Do you know where your business’ money is going? If not, it’s time to investigate. Many small business owners do their own accounting, either with accounting software or manually, with a spreadsheet.

In financial accounting, the cash flow statement, or statement of cash flows, will show where your business’ revenue is coming from and where it’s going. It’s one of the main financial statements used in accounting to provide an overview of business results -- along with the balance sheet, income statement, and statement of stockholders' equity.

But what does the statement of cash flows include? And how is it prepared? We’ll dig into the ins and outs of the cash flow statement below, so you can determine your business’ cash flow and if you can afford that fancy espresso machine for the company break room.

What is Cash Flow?

Cash flow is the net amount of money moving in and out of a business. It shows where cash comes from and how it’s being used.

A positive cash flow means your cash inflows were greater than your cash outflows. If the cash flow is negative, the business might not have enough cash to finance operations. This could mean the business is financing operations by borrowing.

So, how do we determine the cash flow? A statement of cash flows, of course.

There are two methods for determining cash flow: direct and indirect. Both methods look at cash flow over an accounting period, which is typically 12 months.

The direct method is used less often and requires more information than the indirect method. It lists cash inflows and outflows for every type of operating activity, including:

  • Cash collected from customers
  • Employee salaries
  • Interest and dividends received
  • Cash paid to suppliers or vendors
  • Interest paid
  • Income tax paid

The Financial Accounting Standards Board (FASB) prefers the direct method over the indirect method, because the direct method provides a more detailed view of the operating cash inflows and outflows of a business. And it can give decision makers and potential investors a more accurate picture of how a business is doing.

The indirect method is the most popular way to create a statement of cash flows. It starts by looking at the net income from the income statement. And it’s broken down into three main parts:

  • Operating activities include revenue and operating expenses. They are only included if the cash payment occurred during the account period the statement reports on.
  • Investing activities include purchasing property, a manufacturing plant, or equipment. They might also include the acquisition of a business.
  • Financing activities include issuing shares, selling or repurchasing stock, and paying debt and dividends.

Let’s take a look at the steps you should take to prepare a statement of cash flows using the indirect method.

Once the net cash flows from operating, investing and financing activities are calculated and combined, you’ll see the net cash increase or decrease for the period. This confirms the net of these changes is equal to the change in cash on the balance sheet.

Operating Cash Flow

Operating cash flow (OCF or CFO) is the first portion of the statement of cash flows. And it determines the revenue-generating aspects of the business. The formula for calculating operating cash flow is:

Operating Cash Flow (OCF) = Total Revenue - Operating Expenses

For a business to be successful, long-term cash inflows must be greater than outflows. If outflows are greater than inflows, the business will likely need external financing.

Free Cash Flow

A company’s free cash flow is the cash they generate minus the cost of expenditures on assets. Below is the formula for calculating free cash flow:

Free cash flow = Net cash flow from operating activities - Capital expenditures

This gives you the remaining cash amount after your business pays for operating expenses and capital expenditures. The calculation is important because it shows if a business has enough cash left over to pay back investors.

Discounted Cash Flow

Discounted cash flow (DCF) is a method used to evaluate a potential investment opportunity. The discounted cash flow can be used to value a:

  • Business
  • Project or initiative
  • Bond
  • Company’s shares

The result shows how much return you can expect to earn from the investment. Here’s how to calculate discounted cash flow:

DCF = [CF1 / (1+r)1] + [CF2 / (1+r)2] + ... + [CFn / (1+r)n]

CF = cash flow in the period

n = the period number (years, quarters, or months)

r = discount rate or WACC (i.e., the rate a business expects to pay for its assets)

The DCF takes into account the time value of money -- the concept that a dollar today is worth more than a dollar tomorrow due to its earning potential (e.g., interest rate).

If you pay more than the DCF value, the return will be less than the discount rate. And if you pay less than the DCF value, the return will be greater than the discount rate. When the DCF value is higher than the cost of the potential investment, it’s likely a good one.

Whether you’re determining where your money is coming from and where it’s going or looking for investors and financing -- the cash flows allow you to see how cash is moving in and out of a business. With the information provided by the statement of cash flows, you’ll be well-prepared to make informed decisions about the future of your business.

HubSpot CRM

Originally published Sep 20, 2018 7:30:00 AM, updated September 20 2018

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