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: