When you run a small business, you wear many hats—including finance manager. But although you may manage your business’s finances, you might not be an expert. Our new weekly series will break down the most popular financial terms, documents, methods, and more that your business needs to know.
To kick things off, let’s get to know more about your statement of cash flows.
The statement of cash flows is basically a snapshot of your business’s financial health. It can be presented in two formats:
For our purpose we’re going to focus on the indirect method, because it’s much more useful when analyzing your business.
The indirect method statement of cash flows shows you at a glance whether your cash flows are coming from operating, investing, or financing activities.
A healthy business drives their cash flows from operations and reinvests capital. This means you want to see positive cash flows from operations, and you want to see cash outflows in investing activities.
Here’s the layout of a properly formatted statement of cash flows:
Operating activities include anything that results from day-to-day operations. It starts with net income. Your net income is the aggregate of all of the activity from your profit and loss, or your income statement.
If the business were a pure cash-basis business, then the net income would equal your net cash flow. This means that all of your income for the year would have been collected, and all of your expenses paid. The net income would be the exact same thing as your net cash flow.
But here’s the thing. While you may file your taxes on a cash basis, you can never run or analyze a business that way. You must look at your reports on an accrual basis so that you can properly analyze what’s going on.
This brings us to everything that appears on the statement of cash flows, in the operating activities, after the net income.
The statement of cash flows reconciles your accrual basis net income to your cash balance at the end of a period. We’ll go over this in a more simple way with an example.
Based on all those facts, at the end of year 1 you will have $85,000.
How does that math work? Well, we start the statement of cash flows with the net income of $100,000.
But $25,000 has not yet been collected. It is sitting in accounts receivable, so that has to be subtracted from the $100K to arrive at cash.
In other words, an increase to accounts receivable during the period has to be subtracted from net income to arrive at cash.
So we should have $75,000 in the bank. That IS in fact our net operating cash flow.
Remember that you started your business off with $10K. That isn’t income, so it wasn’t included in the $100K net income. That falls under “Financing Activities.” It’s money that went into the bank account but isn’t included in net income, so it has to be added to net income to arrive at cash.
We wind up with $85,000 in the bank at the end of the year.
In case you missed it, learn more about how a statement of cash flow works with our latest video.