4.01 – Introducing The Cash Flow Statement
Understanding the Cash Flow Statement
While the income statement and balance sheet provide crucial information about a business’s financial affairs, understanding cash flows is equally important. The income statement reveals revenue and profit, while the balance sheet details assets, liabilities, and capital sources. However, the statement of cash flows offers insight into the cash movements within the business, helping to explain why cash flow from profit might differ from net income and summarizing the investing and financing activities over a period.
Importance of the Cash Flow Statement
The statement of cash flows serves two primary purposes:
Explains Differences
It clarifies why cash flow from profit often differs from bottom-line profit.
Summarizes Activities
It provides a summary of the investing and financing activities during the period.
Understanding these aspects helps in managing all sources and uses of cash in an integrated manner.
Key Advice
When analyzing financial statements, it’s crucial to:
- Understand the income statement.
- Trust the balance sheet.
- Rely on the statement of cash flows.
The cash flow statement, while often the most challenging to understand, provides invaluable information about how a business generates and uses its essential lifeline: cash.
Critical Conversations
Management might need to explain why sales revenue fell short of forecasts or why an anticipated profit turned into a loss. However, explaining a cash shortage is even more critical. The cash flow statement helps ensure that businesses maintain enough cash to support ongoing operations. The importance of cash flow in showing financial health cannot be overstated.
Structure of the Cash Flow Statement
Unlike the income statement and balance sheet, the cash flow statement doesn’t have an obvious natural structure. The accounting rule-making body determined the following format:
- +/- Cash Flow from Operating Activities
- +/- Cash Flow from Investing Activities
- +/- Cash Flow from Financing Activities
- = Cash Increase or Decrease during Period (Beginning Cash Balance)
- = Ending Cash Balance
Cash flow from investing activities is generally negative for technology businesses due to spending on new long-term assets. Conversely, cash flow from operating activities should be positive unless the business suffered significant losses.
The Direct Method
The cash flow statement starts with cash from profit-making activities, known as cash flow from operating activities. Operating activities include transactions related to sales and expenses. The direct method presents sales revenue and expenses on a cash basis, contrasting with the accrual basis used in income statements. This method reports the cash flows connected with sales and expenses directly.
The Indirect Method
The indirect method starts with net income and adjusts it to reconcile with cash flow from operating activities. This method includes changes in assets and liabilities affecting cash flow, essentially combining the supplemental schedule required under the direct method into the main statement. Most businesses prefer the indirect method due to its comprehensive nature.
Summary
Both methods ultimately report the same cash flow from operating activities for a period, which typically differs from net income. Understanding this difference is key to comprehending a business’s financial dynamics.
