The cash flow statement in accounting is one of the four basic financial statements. It presents the cash inflows and outflows of a business’s operating, investing, and financing activities. Reviewing it can give you information about your cash flow as opposed to net income.
Below is a cash flow statement example:
| INFINITY STONES INC.Statement of Cash FlowsFor the Year Ended December 31, 2022 | ||
|---|---|---|
| Cash flows from operating activities: | ||
| Net income | $ 62,500 | |
Adjustments to reconcile net income to net cash provided by operating activities:
| $ 16,500 1,000 (21,000) (27,500) 1,500 (3,500) | |
| Net adjustments | (33,000) | |
| NET CASH PROVIDED BY OPERATING ACTIVITIES | 29,500 | |
| Cash flows from investing activities:Proceeds for sale of landProceeds for sale of old equipmentPurchase of new equipment | $ 12,500 17,000 (83,000) | |
| NET CASH USED BY INVESTING ACTIVITIES | (53,500) | |
| Cash flows from financing activities:Principal paid on notes payableIssuance of common stocksPayment of dividends | $ (20,000) 80,000 (27,500) | |
| NET CASH PROVIDED BY FINANCING ACTIVITIES | 32,500 | |
| NET INCREASE IN CASH | $ 8,500 | |
| Add: Cash balance as of December 31, 2021 | 18,500 | |
| CASH BALANCE AS OF DECEMBER 31, 2022 | $ 27,000 | |
The cash flow statement above uses the indirect method in computing the net cash flow from operating activities. In this article, we’ll explain each part of the cash flow statement, go over the difference between the indirect and direct method, and illustrate an example for good measure. With small business accounting software, you can generate a cash flow statement with a few clicks. Choose among our top picks in our best small business accounting software guide.
What Are Operating Activities on a Cash Flow Statement?
The operating activities section of the cash flow statement shows the cash flow generated or used in the core operations of the company. These activities involve actual cash receipts from sales and actual cash payments to suppliers and employees. There are two ways to present the operating activities section: the indirect or direct method.
The indirect method presents operating activities starting with net income and followed by reconciliation adjustments. The reconciliations consist of two types. First, adjustments must be made to convert the accrual-basis net income to cash flow. Second, gains and losses included in net income that aren’t related to core operating activities must be removed.
On the other hand, rather than starting with net income and making adjustments, the direct method reports the cash receipts and disbursements of operations, not increases or decreases in certain accounts. This method explicitly shows where cash came from and where it went.
What Are Investing Activities on a Cash Flow Statement?
The investing activities section presents all purchases and disposal of long-term assets, including loans and investments. Investing activities often include
- Purchase and disposal of property, plant, and equipment (PPE).
- Sale or purchase of debt and equity securities of other companies.
- Collection of loans extended to other companies.
- Provision of loans to other companies.
What Are Financing Activities on a Cash Flow Statement?
The financing activities section involves liability and equity items. It presents cash inflows from new issuances of stocks or loans and cash outflows from payment of dividends or settlement of liabilities. Financing activities often include
- Issuance of common or preferred stocks.
- Issuance of debt securities, like bonds and notes.
- Payment of dividends to stockholders.
- Principal payments of long-term debt.
- Reacquisition of capital stock or treasury stock.
Cash Flow Statement Example & Illustration
Let’s use the information from Infinity Stones Inc., a fictitious company selling jewelry, in making a statement of cash flows. Below is the company’s income statement and comparative balance sheet.
| INFINITY STONES INC.Statement of Cash FlowsFor the Year Ended December 31, 2022 | ||
|---|---|---|
| SalesCost of goods soldGross profitOperating expensesInterest expenseLoss on sale of equipmentIncome from operationsIncome tax expenseNET INCOME | 107,500 6,000 4,000 | $ 445,000 212,500 212,500 117,500 95,000 32,500 $ 62,500 |
| INFINITY STONES INC.Statement of Cash FlowsFor the Year Ended December 31, 2022 | |||
|---|---|---|---|
| ASSETS | 2022 | 2021 | Change |
| CashAccounts receivableInventoryPrepaid expensesLandBuildingsAccumulated depreciation - buildingEquipmentAccumulated depreciation - equipment Totals | $ 27,000 34,000 27,500 1,500 22,500 100,000 (11,000) 96,500 (17,000)$ 286,500 | $ 18,500 13,000 - 3,000 35,000 100,000 (5,500) 34,000 (5,000)$ 187,500 | 8,500 increase21,000 increase27,500 increase1,500 decrease12,500 decrease -5,500 increase62,500 increase9,000 increase |
| LIABILITIES EQUITY | |||
| Accounts payableNotes payableCommon Stock ($1 par)Retained earnings Totals | $ 16,500 55,000 110,000 105,000$ 286,500 | $ 20,000 75,000 30,000 62,500$ 187,500 | 3,500 decrease20,000 decrease80,000 increase40,500 increase |
Additional information:
- Operating expenses include depreciation expense of $16,500 and expiration of prepaid expenses of $1,000.
