Article
How to Prepare a Cash Flow Statement
What is a Cash Flow Statement?
A cash flow statement is one of the most essential financial reports for any business, providing a clear picture of how money moves in and out of the organization. Unlike the income statement, which records revenues and expenses, or the balance sheet, which shows assets and liabilities, the cash flow statement focuses on actual liquidity—how much cash a business generates and uses over a specific period.
Understanding what is a cash flow statement is crucial because it highlights whether a business has enough liquidity to meet its short-term obligations, pay employees, and fund future growth. By tracking both inflows (such as sales revenue, loans, or investments) and outflows (such as rent, payroll, and supplier payments), companies can better manage financial health and avoid cash shortages.
For small businesses, start-ups, and large corporations alike, the cash flow statement is not only a compliance requirement but also a decision-making tool. It helps owners and managers assess financial performance, monitor trends, and plan strategically for expansion or cost control. In essence, the cash flow statement connects profitability with real-world financial sustainability, making it indispensable in effective financial reporting. Checkout> Driving Business Value Through Cash Flow Optimisation Course
Why a Cash Flow Statement Matters
The importance of cash flow statement reporting goes beyond compliance—it is a critical tool for financial decision-making. By focusing on actual inflows and outflows, businesses can understand their true liquidity position rather than relying only on profits recorded in income statements. This makes the cash flow statement one of the most reliable indicators of financial strength.
Helps Evaluate Liquidity and Financial Health
A primary purpose of cash flow analysis is to assess whether a business generates enough cash to cover day-to-day expenses. Tracking operating cash flow allows companies to:
- Ensure they can pay suppliers, employees, and creditors on time.
- Identify potential shortfalls before they become serious problems.
- Plan for growth while maintaining stability.
Supports Investment and Credit Decisions
Investors and lenders pay close attention to the cash flow statement. Unlike net income, which can be influenced by accounting practices, cash flow offers a realistic picture of a company’s financial capacity. It helps stakeholders:
- Evaluate whether a business can generate sustainable returns.
- Assess repayment ability before granting loans or credit.
- Measure overall financial resilience in changing market conditions.
Provides Transparency for Stakeholders
The importance of cash flow statement reporting also lies in building trust. Clear disclosure of cash inflows and outflows offers transparency to shareholders, regulators, and partners. This openness:
- Strengthens credibility with investors and creditors.
- Provides insights into how management allocates resources.
- Helps stakeholders make informed, confident decisions.
In short, the purpose of cash flow reporting is not just tracking money but ensuring accountability, supporting financial planning, and safeguarding business sustainability.
Components of a Cash Flow Statement
A cash flow statement is divided into three key sections that show how money moves through different areas of the business. Understanding the parts of a cash flow statement helps business owners, investors, and stakeholders analyze financial performance in detail. These three sections of cash flow provide a complete view of liquidity and long-term sustainability.
Operating Activities
Operating activities reflect the core transactions of the business—cash generated or spent through daily operations. This includes:
- Cash received from sales of goods and services
- Payments to suppliers and employees
- Taxes and interest payments
Since operating activities represent the heart of the business, they are closely watched to determine whether the company generates enough cash to sustain itself without external funding.
Investing Activities
This section tracks cash flow related to long-term assets and investments. Examples include:
- Purchases of property, equipment, or technology
- Proceeds from selling assets
- Investments in securities or other businesses
Investing activities reveal how much a business is reinvesting in growth versus liquidating assets. Negative cash flow here is not always bad—it may signal expansion through asset acquisition.
Financing Activities
Financing activities involve transactions with investors, lenders, and owners. These include:
- Borrowing funds through loans or issuing bonds
- Raising capital via equity issuance
- Dividend payments to shareholders
- Repayment of debt
This part of the cash flow statement shows how the company funds its operations and growth. A healthy balance between borrowing, equity, and returns to shareholders indicates solid financial management.
Together, these three parts of a cash flow statement provide insight into whether a company is generating, investing, and financing cash responsibly, helping stakeholders assess overall financial stability. Checkout> Bank Reconciliation and Petty Cash Management Course
Methods of Preparing a Cash Flow Statement
When it comes to creating a cash flow statement, businesses can choose between two main approaches: the direct method and the indirect method. Both are recognized under accounting standards, but they differ in how cash flows are presented. Understanding these cash flow preparation methods is essential for selecting the one that best fits a company’s reporting needs.
