You need to understand direct vs. indirect cash flow forecasting to make short and long-term business decisions. This article will show you how.
Welcome to the third and final installment of our series on understanding financial statements for startup founders. Now that you’ve mastered the P&L statement and balance sheet, it’s time to dive into the third and final of the three key financial reports: The cash flow statement.
Prior to diving in, it’s important to address three notes and assumptions you should bear in mind as you read through this article and the others in this series.
This article is based on the use of the accrual accounting method, which tracks money not in terms of cash inflows or outflows, but in terms of when it is earned or due (as opposed to the cash accounting method, which books expenses and income when cash exchanges hands).
At Zeni, we use accrual accounting method for all of our customers and recommend it to startups and small businesses because it gives you a more accurate overview of your business’s financial health, allows for strategic business decisions and the ability to scale and prepare for exit scenarios such as mergers/acquisitions or initial public offerings.
Plus, the accrual accounting method is required for businesses earning $5 million annually in revenue or businesses that report financial statements to outside parties, such as investors, per GAAP.
Generally Accepted Accounting Principles (GAAP) are principles, standards, and procedures established by the Financial Accounting Standards Board, or FASB. All publicly traded companies must comply with GAAP standards. GAAP accounting is used to help standardize procedures and processes so a company’s financial statements are completed consistently from company to company.
GAAP allows investors to compare and contrast the information contained in financial statements of various companies and industries. Zeni prepares all financial statements in accordance with GAAP. Our approach of using GAAP with new, emerging growth companies lays the foundation for scalability as well as being prepared for any potential exit strategy such as initial public offering and/or acquisition.
This article series was written to provide those without significant experience with financial statements a working knowledge of the cash flow statement. This article and the others in this series shouldn’t be substituted for the expert advice of an experienced bookkeeper or accountant. If something in your financial statements doesn’t seem right, ask an experienced bookkeeper or accountant for assistance or get in touch with the Zeni Finance Team.
A cash flow statement, or statement of cash flows, gives a summary of the amount of cash and cash equivalents that enter and leave your company during any given period of time. Cash equivalents include cash held in bank accounts, short-term investments, and any highly-liquid assets, such as stocks, bonds, and mutual funds.
The cash flow statement demonstrates how a company spends money (cash outflows) and where that money comes from (cash inflows). It serves as a bridge between the P&L statement and the balance sheet by providing insight into the money that moves through your business during the reporting or accounting period.
Unlike the P&L and balance sheet which reflect future incoming and outgoing cash that is recorded on credit, the cash flow statement only reflects movement of cash in the current reporting period.
A typical cash flow statement is broken down into three to four components. These are:
Cash flow statements generally reflect three categories: Operating Activities, Investing Activities and Financing Activities. In some cases, a disclosure of noncash activities is also reflected on the cash flow statement.
The operating activities section reflects the main revenue-generating activities of a business and any cash flows from current assets and current liabilities, as noted on your balance sheet.
This includes any sources and uses of cash from business activities (in other words, how much cash your company’s products or services generate). Changes in the balances of net income, accounts receivable, depreciation, inventory, and accounts payable are typically reflected here.
Cash flows that come from the purchase and/or sale of long-term assets and other investments are considered cash from investing activities. This includes the cash flows resulting from the buying and selling of Property, Plant, and Equipment (PP&E), including real estate purchases, other non-current assets, and/or other financial assets.
Cash from investing activities also includes any sources and uses of cash from a company’s investments. Purchases or sales of assets, loans made to vendors or received from customers, or any payments related to mergers or acquisitions are reflected here.
The cash flows that result from changes in the size and composition of the contributed equity capital or borrowings (think bonds, stocks, or dividends) are considered to be cash from financing activities.
Cash from financing activities also includes the sources of cash from investors and/or banks, as well as the uses of cash paid out to shareholders. Dividend payments, stock repurchase payments, and debt principal repayment are reflected here.
The disclosure of noncash activities is sometimes included on the cash flow statement. Some examples of activities included in this section are issuing stock to retire a debt, exchanging non-cash assets, and paying for services availed by issuing stock instead of providing a cash payment.
In short, the cash flow statement is another instrument used to assess the financial health of a company.
Investors use the cash flow statement to see how a company’s operations run, and where money comes from and goes to so they can decide whether the company is financially stable or not.
Creditors, on the other hand, use the cash flow statement to understand how much liquidity the company has in order to cover its obligations.
There are two methods of calculating cash flow – the direct cash flow method and the indirect cash flow method.
Cash flow = Cash from operating activities +/- Cash from investing activities + Cash from financing activities
The direct cash flow method summarizes a company’s various types of cash payments and receipts. It’s calculated using beginning and ending cash balances of business accounts and analyzing the net increase or decrease in them.
With the direct cash flow method, operating cash flows are presented as a list of cash flows. This method is simple and more meaningful to founders or to those with limited financial expertise.
The indirect cash flow method is calculated by first taking the net income from a company’s P&L statement. Using the accrual method of accounting, revenue is only recognized when it’s earned, not when it’s received. Because net income doesn’t accurately reflect net cash flow from operating activities, it’s necessary to adjust earnings before interest and taxes (EBIT) for items that affect net income, even though no cash has been received or paid against them.
With the indirect cash flow method, operating cash flows are presented as a reconciliation from profit to cash flow. The formula above explains how the indirect cash flow method is used to calculate cash flow.
The cash flow statement is a valuable resource to founders, business owners, investors, and creditors alike. It provides an overview of the traffic of your cash and cash equivalents so you can better understand the movement of your company’s money.
If you missed the previous two articles in this series breaking down important financial statements for startups, be sure to read the P&L statement and balance sheet articles; this will help you understand the different reports at a granular level, and how to use them in conjunction with one another for financial analysis to help inform important business decisions.
At Zeni, we combine the power of AI with the expertise of a finance team to give startups like yours a simple way to manage everything finance-related, from bookkeeping and accounting to invoicing, bill paying, yearly taxes, budgeting and forecasting, and more. Built specifically for startups, Zeni provides full visibility over all aspects of your financial situation at all times, and streamlines and automates many basic financial functions. (Among other things, the Zeni Dashboard automatically calculates your net burn, runway and cash zero date!)