The statement of cash flows (SOCF) is often the least utilized of the financial reports. Most people have never even heard of it. Yet a negative cash flow is one of the top reasons that businesses fail.
It’s entirely possible to have lots of sales at a good profit and for the company still to go under due to poor cash management. Sales next month don't mean a lot if you can't pay your bills today.
Let's start this journey by defining cash flow:
Cash flow is the money that is spent or received by a business.
The statement of cash flows shows the cash flow for a specific period. This report tells you whether you have more or less cash at the end of a period than you did at the beginning. In most cases, a period is 1 month or 1 year.
This is incredibly helpful to a business owner as it tells them if there is more cash coming into the business than going out. While it's expected that any business will occasionally have to spend more than they are making in a period, it is cause for concern if it is happening on an ongoing basis.
There are 3 main components of the statement of cash flows:
Operating Activities
Investing Activities
Financing Activities
Let’s break it down a little more:
Operating Activities
These are the day-to-day activities for your business that cause cash to flow in and out. This normally includes things like the purchase of materials, cost of production, sales, and expenses.
Investing Activities
These are the transactions that you don’t see quite as often; like buying equipment, buildings or furniture. You buy these items expecting that they will help you to earn more money in the future so you are investing in the business.
Financing Activities
This is where you account for any loans for the business, including taking out new loans, and the debt still owed and paid on previous loans. Often, the loans for the items from investing activities will be what you see in this section, such as a loan to buy a vehicle or building.
Overview:
The SOCF takes the net income or loss (total revenue - total expenses) from the same time frame of the income statement, then makes adjustments so the total reflects cash only. For example, accounts receivable are removed from the total. A/R are considered an asset and are included in the net income, but they don’t reflect cash since they haven’t been paid yet. So they have to be taken out.
The three sections of the SOCF (operating, investing, and financing) are used to adjust the net income to determine the affect that all of these activities have on the actual cash flow of the business.
Recap:
Cash flow is essentially how much money you have in your accounts. The statement of cash flows shows you whether that amount is going up or down over time.
You want to see that number increasing or, at the very least, staying the same. If you see that it is going down on a regular basis, then your business may be heading towards financial troubles. The cash that you have coming in isn’t covering your expenses. If that number is going down long enough, you will find yourself out of cash and struggling to stay afloat.
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