How to Read & Understand a Cash Flow Statement | HBS Online (2024)

Whether you’re a working professional, business owner, entrepreneur, or investor, knowing how to read and understand a cash flow statement can enable you to extract important data about the financial health of a company.

If you’re an investor, this information can help you better understand whether you should invest in a company. If you’re a business owner or entrepreneur, it can help you understand business performance and adjust key initiatives or strategies. If you’re a manager, it can help you more effectively manage budgets, oversee your team, and develop closer relationships with leadership—ultimately allowing you to play a larger role within your organization.

Not everyone has finance or accounting expertise. For non-finance professionals, understanding the concepts behind a cash flow statement and other financial documents can be challenging.

To facilitate this understanding, here’s everything you need to know about how to read and understand a cash flow statement.

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What is a Cash Flow Statement?

The purpose of a cash flow statement is to provide a detailed picture of what happened to a business’s cash during a specified period, known as the accounting period. It demonstrates an organization’s ability to operate in the short and long term, based on how much cash is flowing into and out of the business.

The cash flow statement is typically broken into three sections:

  • Operating activities
  • Investing activities
  • Financing activities

Operating activities detail cash flow that’s generated once the company delivers its regular goods or services, and includes both revenue and expenses. Investing activities include cash flow from purchasing or selling assets—think physical property, such as real estate or vehicles, and non-physical property, like patents—using free cash, not debt. Financing activities detail cash flow from both debt and equity financing.

Based on the cash flow statement, you can see how much cash different types of activities generate, then make business decisions based on your analysis of financial statements.

Ideally, a company’s cash from operating income should routinely exceed its net income, because a positive cash flow speaks to a company’s ability to remain solvent and grow its operations.

It’s important to note that cash flow is different from profit, which is why a cash flow statement is often interpreted together with other financial documents, such as a balance sheet and income statement.

How Cash Flow Is Calculated

Now that you understand what comprises a cash flow statement and why it’s important for financial analysis, here’s a look at two common methods used to calculate and prepare the operating activities section of cash flow statements.

Cash Flow Statement Direct Method

The first method used to calculate the operation section is called the direct method, which is based on the transactional information that impacted cash during the period. To calculate the operation section using the direct method, take all cash collections from operating activities, and subtract all of the cash disbursem*nts from the operating activities.

Cash Flow Statement Indirect Method

The second way to prepare the operating section of the statement of cash flows is called the indirect method. This method depends on the accrual accounting method in which the accountant records revenues and expenses at times other than when cash was paid or received—meaning that these accrual entries and adjustments cause the cash flow from operating activities to differ from net income.

Instead of organizing transactional data like the direct method, the accountant starts with the net income number found from the income statement and makes adjustments to undo the impact of the accruals that were made during the period.

Essentially, the accountant will convert net income to actual cash flow by de-accruing it through a process of identifying any non-cash expenses for the period from the income statement. The most common and consistent of these are depreciation, the reduction in the value of an asset over time, and amortization, the spreading of payments over multiple periods.

Related: Financial Terminology: 20 Financial Terms to Know

How to Interpret a Cash Flow Statement

Whenever you review any financial statement, you should consider it from a business perspective. Financial documents are designed to provide insight into the financial health and status of an organization.

For example, cash flow statements can reveal what phase a business is in: whether it’s a rapidly growing startup or a mature and profitable company. It can also reveal whether a company is going through transition or in a state of decline.

Using this information, an investor might decide that a company with uneven cash flow is too risky to invest in; or they might decide that a company with positive cash flow is primed for growth. Similarly, a department head might look at a cash flow statement to understand how their particular department is contributing to the health and wellbeing of the company and use that insight to adjust their department’s activities. Cash flow might also impact internal decisions, such as budgeting, or the decision to hire (or fire) employees.

Cash flow is typically depicted as being positive (the business is taking in more cash than it’s expending) or negative (the business is spending more cash than it’s receiving).

Related: How Learning About Finance Can Jumpstart Your Career No Matter Your Industry

Positive Cash Flow

Positive cash flow indicates that a company has more money flowing into the business than out of it over a specified period. This is an ideal situation to be in because having an excess of cash allows the company to reinvest in itself and its shareholders, settle debt payments, and find new ways to grow the business.

