Statement of Cash Flows

By Gregg Schoenberg Tuesday, January 31, 2012

Now that we have completed our guides to understanding your company’s balance sheet and income statement, it is time to turn our attention to the third and final of the major financial statements, the statement of cash flows

Understanding the Cash Flow Statement

Like the income statement, the statement of cash flows gives us a picture of a company’s performance for a period of time, usually a calendar year or quarter.  But while the income statement is concerned with tracking net income, the statement of cash flows, as the name implies, is concerned with reporting changes in a firm’s cash position.

 As we take a look at our sample statement of cash flows and decipher its entries, we will see that a company’s net income is very different from its cash position.

ABC Corp. Statement of Cash Flows for 2020
Operating Activities Cash Provided or Used
Net Income $23,000
Adjustments Due to Changes in Working Capital:  
   Increase in Accounts Receivable ($12,500)
   Increase in Inventories ($15,000)
   Increase in Accounts Payable $1,500
   Increase in Accrued Payroll $1,000
Net Cash Provided by Operating Activities ($2,000)
   
Investing Activities  
   Cash Used to Acquire Fixed Assets ($8,500)
   Sale of Short-Term Investments $2,000
Net Cash Provided by Investing Activities ($6,500)
   
FinancingActivities  
   Increase in notes payable $3,500
Net Cash Provided by Financing Activities $3,500
   
Summary  
Net Change in Cash ($5,000)
Cash at Beginning of Year $12,000
Cash at End of Year $7,000

 

As we can note from the above sample of our fictitious ABC Corporation, the statement of cash flows is broken down into three categories—operating activities, investing activities, and financing activities—plus a summary section at the bottom. If you are now familiar with the balance sheet and income statement, you should recognize most of the line items here, because the statement of cash flows pulls information from those two statements in order to analyze their effects on ABC’s cash position.

 As we go through the entries below, you may want to refer back to ABC’s balance sheet and income statement to see where the numbers are coming from.

  • Net Income – Is the “bottom line” figure from the income statement.
  • Increases in Accounts Receivable, Inventories, Accounts Payable, and Accrued Payroll* – These are all calculated by taking the difference between these figures on two successive balance sheets (e.g. 2010 and 2009 year-end). 
  • Cash Used to Acquire Fixed Assets – Calculated by taking the difference between the “Fixed Assets” entries on the two most recent balance sheets.
  • Sale of Short-Term Investments – Reflects short-term investments that have been converted to cash.
  • Increase in Notes Payable – Indicates the amount of additional short-term debt ABC has taken on.
  • Net Change in Cash – Equals the sum of the net cash provided by operating, investing, and financing activities.
  • Cash at Beginning of Year – Equals the Cash figure at the top of the most recent balance sheet.
  • Cash at End of Year – Cash at beginning of year minus the net change in cash.

*For simplicity’s sake, we only provided one year’s balance sheet for ABC Corp., but once your business has produced two or more balance sheets you would simply use the two most recent ones in order to make these calculations. One important thing to note here is that an increase in a current asset decreases cash while an increase in a current liability increases cash. For example, if your inventory (a current asset) increased, your cash would have to decrease by a like amount to pay for that inventory.

Analyzing the Cash Flow Statement

Next, we'll look at how to analyze the statement of cash flows and  why one item on it just might be the single most important figure to look at when analyzing any company.

While you might thank that net income (i.e. profits) would be more important as it is the famous “bottom line” number from the income statement—and a favorite of the press when discussing a company’s financial results—savvy investors­, and business owners, prefer to focus on net cash provided by operating activities.

Net income can be subject to distortions—either intentional or unintentional—through tactics like not properly recognizing bad loans or misrepresenting the value of assets. Because it is much harder to misstate profits and working capital, it always pays to look at net cash provided by operating activities, which reflects the effects of changes in working capital on a firm’s net income. There are many examples of companies that have reported positive net income even when they are on the brink of declaring bankruptcy; in almost all of these cases though, net cash from operating activities began to deteriorate much earlier, providing an early clue that the firm was in trouble.

In the case of ABC Corp., we can see that while it had a positive net income of $23,000, its operating activities provided a negative $2,000 of cash flow. This should cause us some concern as we continue to work our through the rest of the statement.

At the bottom of the next section, we see that ABC’s investing activities also resulted in a negative cash flow, in this case the figure is $6,500. And in the last section we finally see some positive cash flow, to the tune of $3,500, as a result of ABC’s financing activities. The end result of all of this is that ABC saw its cash balance decline by $5,000 during the course of the year.

So, what are we to make of all of this? ABC’s operating activities drained it of $2,500 in cash, yet it spent $8,500 on new fixed assets (a long-term investment), and it covered part of these costs by increasing its debt load (the $3,500 in additional notes payable).

The situation at ABC is clearly not sustainable and this is reflected in the fact that its cash balance at the end of year declined by 42% ($5,000/$12,000). 

If ABC keeps on this same path for too much longer, it will eventually run out of cash. In order to remedy the situation, ABC needs to take a hard look at refining its core operating activities, in addition to determining whether it has the right mix of assets to support its business, and whether or not its debt load is sustainable. And, of course, if you start to see your company’s cash position weakening, it is time to think about all of these things before the situation gets too dire.

We hope that you are now better armed to analyze and make decisions about your firms’ financial matters, and encourage you to read further on these topics in a financial management textbook.

*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.

More By Gregg Schoenberg
Leave a Comment
* Required
* Required, will not be published