Editor's Note: This article is part of Inc.'s bi-weekly primer on business terms in partnership with financial information company Sageworks

As someone with responsibilities across the whole organization, you may not feel like you have time to dig through your business’s financial data every day. If you’re lucky, you may have a chief financial officer or a chief operating officer who manages the company’s finances.

However, many companies don’t, and most entrepreneurs can benefit from taking a more hands-on approach to understanding the financial health of their business. You might be surprised at the amount of valuable insight that can be gained from having a firm understanding of your company’s financial statements.

If you’re looking to get a full picture of your business’ financial performance, it’s prudent to study all three of your company’s financial statements: The income statement, the balance sheet and the cash flow statement.

The income statement shows the sales and profitability of your business for a specific period of time, while the balance sheet gives you a snapshot of your overall financial condition at a point in time. The cash flow statement, meanwhile, blends the balance sheet and income statement together in order to display how cash has come into and gone out of your business.

While the cash flow statement is often neglected, it shouldn’t be, given the importance of cash to your business. As Karen Berman and Joe Knight explain in their book, “Financial Intelligence for Entrepreneurs,” you should think of the cash flow statement as a proxy for a company’s bank account, i.e. debits and credits.

Why cash flow matters

One of the reasons the cash flow statement is so helpful is that many companies record transactions when they occur, even if no cash has changed hands yet (called the accrual method of accounting) because of credit arrangements or other factors. As a result, your business may have strong sales and net income as shown on the income statement, but you could be burning through cash quickly.

“In my experience, it’s not lack of profitability or lack of revenue that leads to business failure," says Sageworks chairman Brian Hamilton. "Cash flow is the real killer.”

Famed investor Warren Buffett uses information in the cash flow statement to determine whether a company has a “durable competitive advantage.” Just as Buffett uses the cash flow statement to gain insight about potential investments, you can use it as a means to a kind of self-examination. It’s not necessarily going to be pretty, but an honest assessment of your financial health through the use of the cash flow statement can reveal serious red flags in your business. It might even save it.

How to read it

The cash flow statement is divided into segments in order to outline cash flows from three major activities of all companies: operations, investing and financing.

The information on cash flows from operating activities is really the most critical, Hamilton says, because it shows how much money you are generating from regular operations - from the basic, fundamental production and sales of goods and/or services.

It starts with the net income reported on the income statement, then adds back non-cash expenses (such as depreciation and provisions the company made for doubtful accounts) and adjusts for changes to current assets and current liabilities. For example, a sale made on credit does not affect cash, but it would increase sales (and therefore net income) and would create an increase in accounts receivable. The related increase in accounts receivable is deducted from net income to show the actual cash from operations.

“That number is crucial, because if you compare that to profitability, now you know two things,” Hamilton says. “Are you profitable by GAAP? And are you actually making cash through your operations?”

Looking past the net increase/decrease line

It’s easy to simply look at net increase or decrease in cash for the period, but if you do that, you’ll miss other important information. Knowing how you’re getting and spending your cash allows you to better gauge the quality of your earnings - that is, are they actually sustainable or aided by external factors?

For example, the section on cash flows from financing activities may show that equity was issued to raise cash or to make acquisitions. While raising cash through equity may be a good thing, it’s not money that your business has generated on its own, and your business may not survive long if it doesn’t generate cash on its own. This section on financing will also show whether stock issuances are outpacing or lagging stock repurchases, an issue of keen interest to your shareholders.

A 10,000 foot view

The section on cash flows from investing activities provides a 10,000 foot view perspective: Are you currently investing cash in the future growth of the business through new facilities or other capital expenditures? Are you selling assets to bring in more cash? Are you allocating cash in an entirely different way than peers? Hopefully you already have the answers to these questions, and that the answers are in line with your overall strategic goals as a company. However as your company begins or continues to grow, it cannot hurt to keep a close eye on this 10,000 foot view that the statement of cash flows can provide.

Finally, metrics and ratios based on information contained in the cash flow statement can give you a clear indication of your liquidity, your ability to operate as a going concern and your long-term value. These ratios include the cash interest coverage ratio and the cash current debt coverage ratio. One metric that gets a lot of attention is free cash flow, which is calculated by subtracting capital expenditures from net cash from operations.

This will be an especially important metric to keep your eye on if you’re thinking of going public at some point, as it is the major component used to evaluate pricing for initial public offerings.

Published on: Jul 22, 2014
The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.