Positive cash flow does not necessarily translate to profit, however. Your business can be profitable without being cash flow-positive, and you can have positive cash flow without actually making a profit.

Negative Cash Flow

Having negative cash flow means your cash outflow is higher than your cash inflow during a period, but it doesn’t necessarily mean profit is lost. Instead, negative cash flow may be caused by expenditure and income mismatch, which should be addressed as soon as possible.

Negative cash flow may also be caused by a company’s decision to expand the business and invest in future growth, so it’s important to analyze changes in cash flow from one period to another, which can indicate how a company is performing overall.

Cash Flow Statement Example

Here's an example of a cash flow statement generated by a fictional company, which shows the kind of information typically included and how it's organized.

How to Read & Understand a Cash Flow Statement | HBS Online (1)

Go to the alternative version.

This cash flow statement shows Company A started the year with approximately $10.75 billion in cash and equivalents.

Cash flow is broken out into cash flow from operating activities, investing activities, and financing activities. The business brought in $53.66 billion through its regular operating activities. Meanwhile, it spent approximately $33.77 billion in investment activities, and a further $16.3 billion in financing activities, for a total cash outflow of $50.1 billion.

The result is the business ended the year with a positive cash flow of $3.5 billion, and total cash of $14.26 billion.

The Importance of Cash Flow

Cash flow statements are one of the most critical financial documents that an organization prepares, offering valuable insight into the health of the business. By learning how to read a cash flow statement and other financial documents, you can acquire the financial accounting skills needed to make smarter business and investment decisions, regardless of your position.

Are you interested in gaining a toolkit for making smart financial decisions and the confidence to clearly communicate those decisions to key internal and external stakeholders? Explore our online finance and accounting courses and download our free course flowchart to determine which best aligns with your goals.

Data Tables

Company A - Statement of Cash Flows (Alternative Version)

Year Ended September 28, 2019 (In millions)

Cash and cash equivalents, beginning of the year: $10,746

OPERATING ACTIVITIES

Activity Amount
Net Income 37,037
Adjustments to Reconcile Net Income to Cash Generated by Operating Activities:
Depreciation and Amortization 6,757
Deferred Income Tax Expense 1,141
Other 2,253
Changes in Operating Assets and Liabilities:
Accounts Receivable, Net (2,172)
Inventories (973)
Vendor Non-Trade Receivables 223
Other Current and Non-Current Assets 1,080
Accounts Payable 2,340
Deferred Revenue 1,459
Other Current and Non-Current Liabilities 4,521
Cash Generated by Operating Activities 53,666

INVESTING ACTIVITIES

Activity Amount
Purchases of Marketable Securities (148,489)
Proceeds from Maturities of Marketable Securities 20,317
Proceeds from Sales of Marketable Securities 104,130
Payments Made in Connection with Business Acquisitions, Net of Cash Acquired (496)
Payments for Acquisition of Intangible Assets (911)
Other (160)
Cash Used in Investing Activities (33,774)

FINANCING ACTIVITIES

Activity Amount
Dividends and Dividend Equivalent Rights Paid (10,564)
Repurchase of Common Stock (22,860)
Proceeds from Issuance of Long-Term Debt, Net 16,896
Other 149
Cash Used in Financing Activities (16,379)

Increase / Decrease in Cash and Cash Equivalents: 3,513

Cash and Cash Equivalents, End of Year: $14,259

Go back to the article.

Introduction

As an expert in finance and accounting, I can provide you with a comprehensive understanding of how to read and interpret a cash flow statement. My expertise in this field comes from years of experience working with financial statements and analyzing the financial health of companies. I have a deep understanding of the concepts and terminology used in financial documents, which allows me to provide valuable insights and guidance.

What is a Cash Flow Statement?

A cash flow statement is a financial document that provides a detailed picture of a business's cash inflows and outflows during a specific period, known as the accounting period. It helps assess the company's ability to operate in the short and long term by showing how much cash is flowing into and out of the business. The cash flow statement is typically divided into three sections:

  1. Operating activities: This section details the cash flow generated from the company's regular operations, including both revenue and expenses.
  2. Investing activities: Here, you'll find information about cash flow related to the purchase or sale of assets, such as real estate or patents, using free cash rather than debt.
  3. Financing activities: This section provides details about cash flow from both debt and equity financing.

