How To Prepare A Statement Of Cash Flows

Finance manager preparing statement of cash flows in office

You’re about to learn a valuable skill that will give you a clear picture of your business’s financial health – preparing a statement of cash flows. In this article, we will guide you through the process step by step, ensuring that you have a comprehensive understanding of this essential financial statement. From identifying cash inflows and outflows to categorizing them into operating, investing, and financing activities, we’ve got you covered. So get ready to take control of your cash flow like a pro and make informed business decisions. Let’s dive in!

Understanding the Basics of a Statement of Cash Flows

Definition of a Cash Flow Statement

A statement of cash flows is a financial report that provides a summary of the cash inflows and outflows of a business over a specific period. It shows how cash has been generated and used during the accounting period. The statement of cash flows is one of the three main financial statements, alongside the income statement and balance sheet. It helps stakeholders, such as investors, creditors, and management, understand the sources and uses of cash in a company.

The Purpose and Benefits of a Cash Flow Statement

The primary purpose of a cash flow statement is to provide users with information about a company’s cash flow activities. It helps them assess a company’s ability to generate cash, meet its financial obligations, and fund its operations. By analyzing the cash flow statement, stakeholders can evaluate a company’s liquidity, financial health, and its ability to generate future cash flows. This information is vital for making informed decisions, such as investing in the company, extending credit, or assessing its financial viability.

Key Elements of a Cash Flow Statement

A cash flow statement typically consists of three main sections: operating activities, investing activities, and financing activities. Operating activities include cash transactions related to the core operations of the business, such as revenue from sales and payments to suppliers. Investing activities involve cash flows from the purchase or sale of long-term assets, such as property, plant, and equipment. Financing activities include cash flows from borrowing and repaying debt, issuing or buying back shares, and paying dividends.

Types of Cash Flows

Operating Activities

Operating activities involve the day-to-day cash flows from the company’s core operations. This includes cash received from customers for the sale of goods or services, as well as cash paid to suppliers for purchases, employee salaries, and operating expenses. It also includes interest received and paid, income tax payments, and any other cash flows directly related to the company’s main business activities. Operating cash flows are crucial as they indicate a company’s ability to generate cash from its core operations.

Investing Activities

Investing activities refer to cash flows related to the purchase or sale of long-term assets. This includes cash flows from the acquisition or sale of property, plant, and equipment, investments in other companies, and the purchase or redemption of financial securities. Investing activities also include repayment of loans made to other entities and any other cash flows related to investments. Analyzing the investing activities section helps determine how a company deploys its resources for long-term growth and expansion.

Financing Activities

Financing activities involve cash flows related to the company’s capital structure and raising funds. This includes cash received from issuing shares, borrowing from banks or other sources, and the repayment of debt. It also includes payments of dividends to shareholders and the repurchase of company shares. Monitoring the financing activities section helps assess a company’s ability to attract capital, manage debt, and provide returns to its shareholders.

The Indirect and Direct Methods of Cash Flow

Understanding the Direct Method

The direct method of presenting the cash flow statement shows the actual cash inflows and outflows from operating activities. It starts with the total cash collected from customers and deducts cash paid to suppliers, employees, and other operating expenses. It also includes cash received from other sources, such as interest income, and deducts interest paid and taxes. The direct method provides a more detailed view of the cash flows associated with a company’s operations.

Understanding the Indirect Method

The indirect method starts with the net income from the company’s income statement and adjusts it for non-cash items and changes in working capital. Non-cash items include depreciation, amortization, and non-cash expenses. Changes in working capital include variations in accounts receivable, inventory, and accounts payable. The indirect method indirectly reconciles the net income to the net cash provided by operating activities. It is commonly used because it is simpler and less costly to prepare.

Comparison between Direct and Indirect Methods

Both the direct and indirect methods provide the same result for the cash flow from operating activities. However, the presentation and disclosure of information differ. The direct method provides a more detailed breakdown of cash flows, making it easier to analyze the sources and uses of cash. On the other hand, the indirect method focuses on reconciling net income and adjusts for non-cash items and changes in working capital. The choice between the direct and indirect method depends on the reporting requirements and the level of detail desired by the users of the cash flow statement.