- Land was sold at its book value for cash.
- The company declared and paid cash dividends of $27,500.
- Equipment was purchased for $83,000 using cash. Another piece of equipment was sold for $17,000 while its book value was $18,000.
The indirect method (or reconciliation method) of reporting operating activities starts with accrual net income and converts it to net cash flow from operating activities. In other words, you need to adjust accrual net income for items that increased or decreased net income but didn’t affect cash.
Here’s the process using the indirect method:
- Step 1: Pull up the net income figure from the end-of-period income statement.
- Step 2: Add back to net income all noncash expenses like depreciation, losses, and amortization.
- Step 3: Deduct from net income all noncash revenues and gains.
- Step 4: Add to net income the decreases in accounts receivable (A/R), inventory, and prepaid expenses. Conversely, deduct them from net income if they increased.
- Step 5: Add to net income the increases in accounts payable (A/P) and accrued expenses. Conversely, deduct them from net income if they decreased.
- Step 6: Compute the net adjustments to net income to arrive at the net operating cash flow.
STEPS 1 to 3: Let’s check the income statement and get the net income for the period. Then, determine the items that increased or decreased net income but didn’t affect cash. In the financial statements above, we see depreciation expense and the loss on sale of equipment as noncash items. These items decreased our net income but didn’t have any cash effect, so they must be added back to arrive at operating cash flow.
| INFINITY STONES INC.Statement of Cash FlowsFor the Year Ended December 31, 2022 | ||
|---|---|---|
| Cash flows from operating activities:Net income (Step 1) | $ 62,500 | |
Adjustments to reconcile net income to net cash provided by operating activities:
| $ 16,500 1,000 | |
STEPS 4 to 6: Look at the balance sheet. Focus on A/R, inventory, prepaid expenses, and A/P because these are the only accounts considered for operating activities. Here’s how we’ll reconcile them under the indirect method:
- Increase in A/R: When the balance of A/R increases, it means that accrual-basis sales exceed cash collections during 2022. We deduct the increase to convert accrual net income to cash basis net income.
- Increase in inventory: When the balance of inventory increases, it means that inventory purchases exceed inventory sales. We need to deduct the increase in inventory to net income because accrual basis COGS is lower than cash basis inventory purchases. In other words, we’re adding the increase in inventory to accrual basis COGS.
- Decrease in prepaid expenses: A prepaid expense is an expense paid in advance even if not yet consumed. An example of this would be annual subscriptions. Since the business already paid in advance, the monthly deduction of prepaid expenses has no effect on cash. Hence, we need to add back these deductions to net income.
- Decrease in A/P: When the balance of A/P decreases, it means that COGS and expenses are lower in the accrual basis but higher in the cash basis. We need to deduct the decrease in A/P to adjust the lower accrual basis COGS and expenses.
| INFINITY STONES INC.Statement of Cash FlowsFor the Year Ended December 31, 2022 | ||
|---|---|---|
| Cash flows from operating activities:Net income (Step 1) | $ 62,500 | |
Adjustments to reconcile net income to net cash provided by operating activities:
| $ 16,500 1,000 (21,000) (27,500) 1,500 (3,500) | |
| Net adjustments | (33,000) | |
| NET CASH PROVIDED BY OPERATING ACTIVITIES | 29,500 | |
Under the direct method, we need to analyze the accounts further and determine the amount of cash receipts and cash payments. This is the process using the direct method:
- Step 1: Determine cash receipts from customers.
- Step 2: Compute cash payments to suppliers and operating expenses.
- Step 3: Deduct interest and tax payments.
- Step 4: Compute net cash provided or used by operating activities.
By using the same data from Infinity Stones Inc., let’s try to use the direct method and see if we’ll arrive at $29,500 as net cash provided by operating activities.
STEP 1: To determine cash receipts, we need to look at A/R. Credit sales increase A/R while collections from customers decrease A/R. If we express that as an equation, it should look like this:
Ending A/R = Beginning A/R + Credit Sales – Collections
By rearranging the equation, we compute collections from customers as:
Collections = Beginning A/R + Credit Sales – Ending A/R
Therefore, cash collections from customers are $424,000 (13,000 + 445,000 – 34,000).
