As an entrepreneur, you can better understand how your company is doing by interpreting its four financial statements. The cash flow statement is one of the financial statements. It is also, arguably, the most underestimated financial statement.
The cash flow statement measures how a company is managing its cash. Not understanding it properly may lead to cash flow problems in the company. In fact, according to Webinar Care, 60% of SMEs fail because of problems in their cash flows.
Want to know whether your company is financially healthy? One solution is to learn how to read your cash flow statement.
A cash flow statement indicates the financial health of the company and its liquidity. It shows the business’s “ability” to pay off its debts.
This guide provides a simple and clear way to read a cash flow statement and derive meaningful insights from analyzing it.
Table of Contents
What is a Cash Flow Statement, and Why is it Important?
A cash flow statement is one of the three key financial statements. It provides the inflow and outflow of cash in the business. (Quite literally, every number on the cash flow statement shows money coming in or out of the company.)
A cash flow statement is important because, unlike the income statement, it shows the actual money that the business has on hand. Why is this important? A company might show a great profit figure on the income statement but be low on cash. This affects the company’s ability to pay for its expenses, affecting its liquidity.
A negative cash flow might not necessarily spell disaster for the company.
Stay tuned as we discuss the reasons and factors behind negative cash flows later in this guide.
Overview of the Three Main Sections of the Cash Flow Statement
1. Cash flows from operating activities
This is the first section of the cash flow statement. It shows the total cash generated from the company’s core activities, its operations. The cash figure here indicates the company’s cash profit from operations.
2. Cash flows from investing activities
This section shows the cash generated from investing activities, such as interest and dividends from the company’s investments.
This section will also include irregular payments/receipts due to non-current assets. For example, if a company buys machinery costing $2000, a cash outflow of $2000 will be noted here. Similarly, a company might sell its property, which is shown as a cash inflow.
3. Cash flows from financing activities
Financing activities include issuing or repaying debt, issuing or buying back shares, and paying dividends. Essentially, this section shows how the company funds its operations and growth through external sources or returns capital to shareholders.
Real Example of a Cash Flow Statement
Cash Flow All numbers in thousands
Oceanaides Int. I 2023-12-31
| Cash Flow Statement | 2023-12-31 | 2022-12-21 |
| Cash from operating activities | ||
| Net Income | 4767000 | 3935000 |
| Depreciation & amortization | 2581000 | 2329000 |
| Deferred income taxes | 1473000 | 1364000 |
| Changes in working capital | 219000 | 423000 |
| Accounts receivable | – | – |
| Inventory | -139000 | 324000 |
| Other working capital | 3489000 | 1846000 |
| Other non-cash items | -615000 | -1037000 |
| Net cash provided by operating activities | 8425000 | 7014000 |
| Cash flows from investing activities | ||
| Investments in property, plant and equipment | -4936000 | -5138000 |
| Acquisition, net | -170000 | – |
| Purchases of investments | 0 | -145000 |
| Sales/Maturities of investments | 206000 | 766000 |
| Other investing activities | 58000 | 154000 |
| Net cash used for investing activities | -4563000 | -4393000 |
| Cash flows from financing activities | ||
| Debt repayment | -3320000 | -3052000 |
| Common stock repurchased | -2027000 | -1575000 |
| Dividends paid | -980000 | -909000 |
| Other financing activities | 1697000 | 65000 |
| Net cash used | -2880000 | -1726000 |
| Net change in cash | 982000 | 895000 |
| Cash at the beginning of the period | 2748000 | 1853000 |
| Cash at the end of the period | 3730000 | 2748000 |
How to Read a Cash Flow Statement
Any cash flow statement should have the following key sections:
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities
Cash flows from Operating Activities
| Cash Flow Statement | 2023-12-31 | 2022-12-21 |
|---|---|---|
| Cash from operating activities | ||
| Net Income | 4767000 | 3935000 |
| Depreciation & amortization | 2581000 | 2329000 |
| Deferred income taxes | 1473000 | 1364000 |
| Changes in working capital | 219000 | 423000 |
| Accounts receivable | – | – |
| Inventory | -139000 | 324000 |
| Other working capital | 3489000 | 1846000 |
| Other non-cash items | -615000 | -1037000 |
| Net cash provided by operating activities | 8425000 | 7014000 |
This section tells us the cash flow generated from the business’s day-to-day operations.
Let’s start digging into what the numbers in the above statement mean:
Net Income
The top number at the cash flow statement is the net income. The net income figure comes from the income statement.