Establishing The Reporting Period

Determining The Accounting Period

The accounting period for a cash flow statement is typically one year, known as an annual statement. However, it can also be prepared for shorter periods, such as monthly or quarterly, depending on the company’s reporting needs. The accounting period should align with the company’s financial statements, such as the income statement and balance sheet, to ensure consistency and accuracy in financial reporting. Determining the appropriate accounting period is essential to provide meaningful and relevant information to users of the cash flow statement.

Importance of Consistency in Reporting Periods

Consistency in reporting periods is crucial for proper financial analysis and comparability across periods. It allows stakeholders to track a company’s cash flows over time and identify trends or changes in its financial performance. If a company changes the reporting period frequently, it may create confusion and hinder the ability to make meaningful comparisons. Therefore, it is essential to establish a consistent and regular reporting period for the cash flow statement and adhere to it.

The Process of Gathering Relevant Financial Data

Identifying Source Documents

To prepare a statement of cash flows, you need to gather relevant financial data from various source documents. These documents include cash receipts and disbursement records, sales invoices, purchase invoices, employee payroll records, bank statements, loan agreements, and other financial records. Identifying and collecting the necessary source documents is the first step in ensuring accurate and complete financial information for the cash flow statement.

Sorting Financial Transactions

Once you have gathered the source documents, you need to sort and organize the financial transactions based on their nature and category. This involves categorizing the transactions into operating, investing, and financing activities to ensure proper classification and presentation in the cash flow statement. Sorting the financial transactions allows for a systematic and structured approach to preparing the cash flow statement.

Verification of Financial Data

After sorting the financial transactions, it is essential to verify the accuracy and completeness of the data. This involves cross-referencing the source documents, ensuring that all transactions are recorded, and reviewing the supporting documentation for any discrepancies. Verifying the financial data helps ensure the integrity and reliability of the cash flow statement.

Calculating Cash Flows from Operating Activities

Identifying Revenue and Expense Transactions

To calculate cash flows from operating activities, you need to identify revenue and expense transactions directly related to the company’s core operations. This includes cash received from customers for sales and services rendered and cash paid to suppliers for purchases and operating expenses. Revenue transactions may include cash sales, collections from accounts receivable, and interest and dividend income. Expense transactions may include cash payments to suppliers, employee salaries, rent, and utilities.

Adjustments for Non-Cash Expenses

In addition to cash revenue and expenses, you need to make adjustments for non-cash expenses, such as depreciation and amortization. These expenses do not involve the actual outflow of cash but are recorded in the income statement. To calculate cash flows from operating activities, you add back the non-cash expenses to the net income. This adjustment allows for a more accurate representation of the cash generated from operating activities.

Adjustments for Non-Operating Gains and Losses

Cash flows from operating activities should exclude any gains or losses from non-operating activities. For example, gains or losses on the sale of non-current assets or investments should be excluded from operating activities and classified as investing activities. By excluding non-operating gains and losses, the cash flow statement focuses solely on the cash flows generated by the company’s core operations.

Changes in Current Assets and Current Liabilities

Changes in current assets and current liabilities also impact the calculation of cash flows from operating activities. An increase in current assets (such as accounts receivable or inventory) represents cash outflow, while a decrease represents cash inflow. Conversely, an increase in current liabilities (such as accounts payable or accrued expenses) represents cash inflow, while a decrease represents cash outflow. These changes need to be adjusted for in order to accurately calculate the net cash flows from operating activities.

Calculating Cash Flows from Investing and Financing Activities

Identifying Investing and Financing Transactions

To calculate cash flows from investing activities, you need to identify transactions related to the purchase or sale of long-term assets, investments, and loans made to other entities. This includes cash paid for the purchase of property, plant, and equipment, as well as cash received from the sale of these assets. It also includes cash paid for investments in other companies or financial instruments, and cash received from the sale or redemption of these investments. For financing activities, you need to identify transactions related to issuing shares, borrowing funds, and repaying debt.

Adjustments for Non-Cash Investing and Financing Transactions

Similar to the adjustments made for non-cash expenses in operating activities, you need to exclude any non-cash investing and financing transactions from the cash flow statement. For example, if the company acquires an asset through a non-cash exchange or receives financing through the issuance of shares instead of cash, these transactions are excluded from the cash flows from investing and financing activities. Adjusting for non-cash transactions ensures that the cash flow statement reflects only the actual cash flows in these categories.

