financial position. This over-reliance on external financing is especially risky if used to cover operating expenses and other obligations.
A company can only borrow so much.
Statement of Cash Flows Structure
The statement of cash flows is divided into three sections that outline how cash moves through a business during a specific period.
Here’s a breakdown of the statement’s structure.
Cash From Operating Activities
This section focuses on how cash is generated from a company’s core operations. It is derived by summing the cash inflows and outflows directly related to a company’s primary business activities. Cash from operating activities can be calculated using the direct or indirect method.
The direct method lists and totals all the cash inflows and outflows related to a company’s operating activities. The indirect method starts with a company’s net profit and adjusts for non-cash items and changes in working capital.
Most, if not all, companies use the indirect method.
More on cash from operating activities here.
Cash From Investing Activities
This section reflects the cash inflows and outflows related to buying and selling long-term assets, businesses and financial securities. It gives investors insight into how a company uses its cash resources to expand operations, maintain its existing assets or generate returns through financial investments.
Common cash inflows include:
- Proceeds from the sale of assets
- Proceeds from the sale of financial securities
Common cash outflows include:
- Purchases of property, plant and equipment
- Acquisitions (of businesses)
More on cash from investing activities here.
Cash From Financing Activities
This section shows how the company funds its operations and growth through external financing (debt and equity).
Common cash inflows:
- Proceeds from issuing shares (equity financing)
- Proceeds from borrowing (debt financing)
Common cash outflows:
- Debt repayments
- Dividend payments to shareholders
- Share buybacks
More on cash from financing activities here.
Net Change In Cash and Cash Equivalents
The net change in cash and cash equivalents figure summarises a company’s total cash movements over a specific period. It is calculated by summing the net cash flows from each section of the statement of cash flows.
Net Change in Cash and Cash Equivalents = Net Cash from Operating Activities + Net Cash From Investing Activities + Net Cash From Financing Activities
This figure is then added to the company’s cash balance at the beginning of the period to determine its ending cash balance.
Statement of Cash Flows Example
The following image shows how the statement of cash flows is laid out, how the net change in cash and cash equivalents is calculated, and how the beginning and ending cash balances are reconciled.
Image 1: Statement of Cash Flows Example
Key Takeaways
- The positive cash from operating activities indicates the company is generating sufficient cash from its core operations, which is a strong signal of a healthy business.
- Negative cash from investing activities is typical for companies. It largely reflects investments in new assets or acquisitions of other companies to support future growth.
- The negative cash flow from financing indicates that the company is repaying debt, paying dividends and buying back shares – signs that it is focused on reducing leverage and returning value to shareholders.
- The company’s cash position improved during the period, with inflows from operating activities exceeding the outflows from investing and financing activities.
Some Key Insights From The Statement
The statement of cash flows provides several essential insights that help investors evaluate and make informed decisions about a company.
Some of the insights include the following.
Cash Management
The statement of cash flows provides investors with a means of assessing a company’s cash management.
Positive net cash flow trends suggest good liquidity – a company can cover its expenses and other short-term obligations. Consistently negative cash flows could indicate that a company struggles to manage its cash, potentially leading to issues in meeting its short-term obligations.
Free Cash Flow
Free cash flow (FCF) represents a company’s remaining cash after accounting for capital expenditures (cash spent on maintaining existing and purchasing new assets). This leftover cash is available to repay debt and reward shareholders with dividends and stock repurchases.
Free cash flow is calculated as follows.
FCF = Net Cash From Operating Activities – Capital Expenditure (CapEx)
Investors like companies that generate high and increasing amounts of free cash flow because free cash flow is what a company is valued on. The higher the free cash flow, the more valuable the company.
Growth and Expansion
The statement of cash flows also shows a company’s spending for growth and expansion.
The cash from investing activities section details a company’s spending on long-term investments like property, plant and equipment (PPE) and strategic acquisitions of other businesses.
Similarly, the cash from investing activities section shows how a company may prepare for this new growth. Cash inflows from asset sales and divestitures (selling part of or entire businesses) may suggest that the company is pivoting to a new growth strategy or wants a leaner, more streamlined business.
Summary
The statement of cash flows is a vital financial document that provides a detailed account of a company’s cash inflows and outflows during a specific period.
The three sections (operating activities, investing activities and financing activities) of the statement of cash flows reveal how a company generates cash from its core operations, invests in growth, and manages funding through debt or equity.
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