Direct Method
The direct method of cash flow reports actual cash inflows and outflows during a given period. Instead of starting with net income, it lists cash received and payments made.
Examples include:
- Cash collected from customers
- Payments to suppliers and employees
- Cash paid for interest and taxes
Pros:
- Provides clear visibility into actual cash movements
- Easier for stakeholders to understand day-to-day liquidity
Cons:
- More time-consuming to prepare
- Requires detailed tracking of all cash transactions
Indirect Method
The indirect method of cash flow starts with net income from the income statement and adjusts for non-cash items (like depreciation) and changes in working capital. This method is more widely used in practice.
Adjustments typically include:
- Adding back non-cash expenses (e.g., depreciation, amortization)
- Adjusting for changes in accounts receivable, payables, and inventory
Pros:
- Easier and less costly to prepare using existing accounting records
- Aligns net income with cash flow, which many stakeholders find useful
Cons:
- Less detail on specific cash transactions
- May not provide the same level of transparency as the direct method
Key Differences Between the Two
- The direct vs indirect method cash flow debate centers on clarity versus convenience.
- The direct method gives a more transparent view of cash receipts and payments, while the indirect method is easier to prepare and commonly used by businesses.
In short, both cash flow preparation methods serve the same purpose—explaining how cash moves in and out of a business—but the choice depends on whether a company prioritizes transparency for stakeholders or ease of preparation for internal teams. Checkout> Practical Finance & Accounting Course
Step-by-Step: How to Prepare a Cash Flow Statement
Learning how to prepare a cash flow statement is essential for understanding a company’s liquidity and financial health. Whether using the direct or indirect method, the process involves organizing financial data into operating, investing, and financing activities. Below is a simple guide to help you in preparing cash flow statements effectively.
Step 1: Gather Income Statement and Balance Sheet
Start by collecting the company’s financial statements for the reporting period.
- Income statement: provides net income and expense details.
- Balance sheet: shows changes in assets, liabilities, and equity.
- These documents form the foundation for preparing cash flow.
Step 2: Identify Cash Inflows and Outflows
Review financial records to determine all sources and uses of cash.
- Cash inflows: sales revenue, loan proceeds, asset sales.
- Cash outflows: rent, payroll, supplier payments, dividends.
Tracking these movements ensures accuracy in reporting.
Step 3: Separate into Operating, Investing, and Financing Activities
Classify cash movements into the three main categories:
- Operating activities: cash from day-to-day business operations.
- Investing activities: cash from asset purchases or sales.
- Financing activities: cash from borrowing, equity, or dividend payments.
Step 4: Apply Direct or Indirect Method
Choose a cash flow preparation method that fits your needs.
- Direct method: lists actual cash receipts and payments.
- Indirect method: starts with net income and adjusts for non-cash items and working capital changes.
Step 5: Reconcile Beginning and Ending Cash Balances
Finally, ensure the cash flow statement matches the business’s liquidity records.
- Add net cash from operating, investing, and financing activities.
- Confirm that the total reconciles with the beginning and ending cash balances on the balance sheet.
By following this step-by-step approach to preparing cash flow, businesses gain a clear view of their financial position, making it easier to plan ahead, secure funding, and maintain stability.
Cash Flow Statement Example
To better understand how a cash flow statement works, let’s walk through a simple cash flow statement example for a small business. This illustration highlights how both the direct and indirect methods present cash flow, even though they arrive at the same final cash balance.
