Cash Flow Statement

Quick Summary of Cash Flow Statement

Provides information about changes in financial position. The cash flow or flow of funds statement shows how an operation has been financed in the latest accounting period and how resources have been used.

The balance sheet, income statement, and cash flow statement are the three generally accepted financial statements used by most businesses for financial reporting. All three statements are prepared from the same accounting data, but each statement serves its own purpose. The purpose of the cash flow statement is to report how much cash went into and out of a company during a specific time frame like a quarter or a year. In other words, it shows how much cash a company is generating from one period to the next. It shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities.

As an analytical tool, the statement of cash flows is an indicator of a company’s financial strength. It is useful in determining the short-term viability of a company, particularly its ability to pay bills. The statement of cash flows strips out all the abstract, noncash revenues, and expenses that are included in the income statement. Many companies have shown profits on the income statement but have stumbled later because of insufficient cash flows.

Companies can generate cash in several different ways. The cash flow statement organizes and reports the cash generated and used in the following categories:

1. Operating activities – converts the items reported on the income statement from the accrual basis of accounting to cash. This section comes first and tells you how much cash the company generated from its core business, as opposed to peripheral activities such as investing or borrowing. It includes receipts from the sale of goods or services, receipts for the sale of loans, debt or equity instruments in a trading portfolio, interest received on loans, payments to suppliers for goods and services, payments to employees, etc.
2. Investing activities – This section shows the amount of cash firms spend on investments. Investments are usually classified as either capital expenditures–money spent on items such as new equipment, Property, plant, or anything else needed to keep the business running–or monetary investments such as the purchase or sale of long-term investments.
3. Financing activities – This section includes any activities that involve the company’s owners or creditors. It reports the issuance and repurchase of the company’s own bonds and stock and the payment of dividends.
4. Supplemental information – reports the exchange of significant items that did not involve cash and reports the amount of income taxes paid and interest paid. Total cash flow is calculated by adding non-cash charges (such as depreciation) to net income after taxes. It can be attributed to a specific project, or to a business as a whole.

Two different methods used for preparing a Cash Flow Statement can be explained as follows

Direct Method

The direct method of preparing a cash flow statement results in a more easily understood report. Under the direct method, cash and bank accounts are analyzed to identify cash flows during the period. A detailed general ledger report showing all the entries to the cash and bank accounts are used. The cash receipts and disbursements journals may also be used for the purpose. The offsetting entry for each cash entry is then determined in order to decide where each cash movement should be reported on the cash flow statement.

Another way to determine cash flows under the direct method is to prepare a worksheet for each major line item, and eliminate the effects of accrual basis accounting in order to arrive at the net cash effect for that particular line item for the period. For example, the operating activities section may include:

• Cash receipts from customers:
• Net sales per the income statement
• Plus beginning balance in accounts receivable
• Minus ending balance in accounts receivable
• Equals cash receipts from customers

Similar types of calculations can be made of the balance sheet accounts to eliminate the effects of accrual accounting and determine the cash flows to be reported in the investing activities and financing activities sections of the cash flow statement.

Sample cash flow statement using the direct method

Indirect Method

The indirect method is almost universally used, because FAS 95 requires a supplementary report similar to the indirect method if a company chooses to use the direct method. It uses net-income as a starting point, makes adjustments for all transactions for non-cash items, then adjusts for all cash-based transactions. Entries that affect net income but do not represent cash flows could include income you have earned but not yet received, amortization of prepaid expenses, accrued expenses, and depreciation or amortization. This method converts accrual-basis net income (or loss) into cash flow by using a series of additions and deductions. An increase in an asset account is subtracted from net income, and an increase in a liability account is added back to net income. The following is an example of how the indirect method would be presented on the cash flow statement:

Net income per the income statement

Minus entries to income accounts that do not represent cash flows

Plus entries to expense accounts that do not represent cash flows

Equals cash flows before movements in working capital

Plus or minus the change in working capital, as follows:

• If balance of an asset increases, cash flow from operations will decrease.
• If balance of an asset decreases, cash flow from operations will increase.
• If balance of a liability increases, cash flow from operations will increase.
• If balance of a liability decreases, cash flow from operations will decrease.

Current assets (excluding cash and cash equivalents) may include things like inventories and accounts receivable, while current liabilities (excluding short-term debt which would be reported in the financing activities section) would include deferred taxes and accounts payable.

The net effect of the above would then be reported as cash provided by (used in) operating activities.

The cash flows from investing activities and financing activities would be presented the same way as under the direct method.

The cash from operating activities is compared to the company’s net income. If the cash from operating activities is consistently greater than the net income, the company’s net income or earnings are said to be of a “high quality”. If the cash from operating activities is less than net income, a red flag is raised as to why the reported net income is not turning into cash.

Sample cash flow statement using the Indirect method

Synonyms For Cash Flow Statement

Related Phrases

Cash Flow Statement FAQ's

Cite Term

Definition Sources