Understanding Cash Flow Statement

The cash flow statement of a business tells us about the movement of cash in the business based on the changes in the balance sheet and income accounts. The cash flow provides a good indication of the financial health of the company. By looking at the cash flow statement, the management can identify issues with the business such as how efficiently they are running the operations, their credit terms, etc. By looking at these issues they can make changes to improve the business policies.

There are direct and indirect methods of reporting cash flows. In the direct method, it shows major gross receipts and gross cash payments, summarizing inflows and outflows of cash. In the indirect method the statement begins with net income and adjusts for changes in account balances that affect cash on hand.

Net Income is the starting block of the cash flow statements to which adjustments are made to arrive at its cash flow statement.

Depreciation Added Back: While no cash changes hands, over time the value of equipment comes down. This is usually set at a fixed rate is. It is a non-cash item.

Increase in Accounts Receivable: Sales + (Beginning accounts receivable-ending accounts receivable) = cash collections. If the company sold more that it collected, the amount would be negative. This says that the company’s working capital is stuck in the hands of customers. This will affect its future performance. You can think of this as an interest free loan you have provided customers.

Decrease in Prepaid Expenses: Some annual commitments are paid up front, and accounted for month by month. These charges do not require any extra income. This is an amortization adjustment.

Decrease in Inventory: The income statement includes the cost of inventory sold during the month.

An inventory adjustment is needed if:

  • The beginning inventory balance changed at the end of the month, indicating company purchased inventory it bought that it did not sell during the month.
  • The beginning inventory balance changed at the end of the month, indicating company sold from  inventory it bought that it did not buy  during the month

Any cash cost of inventory added to the beginning of inventory must be deducted. This would be a negative adjustment. A positive cash flow adjustment would need to be done if the company sold  goods out of the beginning inventory and did not replace them with cash.

Increase in Accounts Payable: Payment of liabilities requires cash. Any change means it has either paid a liability not included in the income statement or increased money owned to creditors, increasing borrowing from creditors.

If the company uses cash to pay balances, the accounts payable balance is reduced and net income is adjusted downward. The adjustment is negative as it has reduced cash. In the case of increased accounts payable it is positive. The difference in accounts payable from the beginning to the end of the month tells us if cash availability has increased or decreased.

Capital Expenditures: Expenditure made on assets such as purchase of equipment are not charged to income. The cash paid out for them is shown as a reduction in cash.

Short-term Investments Sold: Extra cash in hand is put in short term investments to make the money work. These could be bank certificates or securities. These can be sold when cash is required. This helps idle cash earn some profit.

Other Investments: Companies sometimes do other investments. These include:

  • Acquiring or selling their subsidiaries or other companies
  • Purchasing Land
  • Buying or selling long term investment assets

Increase in Bank Debt: Sometimes companies use short term debt to make purchases or pay other loans. This will reduce cash.

Net Reduction in Long term Debt: If the company makes payments, while making no new borrowing in this category, it would lead to a reduction of long term debt.

Dividends Paid to Stockholders: Profits made are distributed among stockholders. This can happen in the form of dividends. They are paid in cash and appear on the cash flow statement.

Net Cash Flow: This is the difference in cash balances from the beginning to the end of the period of the report. This final step of the cash flow statement is added to the beginning balance of cash on the balance sheet of the month that is getting reported.

The cash flow statement helps understand and track the cash related activities of the company, be it purchase of assets, payouts to stock holders, short term investments or borrowings.