Business Scenario
A small retail shop has the following financial data for one year:
- Net income: $20,000
- Cash sales: $50,000
- Customer payments on credit sales: $15,000
- Payments to suppliers: $30,000
- Employee wages: $10,000
- Rent: $5,000
- Purchase of equipment: $8,000
- Loan received: $12,000
- Dividend paid: $4,000
- Beginning cash balance: $5,000
Direct Method – Cash Flow Illustration
Operating Activities
- Cash received from sales/customers: $65,000
- Cash paid to suppliers: ($30,000)
- Cash paid for wages: ($10,000)
- Cash paid for rent: ($5,000)
Net cash from operating activities: $20,000
Investing Activities
- Equipment purchase: ($8,000)
Net cash from investing activities: ($8,000)
Financing Activities
- Loan received: $12,000
- Dividend paid: ($4,000)
Net cash from financing activities: $8,000
Net Increase in Cash: $20,000
Ending Cash Balance: $25,000 ($5,000 beginning + $20,000 increase)
Indirect Method – Cash Flow Illustration
Operating Activities
- Net income: $20,000
- Adjustments for non-cash items: $0 (none in this example)
- Changes in working capital: $0 (already reflected)
Net cash from operating activities: $20,000
Investing Activities
- Equipment purchase: ($8,000)
Net cash from investing activities: ($8,000)
Financing Activities
- Loan received: $12,000
- Dividend paid: ($4,000)
Net cash from financing activities: $8,000
Net Increase in Cash: $20,000
Ending Cash Balance: $25,000
Key Takeaway
This cash flow illustration shows that while the direct method details actual cash inflows and outflows, the indirect method begins with net income and adjusts from there. Both methods reconcile to the same ending cash balance, ensuring accuracy in financial reporting.
Common Mistakes in Preparing Cash Flow Statements
Even experienced business owners and accountants can make errors when preparing cash flow reports. Recognizing the most frequent mistakes in cash flow statement preparation helps ensure accuracy and avoids misinterpretation of financial health. Below are common pitfalls to watch out for.
Confusing Profit with Cash Flow
One of the most common errors in cash flow reporting is assuming that profit equals cash flow.
- Profit reflects revenues and expenses, which may include non-cash items like depreciation.
- Cash flow focuses on actual money moving in and out of the business.
- A company can show profit on paper while facing cash shortages in reality.
Ignoring Non-Cash Items
Another mistake is failing to adjust for non-cash items such as depreciation, amortization, or bad debt provisions.
- Non-cash expenses reduce accounting profit but don’t affect liquidity.
- The indirect method of preparing cash flow corrects this by adding back these adjustments.
- Ignoring them can distort the real financial picture.
Misclassifying Transactions Across Activities
Misclassification is a frequent source of confusion in cash flow statements.
- Operating, investing, and financing activities each serve different purposes.
- Recording loan proceeds under operating instead of financing, for example, creates misleading results.
- Consistency in classification is critical for stakeholder trust and accurate reporting.
Avoiding these mistakes in cash flow statement preparation ensures the report reflects the true financial position of the business and supports smarter decision-making.
FAQs on Cash Flow Statements
What is the easiest way to prepare a cash flow statement?
The easiest way to prepare a cash flow statement is by using the indirect method. It starts with net income and adjusts for non-cash items and changes in working capital, making it less time-consuming than tracking every cash transaction under the direct method. Many businesses also use accounting software to simplify the process.
Which method is better: direct or indirect?
The direct vs indirect method cash flow debate depends on business needs. The direct method provides more transparency by showing actual inflows and outflows, but it requires detailed tracking. The indirect method is easier to prepare and aligns with other financial statements, which is why it is more widely used in practice. Both methods arrive at the same ending cash balance.
How does a cash flow statement differ from an income statement?
While both are financial reports, they serve different purposes.
The income statement shows revenues and expenses over a period to measure profitability.
The cash flow statement focuses only on actual cash inflows and outflows, giving a clearer picture of liquidity.
This distinction is part of the cash flow basics every business owner should understand.Can individuals also use cash flow statements?
Yes, cash flow statements aren’t limited to businesses. Individuals can also prepare personal cash flow statements to track income, expenses, and savings. This helps in budgeting, managing debt, and planning for future financial goals, using the same cash flow basics applied in business reporting.
Conclusion
Mastering how to prepare cash flow statements is one of the most important skills for maintaining financial health in any business. Unlike profit reports, a cash flow statement provides clarity on real liquidity—showing whether a company can meet its obligations, invest in growth, and sustain operations. By understanding the components, methods, and common errors, business owners and finance professionals can make better decisions and build stronger financial strategies.
The best way to gain confidence is through practice. Use a cash flow statement example or a ready-made template to walk through the process step by step. Applying these tools in real or simulated scenarios will help reinforce your understanding and ensure accuracy when handling actual business finances.
Take the next step today—review your company’s financials, try preparing cash flow with a simple template, and strengthen your ability to manage cash effectively. With regular practice, you will not only stay compliant but also gain the insights needed to grow and protect your business.
Other Recourses:
POPULAR ARTICLES