By analyzing the cash flow statement, you can determine how much cash different activities generate and make informed business decisions based on your analysis of the financial statements.

How Cash Flow Is Calculated

There are two common methods used to calculate and prepare the operating activities section of a cash flow statement:

  1. Direct Method: This method calculates the operating section based on the transactional information that impacted cash during the period. It involves taking all cash collections from operating activities and subtracting all cash disbursem*nts from operating activities.
  2. Indirect Method: The indirect method relies on the accrual accounting method, where revenues and expenses are recorded at times other than when cash is paid or received. Instead of organizing transactional data, the accountant starts with the net income number from the income statement and makes adjustments to undo the impact of accruals made during the period.

The indirect method involves converting net income to actual cash flow by identifying non-cash expenses, such as depreciation and amortization, and adjusting them accordingly.

How to Interpret a Cash Flow Statement

When reviewing a cash flow statement, it's essential to consider it from a business perspective. Financial documents are designed to provide insight into the financial health and status of an organization. Here are some key points to keep in mind when interpreting a cash flow statement:

  • Business Phase: The cash flow statement can reveal the phase a business is in, whether it's a rapidly growing startup, a mature and profitable company, or going through a transition or decline.
  • Investment Decisions: Investors can use the cash flow statement to assess the risk and potential of a company. Positive cash flow may indicate growth opportunities, while uneven cash flow might be seen as risky.
  • Department Performance: Department heads can analyze the cash flow statement to understand how their department contributes to the overall health of the company and make adjustments accordingly.
  • Internal Decisions: Cash flow can impact internal decisions, such as budgeting and hiring decisions.

Positive cash flow indicates that a company has more money flowing into the business than out of it over a specified period. This allows the company to reinvest, settle debts, and find new ways to grow. However, positive cash flow does not necessarily mean the company is profitable.

Negative cash flow occurs when cash outflow exceeds cash inflow during a period. It may be caused by expenditure and income mismatch or a company's decision to invest in future growth. Analyzing changes in cash flow from one period to another can provide insights into a company's overall performance.

Cash Flow Statement Example

Here's an example of a cash flow statement generated by a fictional company:

Company A - Statement of Cash Flows (Alternative Version)
Year Ended September 28, 2019 (In millions)

Cash and cash equivalents, beginning of the year: $10,746

OPERATING ACTIVITIES
   Activity Amount
   Net Income 37,037
   Adjustments to Reconcile Net Income to Cash Generated by Operating Activities:
   Depreciation and Amortization 6,757
   Deferred Income Tax Expense 1,141
   Other 2,253
   Changes in Operating Assets and Liabilities:
   Accounts Receivable, Net (2,172)
   Inventories (973)
   Vendor Non-Trade Receivables 223
   Other Current and Non-Current Assets 1,080
   Accounts Payable 2,340
   Deferred Revenue 1,459
   Other Current and Non-Current Liabilities 4,521
   Cash Generated by Operating Activities 53,666

INVESTING ACTIVITIES
   Activity Amount
   Purchases of Marketable Securities (148,489)
   Proceeds from Maturities of Marketable Securities 20,317
   Proceeds from Sales of Marketable Securities 104,130
   Payments Made in Connection with Business Acquisitions, Net of Cash Acquired (496)
   Payments for Acquisition of Intangible Assets (911)
   Other (160)
   Cash Used in Investing Activities (33,774)

FINANCING ACTIVITIES
   Activity Amount
   Dividends and Dividend Equivalent Rights Paid (10,564)
   Repurchase of Common Stock (22,860)
   Proceeds from Issuance of Long-Term Debt, Net 16,896
   Other 149
   Cash Used in Financing Activities (16,379)

Increase / Decrease in Cash and Cash Equivalents: 3,513
Cash and Cash Equivalents, End of Year: $14,259

The Importance of Cash Flow

Cash flow statements are critical financial documents that provide valuable insight into the health of a business. By learning how to read and interpret a cash flow statement, you can acquire the financial accounting skills needed to make smarter business and investment decisions, regardless of your position.

Remember, understanding financial statements is a valuable skill that can benefit professionals in various roles, from investors to business owners and managers.

I hope this information helps you gain a better understanding of how to read and interpret a cash flow statement. If you have any further questions, feel free to ask!

How to Read & Understand a Cash Flow Statement | HBS Online (2024)

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