STEP 2: To determine cash payments to suppliers and operating expenses, we need to look at A/P, inventory, prepaid expenses, and accrued expenses. Our formula for computing cash payments would be:
Cash Payments to Suppliers = COGS + (Ending Inventory – Beginning Inventory) + (Ending A/P – Beginning A/P)
Cash Payments for Operating Expenses = Operating Expenses* + (Beginning Prepaid Expense – Ending Prepaid Expense)
*excluding depreciation expense
Cash payments to suppliers is $263,500 (232,500 + 27,500 – 0 + 20,000 – 16,500) and cash payments for operating expenses is $92,500 (94,000 + 3,000 – 1,500).
STEPS 3 to 4: Compute the net cash provided or used by operating activities using the direct method.
| INFINITY STONES INC.Statement of Cash FlowsFor the Year Ended December 31, 2022 | |
|---|---|
| Cash flows from operating activities:Cash receipts from customers (Step 1)Cash payments to suppliers (Step 2)Cash payments for operating expenses (Step 2)Cash payments for interest (Step 3)Cash payments for taxes (Step 3)NET CASH PROVIDED BY OPERATING ACTIVITIES | $ 424,000 (263,500) (92,500) (6,000) (32,500)$ 29,500 |
In the balance sheet of Infinity Stones Inc., we didn’t see an income tax payable and interest payable account. It only means that the business had already paid it, and we need to include it as a cash outflow for operations.
When it comes to preparing this, we only need to follow the cash flow from transactions. If there’s no cash flow, we don’t include it in the cash flow statement.
For investing activities, we need to take note of the following accounts from the balance sheet:
- Decrease in land: If the land account decreased, it only means that we sold a portion of it during the year. Hence, there’s a cash inflow (increase in cash) as a result of the sale.
- Increase in equipment: If the equipment account increased, it means that there’s a purchase of new equipment during the year. Hence, there’s a cash outflow (decrease in cash).
For financing activities, we focus on liabilities and equity accounts in the balance sheet. Particularly, we pay attention to the following:
- Decrease in notes payable: Paying liabilities is a cash outflow and reduces the cash of the business.
- Increase in common stock: An increase in common stock only means that the company issued new stocks. Stock issuances are a cash inflow, and it increases cash.
- Payment of dividends: Dividends must be declared and paid before they can be part of the cash flow statement because dividend declarations alone don’t affect cash.
Let’s complete the investing and financing activities section:
| Cash flows from investing activities:Proceeds from sale of landProceeds from sale of old equipmentPurchase of new equipmentNET CASH USED BY INVESTING ACTIVITIES | $ 12,500 17,000 (83,000) | (53,500) |
|---|---|---|
| Cash flows from financing activities:Payment of notes payableIssuance of common stocksPayment of dividendsNET CASH PROVIDED BY FINANCING ACTIVITIES | (20,000)80,000(27,500) | 32,500 |
After completing the three main areas of the cash flow statement, let’s determine the ending cash balance by following these steps:
- Step 1: Determine the net increase or decrease in cash during the period.
- Step 2: Add the net increase in cash during the period to the beginning cash balance.
- Step 3: Compare if the ending cash balance in the cash flow statement matches the cash balance in the balance sheet. If not, revisit the cash flow statement for miscalculations.
STEP 1: To determine the net increase in cash, you have to add the net cash flow from operating, investing, and financing activities.
| INFINITY STONES INC.Statement of Cash FlowsFor the Year Ended December 31, 2022 | ||
|---|---|---|
| Cash flows from operating activities: | ||
| Cash receipts from customers | $ 424,000 | |
| Cash payments to suppliers | 263,500 | |
| Cash payments for operating expenses | 92,500 | |
| Cash payments for interest | 6,000 | |
| Cash payments for taxes | 32,500 | |
| NET CASH PROVIDED BY OPERATING ACTIVITIES | $ 29,500 | |
| Cash flows from investing activities: | ||
| Sale of land at book value | $ 12,500 | |
| Sale of old equipment | 17,000 | |
| Purchase of new equipment | (83,000) | |
| NET CASH USED BY INVESTING ACTIVITIES | (53,500) | |
| Cash flows from financing activities: | ||
| Payment of notes payable | $ (20,000) | |
| Issuance of common stocks | 80,000 | |
| Payment of dividends | (27,500) | |
| NET CASH PROVIDED BY FINANCING ACTIVITIES | 32,500 | |
| NET INCREASE IN CASH (Step 1) | $ 8,500 | |
STEP 2 to 3: Add the beginning cash balance to the net increase in cash, and check if it matches with the cash balance in the balance sheet.
