The statement of cash flows is possibly one of the most informative financial reports for investors, and yet it can be one of the most overlooked because of its similarity to the income statement. While the bottom line for most investors is profit, the cash flow statement reveals a lot about where that profit is coming from, and whether or not it is sustainable.
What Is Cash Flow?
Cash flow is, quite simply, the rate at which money flows into or out of a business. It's easiest to understand this if you think of it like your bank statement -- money comes in from your paycheck, investments and other income sources, and goes out to cover your expenses. If you've ever been short of cash, you can understand the importance of cash flows. You need to balance the rate of money coming in with the rate of money going out so you are able to meet your larger financial obligations, like paying a mortgage, and still buy food for dinner.
Cash Flow vs. Income Statement
In a financial report, the cash flow statement looks an awful lot like the income statement, but there is a vital difference between the two. The income statement uses accrual reporting: as much as possible, it recognizes expenses at the same time as income. This means, for example, that money spent to purchase inventory doesn't show up on the income statement until that inventory is sold. The cash flow statement recognizes the inventory expense as it happens -- if you buy inventory in December, it shows up on the cash flow statement for that month. When you sell those goods in February, that revenue appears on the cash flow statement for February.
Balancing Cash Flows
Just as in your bank account, the goal for any business is to have money available to pay for expenses, preferably with some left over. A healthy business brings in revenue that pays for the next round of expenses that then brings in more revenue and so on. It's important to see a balance of cash into and out of the business as it shows that the company is able to pay it's bills on time and that revenues are meeting expenses -- the business equivalent of living within one's means.
Sources and Destinations
Sources of income and expenses are just as important as the balance of cash flows. If the business is new or expanding, that initial money input must come from an outside source: a loan, startup capital or a stock or bond issue. If the business is established, some income might come from investment vehicles. None of these is bad, unless the company does not manage the cash flow appropriately. If an established company must borrow to cover an inventory purchase it may be a sign of trouble. Likewise, if management ties up too much operating cash in short term investments, the company may have trouble paying its bills, even if it has enough money.