Non Cash Expenses:
Depreciation and Amortization
Depreciation and amortization are added to the cash flow statement because they are non-cash expenses.
For example, someone buys machinery for $30,000. The machine depreciates each year at 5%. So, the yearly depreciation expense of $1500 will be added to the cash flow statement. $1500 is not an expense paid in cash; it is the loss in the physical value of the machinery.
Deferred Income Taxes
Like depreciation, deferred income taxes are also noncash expenses, which are added back to the cash flow statement.
Changes in Working Capital:
The cash flow statement above shows that Oceanaides Int. reported $219,000 in changes in working capital.
Working capital= Current Assets – Current Liabilities
A positive working capital figure indicates that the company either took a new debt or sold a fixed asset to generate more money. So, in the cash flow statement example above, the amount of debt/money generated is $219,000.
Accounts Receivable:
Accounts receivable can be defined as money the business has the right to receive because of delivering a product or a service.
An increase in accounts receivable means that the company owes more money. The increase also means that less cash is flowing into the business. That’s why we deduct any increase in the accounts receivable from the cash flow statement.
On the other hand, if the accounts receivable decrease between two time periods, the company is receiving actual cash. Hence, the decrease in accounts receivable is added to the cash flow statement.
Inventory:
An increase in inventory means that the company has spent money to buy inventory. That’s why the increase is deducted in the cash flow statement.
In the example above, inventory has increased by $139,000. Hence, this value is deducted from the cash flow statement.
Other Working Capital and other non-cash items
The next item in the cash flow statement is the other working capital. Each item is not written separately to prevent the statement from becoming too long. However, the concept applied is the same as discussed above in the changes in working capital.
Net cash provided by operating activities:
Net cash is an important figure to consider. If it is positive, it indicates that the company is generating cash from its operations. A negative net cash provided by operating activities indicates that the company is losing money and not producing profit.
Cash Flows from Investing Activities
| Cash flows from investing activities | ||
| Investments in property, plant and equipment | -4936000 | -5138000 |
| Acquisition, net | -170000 | – |
| Purchases of investments | 0 | -145000 |
| Sales/Maturities of investments | 206000 | 766000 |
| Other investing activities | 58000 | 154000 |
| Net cash used for investing activities | -4563000 | -4393000 |
This is the second section of the cash flow statement. It shows cash flows from investing activities.
Investments in property, plant, and equipment
The line shows the investments in PPE. This could be anything from offices to machinery to vehicles. These are important assets for carrying out the company’s operations.
In the example above, there is a negative figure of $4936,000. This means that Oceanaides Intl. spent $4936,000 on property, plant, and equipment.
Sometimes, the company purchases PPE but does not make the full payment at once. When this happens, only the amount paid in cash is recorded in the cash flow statement.
Acquisitions
This is the amount the company spent on acquiring another business. It is also an important figure to read in cash flow statements, especially for investors, as it tells us how much the company is investing in other businesses.
Comparing this amount to the amount the company invests in PPE tells us how much more or less the company is investing in its own business than in other businesses.
Why is this important for investors? 👇
It can be a red flag if the acquisition amount is unusually high compared to PPE investments. This indicates that the company is investing more in other businesses than its own. Hence, investors may also not consider investing in it.
In the example above, Oceanaides Intl. spent $4563000 on investment activities in 2023.
Cash Flows from Financing Activities
The company finances its activities with either debt or equity. This section shows how the company is funding its activities.
| Cash flows from financing activities | ||
| Debt repayment | -3320000 | -3052000 |
| Common stock repurchased | -2027000 | -1575000 |
| Dividends paid | -980000 | -909000 |
| Other financing activities | 1697000 | 65000 |
| Net cash used | -2880000 | -1726000 |
| Net change in cash | 982000 | 895000 |
| Cash at the beginning of the period | 2748000 | 1853000 |
Debt Repayment
As the name suggests, this is the amount that the company has paid back its debts.
Dividends paid:
This is the amount that the company has paid to the shareholders. In the example above, the company has paid $980,000.
Other financing activities refer to the company’s money raised through getting a new debt. In the example above, Oceanaides Intl has raised $1697,000 in debt.
The subtotal shows the net cash used by (or provided by) financing activities.
