Understanding the Statement of Cash Flows

A number of my recent postings have been related to definitions of financial terms, financial ratios, and how to make use of them. Among these, a large percentage related to cash and the various things that impact it. In my posting Cash Management-It’s Not About the Cash Account I pointed that to manage cash we needed to get away from focusing so much on the cash account. To understand how cash is generated and used, let’s take a look at the flow of activity that impacts the cash balance. Understanding the statement of cash flows will help accomplish that.

The Statement of Cash Flows

To explain the flow of cash let’s look at some hypothetical financial statements. First is an Income Statement for the current year, then the Balance Sheet for the past two years, and then the Statement of Cash Flows which is developed using the information in the income statement and balance sheets. I have place reference numbers to the right of some of the lines in each statement to show the flow of information.

Study the statements below and then read the explanations that follow the statements.
cash flow diagramNotice first that there is a number 1 beside the Net Income on the Income Statement. Then notice that the number is also next to the Current Year’s Earnings in the Balance Sheet. This is to demonstrate the flow of the net income to the equity section of the balance sheet. Now we can forget about the income statement for now.

Adjustments for Current Activity

Now notice that the Current Year’s Earnings is carried forward to the Net Income line of the Statement of Cash Flows as referenced by the number 1 beside it. Now we will begin adjusting the net income for activity that flows through the current assets and current liabilities. For example, the number 2 beside the accounts receivable in the balance sheet shows an increase of $100,000 for the year. This increase represents a use of cash so it is shown as a negative number on the Statement of Cash Flows. This adjusts for the fact that the net income does not take into consideration sales that have not yet been collected. For example, say a company only had $100,000 in sales for a year and none of it was collected. That means that the $100,000 in sales has not yet been converted to cash. Follow the changes in the current assets to the Statement of Cash Flows and notice that an increase in a current asset represents a use of cash while a decrease in a current asset represents an increase in cash.

Next take a look at the current liabilities section of the balance sheets. Notice that the $200,000 decrease in accounts payable (this has the reference number 7 beside it) is a use of cash. Think about it. If the accounts payable decreased then that means the company used cash to pay vendors. Again, follow the changes in current liabilities from the balance sheets to the Statement of Cash Flows.

There is one more adjustment for current activity. Depreciation expense is a non-cash activity, so it has been added back to the net income. After all these adjustments for current activity to the net income we now move to the next section.

Investing Activity

Under investing activities we adjust for purchases and disposition of non-current assets. In the example, capital expenditures of $25,000 were made for purchases of equipment. Obviously this is a use of cash and thus reduces the cash balance. Now we move to the final section.

Financing Activities

Notice the reference numbers 11 and 12 on the balance sheet show that the company issued additional long-term debt of $25,000 and capital stock of $110,000 (composed of $10,000 in par value of capital stock and another $100,000 of paid-in capital for the issue). Both the increase from issuing long-term notes payable and selling additional capital stock represent increases in cash.

Totaling All the Changes

When we add up the changes due to current activity, investing activity, and financing activity we see the total change in cash of ($25,000). When this decrease is added to the beginning cash balance of $125,000 we get the ending cash balance of $100,000. I have placed a C by the change and the final cash balance that tie to the cash line on the balance sheets.

The Bottom Line

I personally think that of the three major financial statements (the Income Statement, the Balance Sheet, and the Statement of Cash Flows), the Statement of Cash Flows is perhaps the most difficult for most business owners and managers to understand. That said, it is worth spending some time to get a fundamental grasp of how this statement is created. It shows in detail what I meant when I said “Cash Management is not about the Cash Account”. It’s what you do in other areas that ultimately determine the cash amount.

If you would like some help in understanding the statement of cash flows, AimCFO would like to be of assistance.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.


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