Steps on How to Prepare a Cash Flow Statement
A cash flow statement is one of the most important financial reports for any business. It shows how money moves in and out of your company over a specific period, helping you track liquidity and understand your business’s financial health.
Understanding Cash Flow Statements
The cash flow statement summarizes all cash inflows and outflows from operating, investing, and financing activities. Unlike the income statement, which includes non-cash items, this statement focuses only on actual cash movements, making it essential for evaluating a company’s ability to generate cash and meet obligations.
Components of a Cash Flow Statement
- Operating Activities: These are the day-to-day business activities that generate revenue and expenses. Examples include cash received from customers and cash paid for inventory, salaries, rent, or taxes.
- Investing Activities: This section records cash used for or generated by investments in assets. Examples include purchasing equipment, selling property, or receiving returns from investments.
- Financing Activities: Here you capture cash from borrowing, repaying debt, issuing shares, or paying dividends. It reflects how a company funds its operations and growth.
Steps to Prepare a Cash Flow Statement
- Collect Financial Data: Gather the balance sheet, income statement, and other relevant records for the period.
- Calculate Cash from Operating Activities:
- Indirect method: Start with net income and adjust for non-cash expenses (like depreciation) and changes in working capital .
- Direct method: List cash received from customers and subtract cash paid for expenses.
- Determine Cash from Investing Activities: Record cash spent on purchasing fixed assets or received from selling investments.
- Calculate Cash from Financing Activities: Include loans raised or repaid, issuance or buyback of shares, and dividends paid.
- Combine All Sections: Add operating, investing, and financing totals to find the net increase or decrease in cash for the period.
- Reconcile with Opening and Closing Balances: Ensure the closing cash balance equals the ending cash on the balance sheet .
Direct and Indirect Method
When preparing the operating activities section, you can use either:
- Direct Method: Lists all major cash receipts and payments, such as customer payments and supplier payments.
- Indirect Method: Starts with net income and adjusts for non-cash items and changes in working capital.
Differences Between Direct and Indirect Methods
| Feature | Direct Method | Indirect Method |
|---|---|---|
| Starting Point | Actual cash receipts and payments | Net income from the income statement |
| Adjustments | Minimal adjustments | Adjusts for depreciation, accruals, etc. |
| Popularity | Less common due to detailed data requirement | Most common because it uses existing records |
Analyzing a Cash Flow Statement
- Positive operating cash flow signals healthy core operations.
- Negative investing cash flow can mean growth if it comes from asset purchases.
- Positive financing cash flow may show new loans or share issues, while negative indicates debt repayments or dividend payouts.
Common Indicators and Red Flags
- Consistently negative operating cash flow may indicate trouble even if profits look good.
- Large financing inflows can mask weak operating performance.
- Significant unexplained fluctuations may suggest accounting issues.
Cash Flow Statement
| Particulars | Amount |
|---|---|
| Operating Activities | |
| Net Income | 150 |
| Add: Depreciation | 20 |
| Less: Increase in Accounts Receivable | (30) |
| Less: Increase in Inventory | (10) |
| Net Cash from Operating Activities | 130 |
| Investing Activities | |
| Purchase of Equipment | (50) |
| Net Cash from Investing Activities | (50) |
| Financing Activities | |
| Loan Received | 40 |
| Dividend Paid | (20) |
| Net Cash from Financing Activities | 20 |
| Net Increase in Cash | 100 |
| Opening Cash Balance | 50 |
| Closing Cash Balance | 150 |
What is the Statement of Cash Flows?
It is a financial report that provides details of cash inflows and outflows during a period, helping stakeholders understand how a business generates and uses cash.
Why is the Cash Flow Statement Important?
- Shows liquidity and ability to pay bills
- Helps assess operating efficiency
- Guides investment and financing decisions
- Provides insights beyond net profit figures
Cash Flow Definitions
- Cash Inflows: Actual cash received, such as sales collections, loan proceeds, or asset sales.
- Cash Outflows: Actual cash paid, such as supplier payments, salaries, or asset purchases.
Cash Flow Statement Sections
- Operating Activities – core business operations
- Investing Activities – buying or selling long-term assets or investments
- Financing Activities – debt, equity, and dividends
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Conclusion
A cash flow statement tracks the actual movement of money, revealing a company’s ability to generate cash and maintain liquidity. By understanding its components—operating, investing, and financing activities—and following a step-by-step preparation process, businesses can maintain accurate records, plan for growth, and spot financial red flags early. Whether using the direct or indirect method, the goal is the same: present a clear picture of where cash is coming from and where it is going.
As a Chartered Accountant with over 12 years of experience, I am not only skilled in my profession but also passionate about writing. I specialize in producing insightful content on topics like GST, accounts payable, and income tax, confidently delivering valuable information that engages and informs my audience.
Frequently Asked Questions
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What is a cash flow statement and why is it important?
It’s a financial report that shows how cash moves in and out of a business, helping assess liquidity and financial health.
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What are the main components of a cash flow statement?
Operating activities, investing activities, and financing activities.
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How do you prepare a cash flow statement using the direct method?
List all major cash receipts and payments from operations, then add investing and financing cash flows to determine the net change in cash.
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What is the difference between the direct and indirect methods of preparing cash flow statements?
The direct method lists actual cash transactions, while the indirect method adjusts net income for non-cash items and changes in working capital.
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How do operating, investing, and financing activities impact cash flow reporting?
They show how the core business, investments, and funding activities respectively generate or use cash.
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What are common indicators or red flags to look for when analyzing a cash flow statement?
Persistent negative operating cash flow, unexplained large fluctuations, or heavy reliance on financing can signal financial issues.