Public businesses are required to present three financial statements
- Income Statement
- Balance Sheet
- Statement of Cash Flows
Information in the Cash Flow Statement adds to the picture that the other statements provide. A company may have a solid financial position, and it may be generating income, but if it consistently does not convert that income to cash, it will have difficulty surviving.
Components of the Cash Flow Statement
The Cash Flow Statement is broken down into three sections:
- Operating Activities
- Investing Activities
- Financing Activities
The term operating activities is fairly self-explanatory. It relates to items found on the income statement and in the current assets and liabilities sections of the balance sheet
The other two statements pull from the company’s books and usually relate to long term assets or liabilities. Like the income statement, the cash flow statement concerns a period of time, while the balance sheet is shows the assets and liabilities on a specific date. On the Cash flow statement, Net income is listed first, before the other main three parts of the statement.
The Operating Activities Section of the Cash Flow Statement
Operating activities are the first section listed, and the first step within is to add back the depreciation expense from the income statement. The reason it is added back is because depreciation is a non-cash expense. Capital purchases are covered in the financial section of the statement. It is important to pull the number off the income statement, not the accumulated depreciation on the balance sheet.
The purpose of the rest of the statement is to determine how much cash was provided by or used from current assets. Provided by means that a change in the asset increased the amount of cash for the company. Used in means the opposite, that the business had to use cash to complete the transaction.
Understanding how Cash is Used and Provided
Preparing cash flow statements can be difficult for those new to accounting, since assets work opposite the way they are normally viewed. A main item on the statement is usually accounts receivable. When accounts receivable increases, cash decreases, and when it decreases, cash increases.
This can be demonstrated by a simple example. If a company has $10 in cash and $10 in receivables, and it collects the money owed on the receivable, cash as increased to $20 and receivables have dropped to zero. Similarly for inventory, if a company buys some supplies that it places in inventory, the cash is gone, but inventory has increased.
The opposite occurs for liabilities, which increase as cash goes up. It the company borrows on a short term note, the cash increases, as does the liability. When the note is paid, both cash and the liability are decreased.
Once all the changes in current assets and liabilities are completely accounted for, the accountant can move forward on the other aspects of the cash flow statement.
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