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Your Guide to Cash Flow Statements and Why They Are Important

08 Feb 2024

As a business owner, you're likely aware of the crucial role financial management plays in the success of your enterprise. Effectively overseeing your finances involves addressing key questions: What is your current bank balance? What are your sales earnings? How much is allocated to expenses? The good news is that by grasping the concept of cash flow, you can swiftly provide answers to these inquiries.

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Components of a Cash Flow Statement

A cash flow statement is classified into three categories. Let’s discuss them in detail.

  • Operating cash flow: It shows how much cash your business generates from its core operations, such as selling goods or services, paying salaries, or buying supplies. This component is a good indicator of your business's efficiency and profitability.
  • Investing cash flow: It shows how much cash your business spends or receives from its long-term investments, such as buying or selling fixed assets, acquiring or disposing of other companies, or lending or borrowing money. Investing cash flow is a good indicator of your business growth and expansion.
  • Financing cash flow: It reflects how much your company raises or repays from external funding sources, such as issuing or redeeming shares, paying dividends, or taking or repaying loans. Financing cash flow is a good indicator of your business capital structure and solvency.

How to prepare a Cash Flow Statement?

Now that you have an idea to cashflow statement definition, let’s understand the two ways to draft a cash flow. 

  • The direct method displays the specific cash inflows and outflows for every operational activity, such as cash received from customers, money paid to suppliers, or cash used for interest payments. This method provides more transparency.
  • The indirect approach begins by taking the net income from the income report and making adjustments for non-cash items, including depreciation, amortisation, and changes in working capital. It is simple but needs more detail and clarity.

How to analyse a Cash Flow Statement?

To analyse this statement, you need to use some ratios and indicators. These are:

  • Free cash flow is the amount of cash your business has left after paying for its operating and investing activities. You can compute this by deducting the investing cash flow from the operating one. A positive free cash flow means your business generates more cash than it needs, a good sign of financial health. 
  • Cash flow margin is the percentage of cash your business generates from its sales. You can determine this by dividing the operating cash flow by the revenue. A high cash flow margin means that your business converts a large portion of its sales into cash, which is a good sign of efficiency and profitability. 
  • The cash conversion cycle reflects the days your business takes to turn its inventory and receivables into cash. You can calculate this by adding the day's outstanding inventory and sales and subtracting the day's payables outstanding. A short cash conversion cycle means that your business collects cash from its customers and sells its inventory faster than it pays its suppliers, which is a good sign of liquidity and efficiency.

Importance of Cashflow Statement 

By using your cash flow statement, you can:

  • Budget and forecast: You can use your historical cash flow data and expected cash flow drivers to estimate how much cash your business will generate and need. This can help you plan your cash inflows and outflows and avoid cash flow shortages or surpluses.
  • Value your business: You can use your free cash flow to estimate the worth of your business. By discounting your future free cash flows to their present value, you can calculate the net present value of your business, which is one method of business valuation.
  • Apply for a loan: This statement shows your lenders how much cash your business generates and how well you can repay your debt. Lenders are interested in your cash flow because it indicates your ability and willingness to service your debt obligations
  • Evaluate your investment opportunities: You can use this statement to compare the expected returns and risks of different investment options. For example, you can use the net present value or the internal rate of return methods to calculate the profitability and feasibility of investing in a new project, product, or market. 

Conclusion

Cash flow is the lifeblood of your business. It affects your ability to survive, grow, and succeed in the competing and dynamic business environment. By managing your cash flow productively, you can ensure your business has enough cash to meet its current and future needs.

 

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