The ins and outs of a Cash Flow Statement
A cash flow statement summarised into 3 key areas:
1. Operating Cash Flow
Also known as cash flow from operating activities, it reflects the payments from customers and payments to suppliers. This section also includes payments to employees (think of them as a supplier to the business), rents and other running costs. Operating Cashflow forecasts assist in instilling the discipline of regularly reviewing debtors and collectors positions and following up on delays for early warning signs of customer financial distress or dissatisfaction with service/products provided.
2. Investing Cash Flow
Also known as cash flow from investing activities, it records payments for fixed assets and long-life assets i.e. purchasing premises (not rent), motor vehicles and other non-current assets. For lease assets, interest and principal should be separated.
3. Financing Cash Flow
Also known as cash flow from financing activities, it reflects the payments to and from suppliers of capital to the business including debt drawdowns and repayments, interest, equity investment, share buyback, and dividends.
Each section should net off inflows and outflows to show the generation or application of cash in the key segments. The cash flow statement should reconcile with the business bank account at the end of each month. The P&L via accruals (income statement) and the Balance Sheet carry the differences in timing between costs incurred and cash payments (P&L) as well as the store of asset value (Balance Sheet). Asset usage via depreciation charges then flows through to the P&L.
Operating cash flow section is relatively straight forward in its interpretation and summarises the cash position from normal operations. Obviously, a healthy margin is expected if trading conditions and collections are performing well and the business pricing model is generating appropriate returns. Key drivers of negative returns in this area can stem from accelerated creditor payments, delayed collections from debtors or poor pricing practices. The statement should be a granular as required by the nature of each business and facilitate issue identification.
Investing cash flow embraces the decisions of owners to grow and replace the asset base of the business via capital expenditure. As a general guide, businesses operating in a mature state or exhibiting low growth should be capable of funding their asset replacement largely from free cash flow, provided pricing models are accurately recovering the asset base. Growth businesses will use a combination of finance and operating cash flow to fund growth investments. Payments for business acquisitions and divestments will also reflect in this section. Similarly, this section should be as granular as required to tell the story of the business investment and execution of the business plan.
Financing cash flows reflect the sources of funding the business and represent the raising and repayment of the debt, the costs of servicing debt via interest payments and equity payment flows in the form of retained cash earnings, equity raisings (increases) and buybacks (reductions). When managed effectively with actual compared with the forecast, decisions focusing on the distribution or retention of surplus cash to owners via dividends or share buybacks become straightforward in this section.
The Cash Flow Statement in this form and order can also be used to reflect the rights of claimants to business cash flow at law. For this to be effective, tax payments are often presented in operating cash flows. When operating cashflow summarises with tax deducted, key credit ratios can then be calculated using net operating cash flow as the numerator.
When considering the cash flow statement in this context it becomes apparent that this is the most important financial decision-making report to management and owners. Forecast assumptions for collections and payments to ensure adequate cash is available to service financial obligations together with liquidity support for the business become key focus areas driving finance team resource allocation and business controls.
The Cash Flow Statement allows projections around free cash flow for distribution to shareholders via dividend and/or capital return to be contemplated against forecast cash flows. In addition, owners can also contemplate leveraging the business to generate free cash for distributions where sufficient debt servicing capability is evident. The decision on form and structure of the debt facility follows and will include the robustness of operating cash flows. The longer duration of asset lives and robustness or reliability of contracted cash flow, will shape the risk assessment and inform the decision of the structure of the debt facility best suited to the business.