Cash Flow Statements: Understanding How Do They Work?

The Cash Flow Statement is a financial statement of a company. The report shows the ongoing operations and the external investment sources of a company. Essentially, this statement provides the investors of the company with a detailed analysis of all transactions that occur in the company. It is one of the most important financial statements of a company.

How does Cash Flow Statement Format work?

The three most important financial statements for a company are the Balance Sheet, the Income Statement, and the Cash Flow Statement. The Cash Flow Statement acts as a bridge between the Balance Sheet and the Income Statement since it displays the actual movement of money in and out from a business.

The cash flow analysis of a business has three main sections that define the different financial activities of a company. They are:

1. Operating activities 

2. Investing activities

3. Financing activities

Let us elaborate on the activities with an example to make the understanding of the concept easier:

Let’s say you run a pet shelter called Dogs, Cats & Co with Rs 10,000 in hand at the beginning of the year. In the process of running the place, you will not only earn revenue but also incur certain expenses, which we will now proceed to categorise.

Operating Activities:

This section includes all the operational activities of the company. It determines the net income excluding any investing and financing activities. It reflects the cash generated by selling products or services that a company provides. The various revenue sources and expenses in the operating activities are:

• Receipts from the sales of services and goods

• Income tax payments

• Interest payments

• General operating expenses

For Dogs, Cats & Co, operating activities will include:

1. Revenue from pet adoption – Rs 20,000

2. Proceeds from sale of pet walkers for disabled pets – Rs 1,000

3. Buying pet food – Rs 1,500

Investing Activities:

This section shows the investment gains and losses of a company. Specifically, it pertains to purchases or sales of an asset, loan payments to a lender, or payments related to acquisitions or mergers, that can be undertaken through a Demat Account. 

For Dogs, Cats & Co, investing activities will include:

1. Renovating the shelter – Rs 15,000
   
   

Financial Activities:

This section measures the cash flow between the company, its owner/s, and its creditors. It also allows analysts to measure the finances the company gives out in dividends or share buybacks. Cash flow determines the changes in the size and composition of the equity capital (stocks, bonds, and dividends)

For Dogs, Cats & Co, financial activities will include:

1. Loan payment for opening new pet store – Rs 5,000
   
   

How is the Cash Flow Calculated? 

Cash flow is the inflows and outflows of cash or cash equivalents of a company. There are two methods for cash flow calculation, namely:

• Direct Method: In this method of cash flow calculation, you consider all the cash influx from the operating activities and subtract the cash disbursements from the cash influx of the operating activities.
  
  

• Indirect Method: In this method, you take the value of the net income at the end of the reporting period (quarter, month, or year). Then adjust the value of the net income by removing any non-cash expenses from the income statement.
  
  

The Cash Flow Statement of Dogs, Cats & Co will, therefore, look like this:

What is the Importance of the Cash Flow Statement?

This statement gives an insight into the financial well-being of any business, which makes it a critical financial document in a company. It tells us vital information which can be crucial for the future process and expansion of a company. Some of the critical aspects which the Cash Flow Statement brings forth are:

• The quality of earnings of a company in a given period. So, if the net income is less than the cash in the operating activities, then the earning can be seen as high quality.

• It shows the investors of a company the overall performance.

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​​​​​​​*Terms and conditions apply. The information provided in this article is generic in nature and for informational purposes only. It is not a substitute for specific advice in your own circumstances. This is an information communication from HDFC Bank and should not be considered as a suggestion for investment. Investments in securities market are subject to market risks, read all the related documents carefully before investing.