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EduPristine>Blog>How to understand and interpret cash flow statement?

How to understand and interpret cash flow statement?

June 4, 2018

A cash flow statement is essential to any business as it can be the basis of budgeting by assessing the timing and fixing the future cash flows. The statement of cash flow like other two key. A financial statement is a collection of reports presenting inflows and outflows of cash in forms of receipt and payment. This involves various activities of business including operating, investing and financing during a specific period.

A cash flow statement finds out the inward and outward flow of money in a business and therefore acts as a bridge between the income statement and balance sheet. The change in cash per period, as well as the beginning and ending balances of cash, are present in a cash flow statement. While summarizing the amount of cash and cash equivalents flowing in and out of the company, also measures to manage company’s cash position.

Cash flow statement format

The format of cash flow statement includes mainly three parts namely, cash from working activities, cash from investing activities and cash from financing activities. GAAP, a fourth part, the disclosure of non-cash activities is included when cash flow statement is produce under the generally accepted accounting principles

Operating Cash flow

Operating activities reflects the amount of cash generated from products and services of a company and includes the primary revenue producing activities of the business.

There are two modes of presentation of operating cash flows-

  1. direct presentation
  2. indirect presentation.

The direct presentation is a simple but rarely used method which presents operating cash flows simply as a list of cash flows.
cash flow statement
On the other hand, an Indirect method is widely used and hence a common presentation of operating cash flows as a reconciliation from profit to cash flow. Under the indirect method, amortization, deferred tax, depreciation, revenue received from investing activities and profit or loss associated with a noncurrent asset are included.

Investing Cashflow

The acquisition and disposal of non-current assets and any other sources of cash from a company’s investments are included in investing activities. Typically, investing cash flows include the cash flow associated with buying and selling the property, marketable securities and therefore cash changes from investing are ‘cash out’ items. For example, lending money is considered an investing activity.

Financing cash flow

Borrowing and repaying the money, issuing stock and paying dividends are some of the financing activities. These activities result in changes in the size of equity capital and borrowings of the entity.

How to prepare a cash flow statement

To prepare a cash flow statement:

  1. Information is considered from the income statement for the current year
  2. Balance sheet for the past two years
  3. Adjustments of net income for deferrals
  4. Accruals take place

This is applied to convert the accrual basis income statement into a cash flow statement. The statement of cash flow follows activity format and includes, operating cash flows, investing cash flows and financing cash flows. There are two methods to control the cash flow statement. For both the methods, investing cash flows and financing cash flows remain identical. The operating section of the statement can be produced through either direct or indirect method.

The direct method shows the major classes of gross cash receipts and gross cash payments. On the other hand, the direct method follows net income and adjustment of profit/loss by the effect of the transaction. The underlying accounting ideas remain the same.  Hence, working cash flows provide identical result under the direct or indirect method of preparing the cash flow statement. The difference lies in the presentation. Although the direct method is set by IASB, for providing useful information; more than 90% of companies use the indirect method.

Cash flow statement: Direct and Indirect method

The direct and indirect method are two forms of producing a statement of cash flows. The direct method involves tallying all instances of received and paid cash and the total represents the resulting cash flow. However, in the indirect method, the accounting line items are used to show cash flow.

Below is a statement of cash example :

Direct Method :

Operating Activities

Cash received from customers – 800
Cash paid to suppliers – (150)
Employee compensations – (200)
Other operating expenses paid – (250)
Net Cash from operating activities – 200

Investing Activities

Sale of land – 200
Purchase of equipment – (300)
Net cash from investing activities – 100

Financing Activities

Common Share dividends – (200)
Payment on long-term debt – (300)
Net cash from financing activities – (500)
Beginning Cash balance – X
Ending Cash balance – Y

Indirect Method :

Operating Activities

Net income – 50,000
Add: Depreciation expense – 10,000
A decrease in AR – 2,000
Increase in inventory – 3,000
A decrease in prepaid expense – 4,000
Increase in accounts payable – 5,000
Net Cash from operating activities – XXX

Investing Activities

Sale of land – 200
Purchase of equipment – (300)
Net cash from investing activities – 100

Financing Activities

Common Share dividends – (200)
Payment on long-term debt – (300)
Net cash from financing activities – (500)
Beginning Cash balance – X
Ending Cash balance – Y


Cash flow statements show both positive and negative cash flow. While positive cash flows are healthy, negative cash flow should not raise a red flag automatically. Further analysis of cash flows over various periods enables an investor to assess a company’s performance.

An analysis of cash flow statements can reveal many things like the quality of earnings through comparison of cash from operating activities to company’s net income. For example, earnings are said to be higher if cash from operating activities is higher than net income.

The statement of cash flow is a significant measure of profitability and present and future outlook for a company. It decides the strength of a company and provides data whether a company has enough cash to pay its expenses or not.

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