The net change in cash:
After calculating the net cash from financing activities, net change in cash is calculated as follows:
Net cash provided by operations +/- net cash used for investing activities +/- net cash used by financing activities
8425,000- 4563,000- 2880,000= $982,000
| Net change in cash | 982000 | 895000 |
| Cash at the beginning of the period | 2748000 | 1853000 |
| Cash at the end of the period | 3730,000 | 2748,000 |
Net change in cash + Cash at the beginning of the period and cash at the end.
How to Interpret A Cash Flow Statement
Interpreting a company’s cash flow statement involves analyzing costs from each activity: operating, investing, and financing. Start by looking at the net cash inflow/outflow from each activity.
Generally, if the company generates positive net cash flow from each activity, it indicates that it is performing well.
Don’t stress (yet!) because of a negative cash flow. A negative cash flow from any activity does not necessarily indicate a bad sign. Interpret the numbers more to find out the reason behind it.
We discuss the factors contributing to negative cash flow in companies later in this guide.
What Does Cash from Operations Tell You?
Cash generated from operating activities shows how much cash the business earns (or loses) from its core operations. This figure does not consider one-off items such as the sale of machinery or raising money through debt.
Net cash flow from operating activities is one of the key figures to address in the cash flow statement. Why? Because it is the cash profit from operations. To judge the quality of your company’s profit, compare the cash generated from operations to the profit from operations in the income statement. The lesser the difference between these two, the better is the quality of profit.
If, for example, the profit from operations in the income statement (statement of profit or loss) is very high compared to the cash generated from operations, the company cannot turn that profit into cash. This can lead to problems with the company’s short-term liquidity, which means that it may have problems paying its short-term debts (such as accounts payables).
Examining the Movements in Working Capital
One should particularly examine the movements in working capital if:
-you notice a large difference between the cash generated from operations and the profit in the income statement or
–if the cash generated from operations is negative.
Here are some reasons that may have led to this figure:
Large increases in receivables and inventories
On the other hand, occasional fluctuations in receivables and inventories are normal for businesses. However, a consistent and substantial increase in these items on the cash flow statement may signal underlying problems. There can be problems such as the chance of irrecoverable debts.
Whatever the reasons, the company has to have enough cash to meet its short-term debts on time.
Large increases in payables
Sometimes, a company might show positive cash generated from its operations. However, a closer look at the payable figure between two time periods may show a large increase. This indicates that the company might delay paying its suppliers to improve its cash flow position at year-end.
What Does a Positive Cash Flow from Operations Mean?
Except in certain circumstances*, it is important that a company shows positive cash flow from its operations. A positive cash flow from operations means that the business has enough cash to manage its day-to-day operations. For example, this means the business has enough cash to pay its interest payments, taxes, and payables to suppliers without taking on extra debt, selling assets, or issuing shares.
Free Cash
Free cash is the money left over from operations after the company has paid its tax and interest. Examining how the company spends its free cash is important.
Uses of Free Cash
If a company has sufficient free cash, dividends can be paid. This is much better than using longer sources of finance to pay dividends to shareholders.
-Investments in noncurrent assets can be paid using free cash. Investing in them will generate returns for the company afterward.
-Loans can be paid back to reduce the interest payments in the future.
Factors Contributing to Negative Cash Flow in Companies
Negative cash flow indicates that the company is spending more than it earns, but it does not necessarily indicate an underlying issue.
Nevertheless, it’s important to acknowledge that profitability isn’t guaranteed every month. Even renowned and successful corporations encounter challenges in maintaining profitability consistently.
Certain companies may incur losses and exhibit negative cash flow as part of their strategy to enhance future profits. Regardless of your business’s size, encountering periods of negative cash flow is common.
A thorough examination of the cash flow statement can help identify the cause of a negative cash flow.
In the growing phase, companies like startups or SMEs might be investing more in assets, sales, and marketing functions. For example, a company might have invested hugely in a noncurrent asset, which may show as a drain on cash flows. However, this indicates that the company might generate more cash flows from the assets in the future. In this case, a negative cash flow is usually temporary (not a bad sign).
However, negative cash flow can also be a sign of concern. For example, it can be due to high overhead costs, large amounts of irrecoverable debt, or poor financial planning. These issues can affect the company’s performance and ability to cover its daily expenses in the long run.
Ensure Cash Adequacy for Operational And Strategic Needs
Companies that fail to project cash flow accurately face the risk of a liquidity trap—a state of operational burnout that can render even a profitable company cashless.
A company needs to know how to read and interpret its cash flow
statement because it provides vital insights into its financial health, liquidity, and operational efficiency.
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