A cash flow statement is a financial statement that shows the inflow and outflow of cash within a business. It is considered one of the essential reporting documents, along with the income statement and balance sheet, to get an insight into the company’s finances.
A business generally prepares the statement of cash flows at the end of the accounting period. Learning how to prepare a cash flow statement is a crucial task for any business to run its operations smoothly and keep track of sources from where the cash is coming in and going out.
However, making a cash flow statement can be a challenging task. It requires a lot of preparation, collection of documents, and calculations to create a set format of a cash flow statement. So, in this article, we are going to guide you about how to prepare cash flow statement:
How to Prepare a Cash Flow Statement Step by Step
There are two methods used to prepare cash flow Statements:
Direct method: In this method, operating cash receipt (example- receipt from customers) and cash payments (example- payments made to employees, suppliers, etc.) are listed in the operating activities section of the cash flow statement. This method also includes any interest payments made on outstanding debts. This method is also known as the Income statement method.
Indirect method: The indirect method for generating cash flow statements uses accrual accounting information, i.e. where revenue or expenses are included when a transaction is made rather than when money is received. It always starts with the net income taken from the income statement. After that, the net income is adjusted for the changes in assets and liabilities account on the balance sheet either by adding or subtracting it to get the cash flow from operations.
Components of a Cash Flow Statement
Business operations: The statement provides information about funds generated from the day-to-day operations of an organisation. Operating activities are considered those that generate revenue or involve the direct cost of a product/service. Consumer receipts of purchases of essential goods and services, receipts of interest revenues and dividends, and other operating cash receipts are part of the operating processes that produce cash inflows. The company’s cash outflows include payments to vendors, payouts to workers, taxes, and other operational payments.
Investment activities: Investments involve the purchase and sale of long term assets or the purchase and sale of non-cash equivalent assets like buying and selling securities used to produce revenues over a long period of time. Investment cash inflows comprise non-current assets, including properties, plants, and manufacturing equipment. The acquisition or selling of shares or securities may also be involved in the investment activity. Other than this, lending money or collecting loan payments are also part of investment activities.
Financing operations: Financing operations include borrowing money and repayment, issuing stocks (asset), and dividends paid. For instance, the cash flow statement can help you calculate the amount of cash produced or spent due to borrowing funds to purchase machinery or repay a credit.
Cash and Income flow: The income statement and balance sheet are based on the accrual accounting approach (Accounts on a balance sheet that displays liabilities or non-cash based assets), which is derived based on the principle of matching. The principle of matching argues that revenue earned and the expenses incurred to create that revenue should be recorded in the same income statement. It also highlights the cause-and-effect relationship between revenue and expenses.
There are many cases where the revenue and expenditure resulting from accrual and allocations do not involve cash. A company can indeed be earning huge profits while having a severe shortage of cash. In other words, a company might have large inflows of cash but going into loss. Here, a cash flow statement helps to understand how these changes occur in the income statement.
There are two broad categories of items that lead to the difference between income inflow and income outflow, i.e., non-cash income or expenses and non-operating income or expense.
An example of non-cash income or expenditure can be depreciation, and the example of non-operating income or expense can be the profit earned on the purchase of an asset.
It is crucial to include all these transactions in preparation of cash flow statement to understand how a business operates and what can be done to move it in the upward direction.
7 Steps to Prepare a Statement of Cash Flow Statement
So, now we are going to learn the procedure for preparing cash flow statement step by step with the indirect method:
- Start by collecting basic documents and data
- Compute the Balance Sheet changes
- Add each balance sheet change to the cash flow statement
- Adjust the Non-cash expenses from the Profit and Loss Statement
- Based on other data, adjust all the non-cash transactions
- Cross-check all the steps with respect to changes in the Balance sheet
- Do the final check
Step 1 – Start by collecting basic documents and data
In this very first step, you have to collect all the basic and relevant financial documents such as balance sheet, income statement, statement of equity changes, as given below:
- Firstly, you need two Balance Sheets i.e. opening balance sheet and closing balance sheet that can act as the statement of a company’s financial position produced at the end of the financial year.
- You also need to have a statement to report the changes in equity for the current period.
- Next, you need a comprehensive Income statement, also known as the profit or loss statement.
- You also require the cash flow statement from the previous reporting period in hand. It is not a mandatory document to have, but it helps you to make any potential adjustments required for your business operations in the current period.
- Information related to the non-cash or other material transactions done in the current period is also necessary to include in your cash flow statement. Examples of material transactions include:
- Your cash and bank account ledgers to look for major purchases, sales, fixed assets or long-term assets.
- All the financial data from the legal department related to any proceeding against your company, if any.
- Data or memoranda about all the meetings, such as shareholder meetings or board of director’s meetings conducted in or out of the company’s premises.
- Memorandum of all the contracts the company has been into, including all the minor contracts and major ones too. For example, contracts signed with an influencer for your company’s marketing must also be reported here.
- Some might also suggest having immaterial items in your statement. They would not have a that significant impact on the cash flow statement compared to the other factors so it’s a choice whether you want to keep it or not.
It is important to note that some of the information like meeting minutes, contracts may not impact cash flow but they help immensely in the right classification of cash flow into operating, financing or investing activities.
