Understanding your business’s financial health through cash flow statement

Cash flow statement is a financial statement that illustrates the inflows and outflows of company’s cash and cash equivalents over a specific period. It plays a crucial role in financial reporting and gives an understanding of how well a company generates and uses a cash. The cash inflows and outflows are derived from the following cash flow activities:
  1. Operating activities – These are day-to-day business operations that include elements such as cash received from sale, interest received from investment or loan, cash paid to suppliers, salaries, rent, utilities, marketing and other expenses and, of course, changes in working capital.
  2. Investing activities – These mainly include the purchase or sale of long-term assets (PP&E) showing how efficiently the company allocates its resources for making buying and selling decisions.
  3. Financing activities – These include issuing long-term and short-term debt or stock, dividend and principal payments that are associated with raising capital and distributing it to investors.

Evaluating the pros and cons of cash flow calculation methods.

There are 2 methods for calculating the cash flow statement:
  1. Direct method – This is a simple representation of cash receipts and payments. Here the first component for the operating activity is revenue from which the payments and taxes are deducted.
  2. Indirect method – This method is preferred for companies using accrual-based accounting. It begins with net income as the first element then the changes in non-cash transactions are adjusted accordingly.

Actually, the difference between these 2 methods is reflected only in the operating activities. For the investing and financing activities the components are the same for both methods.

The main advantages of direct method are transparency and detailed breakdown of cash flows. It gives a clear understanding of a business’s cash flow drivers. It's important to note that one potential drawback for this method is the time and effort required for data collection process.

Moving forward to indirect method, it is mainly preferable for the companies using accrual-based accounting. This method is simple to implement and widely accepted, while its main disadvantage is the lack of transparency required by certain international accounting rules and accepted procedures.

Ultimately, the selection of either the direct or indirect method depends on company and their reporting requirements. In short, the direct method is easy for external stakeholders to understand but a bit difficult to create compared to the indirect method. Whereas the indirect method is the opposite - less understandable to other people and easier to create for finance professionals. Regardless of the chosen method, the role of cash flow statement is vital in financial analysis and decision-making process.

Contact us today at CFOnline.co to optimize your cash flow statement management and enhance your business profitability!

Prepared by: Seda Janazyan, Business Analyst at CFOnline.co

Quick process

Talk to an expert