| INFINITY STONES INC.Statement of Cash FlowsFor the Year Ended December 31, 2022 | ||
|---|---|---|
| Cash flows from operating activities: | ||
| Cash receipts from customers | $ 424,000 | |
| Cash payments to suppliers | 263,500 | |
| Cash payments for operating expenses | 92,500 | |
| Cash payments for interest | 6,000 | |
| Cash payments for taxes | 32,500 | |
| NET CASH PROVIDED BY OPERATING ACTIVITIES | $ 29,500 | |
| Cash flows from investing activities: | ||
| Sale of land at book value | $ 12,500 | |
| Sale of old equipment | 17,000 | |
| Purchase of new equipment | (83,000) | |
| NET CASH USED BY INVESTING ACTIVITIES | (53,500) | |
| Cash flows from financing activities: | ||
| Payment of notes payable | $ (20,000) | |
| Issuance of common stocks | 80,000 | |
| Payment of dividends | (27,500) | |
| NET CASH PROVIDED BY FINANCING ACTIVITIES | 32,500 | |
| NET INCREASE IN CASH (Step 1) | $ 8,500 | |
| Add: Cash balance as of December 31, 2021 (Step 2) | 18,500 | |
| CASH BALANCE AS OF DECEMBER 31, 2022 (Step 3) | $ 27,000 | |
In the balance sheet of Infinity Stones Inc., the ending cash balance is also $27,000. It only means that we didn’t make any miscalculations in preparing the cash flow statement.
Uses of a Cash Flow Statement
A cash flow statement shows the amount of cash your business generates. Even if you have a large net income, the income statement doesn’t depict your business’ cash generation ability entirely because it uses the accrual basis of accounting.
- Gauges the business’ ability to generate future cash flow: It can provide information about the timing and uncertainty of future cash flows. You can see the relationship of cash flow and sales to create predictions of future cash inflows and outflows.
- Assesses the business’ ability to pay liabilities: It shows how the business generates and uses cash. Employees and creditors can use it to assess if the business can generate enough cash to pay employee salaries or liabilities.
- Presents other sources and uses of cash in the business: Aside from the operating cash flow, the cash flow statement shows the financing and investing activities of the business. You can tell the readers of the cash flow statement that the business has sources or uses of cash other than operations and where each is coming from and going to.
- Evaluates operating cash flow: Every section of the cash flow statement tells how you source and use cash. If you have a bigger cash inflow from financing activities, such as obtaining debt, but are losing cash from operating activities, then it implies that your business’s operations aren’t performing well, unless you’re a new business. Startups often have large cash inflows from financing activity while low cash from operations. But as the business continues to operate, operating cash flow must increase.
Frequently Asked Questions (FAQs)
Which method is better for presenting operating activities?
For small businesses, we recommend using the direct method because it provides more useful information to small business owners. Most companies, including multinational corporations, use the indirect method because it’s less complex to prepare. The main advantage of the indirect method is that it ties the net income from the income statement to the change in cash on the balance sheet. Moreover, the indirect method shows the reconciliation of accrual to cash accounting during the bookkeeping process. In contrast, the direct method shows explicitly where cash is coming from and where it’s going.
How to read and interpret the cash flow statement?
The cash flow statement can tell the business’ stage in the business life cycle. During the launch phase, it’s expected to see significant cash outflows in the investing activities section and very low cash inflows in the operating activities. But as the business approaches growth and shake-out stage, cash flows will increase in operating activities. Aside from that, the cash flow statement can provide information about unusual transactions that occurred in the business such as purchase of treasury shares or sale of business assets.
Should you prepare the cash flow statement?
Yes, because it shows the inflow and outflow of cash. For small businesses that always worry about cash, a cash flow statement can be more meaningful than the income statement. Sometimes, accrual accounting doesn’t portray the true liquidity of the business. Hence, the statement of cash flows can show the business’s ability to generate enough cash in contrast to its ability to generate revenues.
Bottom Line
The cash flow statement shows the operating, financing, and investing cash flows of the business. It provides insights about the business’s ability to generate future cash flows and settle obligations. Preparing the cash flow statement is usually the last step in the order of financial statement preparations. The operating activities section can be presented using the direct or indirect method. However, the financing and investing activities only use the direct method because they explicitly show the flow of cash.
