Importance of Cash Flow Statement with Example
Mia Young
⚡ Smart Summary
Cash Flow Statement is the third core financial report that shows how a company generated and spent cash over a period, complementing the Profit and Loss and Balance Sheet to reveal true liquidity.
What is Cash Flow Statement?
The Cash Flow Statement portrays how a company has spent its cash. It is often used in tandem with the other two key reports – the Profit and Loss and the Balance Sheet. It is the third component of a company’s financial statements.
Why Cash Flow Statement is Important?
The cash flow report is important because it informs the reader of the business cash position. For a business to be successful, it must have sufficient cash at all times. It needs cash to pay its expenses, to pay bank loans, to pay taxes and to purchase new assets. A cash flow report determines whether a business has enough cash to do exactly this.
Having cash is a key requirement for a business to stay solvent. When a business has no longer enough cash to pay its dues, it is often declared bankrupt.
For this introduction to accounting, we will not go through the actual preparation of an actual cash flow report. In fact in the business world, small businesses rarely produce a cash flow report, as a profit and loss report is sufficient for their needs. It is unlikely that a small business such as a bakery will involve complex non-cash transactions that would warrant such information. Therefore, it is considered a waste of time and money to have an accountant prepare a report that would be of little use to anyone.
On the other hand, for large entities such as Nike and Microsoft, having a cash flow report is imperative. Such companies will often have a significant amount of non-cash transactions, sometimes even billions of dollars in revenue that is simply owed to them but has not been received in cash yet. In these situations, a Profit and Loss statement is not always sufficient, and a cash flow report is valuable to many users, such as banks and shareholders.
Components of a Cash Flow Statement
Every cash flow report is split into three standard sections that together explain how a business generated and used cash during the period. Reading them in sequence reveals whether the core business is self-funding, where money is being invested for the future, and how the company is capitalized.
- Operating Activities: Cash received from customers and cash paid to suppliers, employees, and tax authorities. This section is widely considered the most important because it shows whether the day-to-day business generates enough cash to sustain itself.
- Investing Activities: Cash spent on or received from long-term assets such as land, buildings, and equipment, plus purchases and sales of stocks or bonds held as investments.
- Financing Activities: Cash flowing to or from investors and lenders — proceeds from issuing shares or bonds, dividend payments, loan drawdowns, and repayments of principal.
Adding the three sections to the opening cash balance produces the closing cash position that ties back to the Balance Sheet.
Direct Method vs Indirect Method
Accounting standards allow two ways to present the Operating Activities section. Investing and Financing activities are reported identically under both methods.
- Direct Method: Lists actual cash receipts and cash payments — cash from customers, cash paid to suppliers, cash paid to employees. The layout is intuitive because a reader can trace each line to a real bank transaction.
- Indirect Method: Starts with net income and adjusts for non-cash items (such as depreciation and amortization) and changes in working capital (receivables, payables, inventory). Most companies use this method because the required data already exists in the general ledger.
Both methods produce the same total operating cash flow. The choice is a presentation decision, not a cash difference.
Cash Flow Statement Example
Let’s imagine you start a business with $1,000.
With your $1,000 you buy a box of ingredients and bake cakes.
You sell all the cakes to a customer for $5,000.
The customer asks if he can purchase the cakes on credit, meaning he will pay for the cakes at the end of the month. You agree.
Let’s determine your cash position in this scenario.
Revenue: $5,000
Under accounting rules revenue is recognized when it is earned, not when it is received. Therefore, since you have made the sale to your customer, the sale must be recognized as revenue received.
Profit: $4,000
You spent $1,000 on the cakes and sold them for $5,000. This leaves you with a profit of $4,000.
Cash: ZERO!
Even though you have earned $5,000 in revenue and $4,000 in profit, you have ZERO CASH. This scenario can play out often in the business world, particularly with large corporations, which signifies the importance of producing a cash flow report.
The purpose of this lesson is to describe the merits of a cash flow report and when it may be necessary. However, you will probably find that the majority of small businesses do not find this report necessary – a Profit and Loss statement is often all they require for their tax and planning needs.
Trial Balance Vs. Profit and Loss Vs. Balance Sheet Vs. Cash Flow Statement
| Trial Balance | Profit and Loss | Balance Sheet | Cash Flow Statement | |
|---|---|---|---|---|
| Accounts included | All Accounts | Revenue & Expenses | Assets, Liabilities, Drawings and Owner’s Equity | Bank |
| Type | For internal users | For external users | For external users | For external users |
| Key information displayed | Confirmation that debit accounts balance with credit accounts | Profit or Loss for the year | Value of the business’s net assets | Increase or decrease in bank balance |
| Structure | All debit accounts on the left, all credit accounts on the right | Revenue minus expenses equals profit | Assets minus liabilities equals Owner’s Equity | Starts with bank balance at the start of the year Add cash received Minus cash spent Equals closing bank balance |