Step 2 – Compute the Balance Sheet changes
In the second step of preparing a cash flow statement, you have to generate a table with three columns from the closing and opening balance sheet. The first column will have the title of caption in the balance sheet, the second including the balance of this caption from the closing balance sheet, and the third including the balance of this caption from the opening balance sheet.
Examine the table to see if you have entered the digits and amounts accurately on the right side. You will get the total of the balance sheet zero if you have done all the calculation parts correctly. This is because:
Assets = (Equity + Liabilities)
Now add another column to the three-column table to note the changes in Balance Sheet over the current period. To do this, simply calculate all the changes accurately using the formula:
Opening Balance Sheet – Closing Balance Sheet.
Keep in mind not to do vice versa. As a check, sum of all the Balance Sheet changes should be Zero.
Note: You can use your general ledger instead of the balance sheet to report the details precisely as the balance sheet has aggregated figures. It also depends on the type of details you require in your cash flow statement.
Step 3 – Add each balance sheet change to the cash flow statement
It is important to note that even a minor change to the balance sheet has an enormous impact on the cash flow statement. Even if you have made a non-cash item addition to the balance sheet, you have to include it in your cash flow statement.
If you are maintaining a cash flow statement for a while, you can simply use the statement of the previous period and copy-paste the individual caption titles. You will then have all the same titles (items) for the current period also, and for any new items, you can simply create additional lines.
Now, you have to take a look at each one of the changes in your balance sheet and then note each amount of cash in the new cash flow statement. For instance, you have got – 15000 as the expense in equipment purchases. So, you have to enter this amount in the investment side of your cash flows statement.
The only thing to remember here is the total of balance sheet changes should be zero. If you have got the total as zero, then you have done the correct calculations. If it’s not calculated to zero, you have definitely made some errors or mistakes that you need to review. Just go back to the table and check all the values separately.
Step 4 – Adjust the Non-cash expenses from the Profit and Loss Statement
You now have a good foundation to complete your cash flow statement effectively. However, there’s more work you have to do to make an effective cash flow statement that can give you a detailed analysis of your cash earning and spending.
Now, take the profit or loss statement. After taking these documents out, you have to note down any of the non-cash transactions you come to see in those records.
Following are the types of non-cash transactions:
- Barter transactions (exchange of goods).
- Revenue and cost of interests.
- Foreign exchange fluctuations at the end period.
- Expenditure for depreciation
- Revaluation of assets and liabilities
- Expenditure on income tax
Once a non-monetary transaction is identified, just adjust it in the blank cash flow statement. Make changes in every single column. Making changes in every column simply includes assigning a number to one title and subtracting it from another, like double accounting.
The key here is to find which items have to be added and which ones to subtract and which cash flows are affected by the non-cash items.
Continue entering the data till you recognise all non-cash items from the entire income statement. Make sure you verify the total amount after each change. The thing here to remember is that you make adjustments on both sides in a way that it should always maintain the total as zero.
Step 5 – Based on other data, adjust all the non-cash transactions
This step is similar to the one above. However, here you must seek some other sources of information. Most of them were stated in the first step above. For instance, if you see from the financial records of your company that you have a new equipment lease agreement, then there will definitely be an out-of-sight non-cash adjustment. Therefore, you have to make adjustments for this finance in a similar way done in the above step.
Here also, you have to keep in mind that the total should always be zero. This can be continued until all of the relevant information is revised. Please remember that you have to make all adjustments in separate columns.
Step 6 – Cross-check all the steps with respect to changes in the Balance sheet
This is not a mandatory step to follow while making your cash flow statement. If you are sure that you have made adjustments from all available departments in your business to your cash flow statement, then you can skip this step. However, if you want to ensure that you have included all non-cash adjustments to the cash flow statement without missing anything important, it is recommended to perform this step.
Here all you have to do is simply take the largest non-cash items from your balance sheet and balance their movements from opening to closing balance. Check that every change in your statement of cash flows has been taken into consideration to date.
Step 7 – Do the final check
Now that you’ve already spent a great deal of effort and made quite a bit of adjustment in your cash flow statement such that your non-cash adjustments total is always zero.
When you reach step 7, you will have a big sheet with the first column – captions or titles of your statement of cash flows, the second column- changes in the balance sheet, and subsequent columns (column3 – column X) for individual adjustments.
It’s time you make a very last column. The statement of cash flows ultimately will be the last column. You can make a “horizontal” line between the individual items from the statement of cash flow that summarises the figures from columns 2 to x throughout the separate sections or elements in the statement of cash flows.
Lastly, check over the last vertical line and verify the total. If it’s zero, you have done a great job, and your cash flow statement is fully ready!
A cash flow statement is an essential financial document of a company that determines its financial strength and profitability. It helps to understand whether a company has enough cash or liquidity to carry out its day-to-day operations. When you maintain a cash flow statement, an investor or creditor can estimate how much cash a company generates and get valuable insight into its financial position.
Now that you know the format of a cash flow statement in detail, it’s time that you build a cash flow statement on your own with the steps discussed above. We hope this article helped you understand how to prepare a cash flow statement.