How to Prepare a Statement of Cash Flows: A Step-by-Step Guide

A statement of cash flows is one of the most important financial statements for a business. It provides valuable insights into a company’s liquidity, showing how cash moves in and out of the business over a specific period. Understanding how to prepare a statement of cash flows is essential for business owners, accountants, and financial analysts alike.

If you’re new to this financial statement or want a better grasp on preparing it accurately, this guide will walk you through the process step by step.

What is a Statement of Cash Flows?

The statement of cash flows is a financial report that tracks the cash generated and used by a business during a given period. It breaks down cash activities into three main categories:

Operating Activities – Cash flows related to the company’s primary business operations, such as revenue from sales and payments for expenses.
Investing Activities – Cash flows from buying or selling assets like equipment, property, or investments.
Financing Activities – Cash flows associated with borrowing, repaying loans, issuing stock, or paying dividends.

Why is the Statement of Cash Flows Important?

Before diving into the preparation process, it’s important to understand why this financial statement matters. The statement of cash flows:

Helps business owners and investors assess a company’s ability to generate cash.
Provides insight into a company’s liquidity and financial health.
Complements the balance sheet and income statement by revealing actual cash movements.
Helps businesses plan for future cash needs and avoid financial shortfalls.

Now, let’s walk through the process of preparing a statement of cash flows.

Step 1: Gather Necessary Financial Information

To prepare a statement of cash flows, you’ll need data from the company’s:

Income statement (profit and loss statement)
Balance sheet (from the beginning and end of the period)
Additional financial records related to cash transactions

Having these documents on hand will make it easier to track cash inflows and outflows accurately.

Step 2: Choose the Cash Flow Method

There are two main methods for preparing the cash flow statement:

Direct Method – Lists actual cash receipts and cash payments from operating activities.
Indirect Method – Starts with net income from the income statement and adjusts for non-cash transactions and changes in working capital.

The indirect method is the most commonly used approach since it connects the statement of cash flows to the income statement and balance sheet.

Step 3: Calculate Cash Flows from Operating Activities

If using the indirect method, start with the net income from the income statement. Then, adjust for non-cash expenses and changes in working capital:

Adjust for Non-Cash Items

Non-cash expenses include:

Depreciation and Amortization – Added back to net income because they reduce reported earnings without affecting cash.
Losses and Gains on Asset Sales – Removed from net income because these are investing, not operating, activities.

Adjust for Changes in Working Capital

Changes in current assets and liabilities impact operating cash flow:

Accounts Receivable – If receivables increase, it means more sales were made on credit, reducing cash flow.
Inventory – If inventory increases, cash was used to purchase more goods, lowering cash flow.
Accounts Payable – If payables increase, the company delayed payments, improving cash flow.
Other Current Liabilities – Changes in wages payable, taxes payable, and accrued expenses also impact cash flow.

After making these adjustments, you’ll arrive at the net cash provided by (or used in) operating activities.

Step 4: Calculate Cash Flows from Investing Activities

This section includes transactions related to the purchase or sale of long-term assets and investments. Examples include:

Cash spent on purchasing property, plant, and equipment (negative cash flow)
Proceeds from selling assets (positive cash flow)
Investments in securities or subsidiaries (negative cash flow)
Sales of investments (positive cash flow)

If a company is investing heavily in new assets, it may show a negative cash flow from investing activities, which is not necessarily bad if it’s for business growth.

Step 5: Calculate Cash Flows from Financing Activities

The financing section reports transactions related to debt and equity financing. Examples include:

Borrowing from banks or issuing bonds (positive cash flow)
Repaying loans or redeeming bonds (negative cash flow)
Issuing new stock (positive cash flow)
Paying dividends to shareholders (negative cash flow)

Financing activities reveal how a company funds its operations and growth.

Step 6: Calculate Net Cash Flow and Reconcile with Cash Balances

Now, sum up the three sections:

The result shows the overall increase or decrease in cash during the period. This amount should reconcile with the change in cash balances reported on the balance sheet.

Finally, verify that the ending cash balance matches the cash amount listed on the balance sheet.

Example of a Statement of Cash Flows (Indirect Method)

Here’s a simplified example:

XYZ Company
Statement of Cash Flows
For the Year Ended December 31, 2023

Cash Flows from Operating Activities:

Net Income: $50,000
Add: Depreciation: $5,000
Less: Increase in Accounts Receivable: ($3,000)
Add: Increase in Accounts Payable: $2,000

Net Cash Provided by Operating Activities: $54,000

Cash Flows from Investing Activities:

Purchase of Equipment: ($10,000)
Sale of Investments: $5,000

Net Cash Used in Investing Activities: ($5,000)

Cash Flows from Financing Activities:

Loan Proceeds: $20,000
Dividend Payments: ($5,000)

Net Cash Provided by Financing Activities: $15,000

Net Increase in Cash: $64,000

Beginning Cash Balance: $10,000
Ending Cash Balance: $74,000

Common Mistakes to Avoid

When preparing a statement of cash flows, avoid these common errors:

Forgetting to adjust for non-cash expenses like depreciation.
Misclassifying financing and investing transactions.
Failing to reconcile cash balances with the balance sheet.
Overlooking changes in working capital that impact cash flow.

Final Thoughts

Preparing a statement of cash flows may seem daunting at first, but once you understand the process, it becomes a powerful tool for assessing a company’s financial health. By following these steps and ensuring accuracy, you’ll gain valuable insights into how cash flows through a business, helping with better financial planning and decision-making.

Whether you’re a small business owner, an investor, or an accountant, mastering the statement of cash flows is essential for financial success. So, roll up your sleeves, gather your financial data, and start tracking cash like a pro!