There is a need why understanding the cash flow statement is necessary. This is because, it is the cash flow statement that helps you. Know how much cash is entering or leaving your business. Together with balance sheets and income statements, the cash flow. Statement is one of the three most important financial statements for managing your small. Business accounting and ensuring that you have enough cash to keep operating.
Is Cash Flow Statement Necessary?
For those who use accrual accounting, cash flow statements. Are essential for three reasons:
The cash flow statement shows your liquidity. Which enables you to know exactly how much operating cash flow you have in case. You have a need for it. It helps you know what you can or can’t afford.
Cash flow statements also show you changes in assets, liabilities, and equity in the forms of cash outflows, cash inflows. And cash being held. Now, these three categories, are the core of your. Business accounting, and together they form the accounting equation that enables. You to measure your performance.
It enables you to predict future cash flows. By using the cash flow statements to create cash flow projections. This helps you plan for how. Much liquidity your business will likely have in the future. Now, this is quite important if. You are making long term business plans.
Also if you are planning on securing a loan or line of credit. You will need up-to-date cash flow statements to apply.
Negative Cash Flow Vs. Positive Cash Flow
If your cash flow statement is reflecting a negative number at the bottom, it means you lost cash during the accounting period. This means you have a negative cash flow. However, it is important to understand that a. Negative cash flow is not always a bad thing. This is because, some months you may. Have to spend cash, in order to make money later on by investing in equipment.
If on the other hand, you have a positive number at the. Bottom of your statement, it means you have a. Positive cash flow for the month. Bear in mind also that a positive cash flow is not always a good thing in the long term. This is because, while it gives you more liquidity now. There are negative reasons you may have that money. At the end of the day, a positive cash flow is not always a positive overall.
Where Do Cash Flow Statements Come From?
Cash flow statements can be calculated each month, depending on the information on your income statements and balance sheets, if you do your bookkeeping in Excel. On the other hand, if you use accounting software, it can create cash flow statements depending on the information that you have already entered in the general ledger.
Understand that even with both methods, your cash flow statement is only accurate as long as the rest of your bookkeeping is accurate also. If you want to be doubly sure that you are on the right track, then you will have to hire a bookkeeper. They will ensure that everything adds up so that you always have your cash flow statement giving you an accurate picture.
How to Calculate Cash Flow
You can calculate cash flow, by making adjustments to net income by adding or subtracting differences in revenue, expenses, and credit transactions (which appears on the balance sheet and income statement) resulting from transactions that take place from one period to the next. Understand that these adjustments are made as a result of non-cash items which are calculated into net income (income statement) and total assets and liabilities (balance sheet). Thus, because not all transactions involve actual cash items, many items have to be re-evaluated when calculating cash flow from operations.
Thus, you can calculate cash flow using two methods, known as the direct method, and indirect method.
Direct Cash Flow Method
The direct method adds up the different types of cash payments and receipts, which includes cash paid to suppliers, cash receipts from customers and cash paid out in salaries. Now, these figures are calculated by using the beginning and ending balances of a variety of business accounts and examining the net decrease or increase in the accounts.
It is also important to note that, even if you record cash flows in real-time with the direct method, you will also need to use the indirect method in reconciling your statement of cash flow with your income statement. Thus, you can usually expect the direct method to take longer than the indirect method.
Indirect Cash Flow Method
For the indirect method, cash flow from operating activities is calculated by taking first the net income off of a company’s income statement. This is owing to the fact that a company’s income statement is prepared on an accrual basis, and revenue is only recognized when it is earned and not when it is received. Thus net income is not an accurate representation of net cash flow from operating activities, thus it becomes necessary to adjust earnings before interest and taxes (EBIT) for items that affect net income, although no actual cash has yet been received or paid against them. The indirect method also makes adjustments to add back non-operating activities that do not affect a company’s operating cash flow.
Since the indirect method is actually simpler than the direct method, many small businesses prefer to use this approach. Also, when you use the indirect method, you do not have to go back and reconcile your statements with the direct method.
The Three Sections of a Cash Flow Statement
The following, are the three sections of the statement of cash flows, which designate ways with which cash can enter and leave your business.
Cash Flow from Operating Activities
Cash flow from operating activities is cash that is earned or spent in the course of regular business activity. It can be described as the main way your business makes money, by selling products or services.
Cash Flow from Investing Activities
This is cash earned or spent from investments your company makes, like purchasing equipment or investing in other companies.
Cash Flow from Financing Activities
This is cash earned or spent in the course of financing your company with loans, lines of credit, or owner’s equity.