When discussing financial statements, most people think about the two most common ones: the Income Statement, also known as Profit and Loss Statement and the Balance Sheet.
However, there is a third crucial financial report often overlooked: Statement of Cash Flows. While the Income Statement and Balance Sheet offer important data, the purpose of the Statement of Cash Flows is to bring the bigger picture together, showing the actual movement of cash in and out of the business. Cash is what keeps a business running, and Cash Flow Statements offer a clear view of where that cash is coming from and where it’s going.
What is a Statement of Cash Flows?
A statement of cash flows is a financial report that summarizes how cash moves through a business over a specific period, such as a month, quarter, or year. The Statement of Cash Flows provides insight into a company’s liquidity, which is vital for assessing the ability to meet short-term obligations and invest in growth.
It organizes cash activity into three categories:
- Operating activities – cash generated or used by day-to-day business
- Investing activities – cash used to buy or received from selling long-term assets
- Financing activities – cash from borrowing, repaying debt, or issuing equity
Together, these sections reconcile beginning cash to ending cash, showing whether cash increased or decreased during the reporting period.
Why is the Statement of Cash Flow Important?
The statement of cash flows is important because most businesses use accrual accounting, which records revenue and expenses when they are earned or incurred, not when cash is received or paid. As a result, profitability on the income statement does not always reflect how much cash the company has available.
For example, under accrual accounting, if you sign a five-year lease with the first six months rent-free, you don’t simply report zero lease expenses for the first six months. Instead, the expenses are evenly spread over the entire lease term, even if no cash changes hands initially.
While the accrual method of accounting provides a more accurate picture of the company’s financial obligations and profitability, it doesn’t reveal how much cash the company has at the moment. The statement of cash flows fills this gap by showing the actual cash collected and spent during the period, helping investors, lenders, and leadership evaluate liquidity and the company’s ability to meet short-term obligations and fund growth.
What Does a Cash Flow Statement Show?
A cash flow statement shows how cash actually moves through a business during a reporting period. It highlights whether cash is being generated from everyday operations, invested in long-term assets, or raised through financing activities. Together, these categories explain why cash increased or decreased and how sustainable a company’s cash position is.
Cash Flows from Operating Activities
This section includes the day-to-day cash transactions related to the core operations of the business. For example, it shows cash outflows from purchasing raw materials or paying wages and inflows from selling goods or services.
Cash Flows from Investing Activities
These cash flows stem from purchasing or selling long-term assets, such as property, equipment, or securities. If a company buys machinery to produce its products, that would fall under investing activities.
Cash Flows from Financing Activities
This includes cash inflows and outflows related to equity and debt. Examples are taking out a loan (an inflow) or paying off the principal on that loan (an outflow). This section is particularly important for startups or companies with fluctuating cash flows that may rely on external financing to fund operations.
Cash Flow Statement Example
Below is an example of a simplified statement of cash flows for a hypothetical company for the year ended December 31.
Example Statement of Cash Flows
Cash Flows from Operating Activities
- Net income: $450,000
- Depreciation and amortization: $120,000
- Increase in accounts receivable: ($80,000)
- Increase in accounts payable: $55,000
Net cash provided by operating activities: $545,000
Cash Flows from Investing Activities
- Purchase of equipment: ($300,000)
- Sale of fixed assets: $50,000
Net cash used in investing activities: ($250,000)
Cash Flows from Financing Activities
- Proceeds from long-term debt: $200,000
- Repayment of loan principal: ($150,000)
- Dividends paid: ($75,000)
Net cash used in financing activities: ($25,000)
Net increase in cash: $270,000
Cash at beginning of period: $180,000
Cash at end of period: $450,000
How to Read This Example Cash Flow Statement
The company invested heavily in equipment, resulting in negative investing cash flow, which may indicate investment in future growth. Financing activity was relatively modest, with new debt largely offset by principal repayments and dividends.
Together, these sections explain why cash increased by $270,000 during the year and how operating, investing, and financing decisions contributed to that change.
The Importance of Differentiating Cash Flows
A key aspect of the Statement of Cash Flows is not just report cash inflows and outflows but differentiating between operational, investing, and financing activities. For example, you may have plenty of cash, but if most of it comes from financing activities (debt), that’s not necessarily sustainable in the long run. While some debt can be healthy, the company needs a balance of cash inflows from regular operations to be sustainable.
Investors care deeply about liquidity, the ability to convert assets into cash to pay bills. A strong Statement of Cash Flows that shows healthy operating cash flows can reassure investors about a company’s long-term viability.
Handling Leases in the Statement of Cash Flows
Lease payments, whether from finance leases or operating leases, also show up in the Statement of Cash Flows. How these payments are classified varies based on the type of lease:
Finance Leases
Financial leases are treated similarly to debt. The principal portion of lease payments is considered a financing activity, while the interest portion is considered interest paid, which might be recorded as an operating or financing activity depending on the company’s accounting policy.
Operating Leases
Operating Leases are simpler, lease payments are treated as cash outflows from operations. There’s no ownership transfer at the end of an operating lease, so the payments are considered a standard operational expense.
For companies using complex lease agreements, understanding how to categorize cash flows correctly is crucial. Some companies may want to differentiate the interest and principal components of their lease payments even for operating leases. This is where a specialized accounting software can simplify the process. It helps companies manage the nuances of lease accounting under standards like Topic 230 of the accounting code, which governs the treatment of interest in the Statement of Cash Flows.
Statement of Cash Flows in Short-Term Leases
Short-term leases, those lasting 12 months or less, are handled differently. Most companies opt for the practical expedient, excluding these leases from recognition as assets and liabilities. In the Statement of Cash Flows, short-term leases are reported as operational cash outflows, and there is typically no need for straight-lining or other complex accounting treatments.
However, even though they are pair together under operating activities, companies are required to distinguish cash flows from short-term leases from those of other operating leases in their reporting.
Cash Flows Statements Disclosure Requirements
Disclosure is another key aspect of lease accounting and the statement of cash flow. Alongside cash flows from leases, companies must disclose their future cash obligations for the next five years and beyond. This gives stakeholders insight into future financial commitments and how they might affect cash flow down the road.
In particular, businesses must demonstrate their ability to meet non-current (longer-term) cash obligations with their available cash and operational cash inflows. If they can’t, it could be a red flag for investors and lenders.
The Role of Software in Cash Flows Statement Management
With the complexities involved in properly accounting for leases and cash flows, Visual Lease software solutions become invaluable. For instance our software helps businesses comply with lease accounting standards, accurately segregating operating from financing activities, and automating the calculation of interest and principal components for leases. It simplifies the process of preparing financial statements and ensures accuracy and transparency for stakeholders.
By using tools like Visual Lease, companies can navigate the complexities of lease accounting, ensure compliance, and provide investors with the transparency they need to make informed decisions. In an increasingly complex financial world, understanding and managing cash flow has never been more important.