Calculations for Investing and Financing Cash Flows

Once the non-cash transactions are adjusted or excluded, you can calculate the net cash flows from investing and financing activities. This involves summing up the cash inflows and outflows in each category and determining the overall net change in cash. Cash flows from investing and financing activities provide insight into how a company is allocating its resources and managing its capital structure.

Preparing the Initial Draft of the Cash Flow Statement

Writing the Header and Body

To begin preparing the cash flow statement, you need to write the header, which includes the name of the company, the title of the statement, and the accounting period covered. The body of the statement consists of three main sections: operating activities, investing activities, and financing activities. Each section should include a subtotal for cash flows, followed by a net cash change for the period. The operating activities section should start with the net income, adjusted for non-cash items and changes in working capital. The investing and financing activities sections should include the cash flows identified and adjusted earlier.

Detailing Cash Transitions

Within each section of the cash flow statement, it is essential to provide a breakdown of the individual cash flows. For example, in the operating activities section, you may include line items for cash received from customers, cash paid to suppliers, and cash paid for operating expenses. This level of detail allows stakeholders to understand the specific sources and uses of cash within each category.

Cross-checking for Errors

After preparing the initial draft of the cash flow statement, it is crucial to cross-check the numbers and formulas for accuracy. This involves reviewing the calculations, verifying the source documents, and ensuring that all adjustments and exclusions are correctly reflected. Cross-checking for errors helps maintain the integrity and reliability of the cash flow statement.

Finalizing the Cash Flow Statement

Double Checking All Calculations and Entries

Before finalizing the cash flow statement, it is essential to double-check all calculations and entries. This includes verifying the formulas, confirming the accuracy of the numerical values, and reviewing all adjustments and exclusions. Double-checking ensures that the cash flow statement is error-free and provides reliable information to users.

Adding Up the Total Cash Flow

The next step in finalizing the cash flow statement is adding up the total cash flow for the period. This involves summing up the net cash flows from operating activities, investing activities, and financing activities. The total cash flow provides an overview of the net change in cash for the accounting period.

Preparing Final Reports for Review

Once the cash flow statement is finalized, it should be prepared along with other financial statements, such as the income statement and balance sheet, for review. These financial reports provide a comprehensive view of a company’s financial performance and position. They should be reviewed by relevant stakeholders, including management, auditors, and investors, to ensure accuracy and compliance with accounting standards.

Analysis and Interpretation of a Cash Flow Statement

Using Cash Flow Ratios

Cash flow ratios are financial metrics derived from the cash flow statement that provide insights into a company’s liquidity, solvency, and operational efficiency. Examples of cash flow ratios include the cash flow margin, cash flow return on investment, and operating cash flow ratio. By analyzing these ratios, stakeholders can assess the financial health and long-term sustainability of a company.

Understanding Cash Flow Trends

By comparing the cash flow statement over multiple periods, stakeholders can identify and understand cash flow trends. Positive trends, such as increasing cash flows from operating activities, may indicate improving profitability and efficiency. Negative trends, such as decreasing cash flows from investing activities, may raise concerns about a company’s ability to generate growth and returns. Monitoring cash flow trends helps stakeholders identify areas of strength or weakness and make informed decisions.

Interpreting Result for Decision Making

Ultimately, the cash flow statement is a tool for decision-making. It provides valuable information for stakeholders to assess a company’s financial performance, liquidity, and ability to generate cash. The analysis and interpretation of the cash flow statement allow stakeholders to make informed decisions, such as investing in the company, extending credit, or adjusting business strategies. It provides a deeper understanding of the company’s financial position and helps guide future actions and decisions.

In conclusion, understanding the basics of a statement of cash flows is crucial for anyone involved in financial analysis and decision-making. By defining the cash flow statement and its purpose, exploring the different types of cash flows, and understanding the direct and indirect methods, you gain a solid foundation for interpreting and preparing cash flow statements. With proper attention to gathering relevant financial data, calculating cash flows, and finalizing the statement, you can provide accurate and informative reports for stakeholders. The analysis and interpretation of the cash flow statement allow for informed decision-making and a deeper understanding of a company’s financial health and prospects.

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