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Cash Flow Statements - General Basics

Cash is King! This is what I hear from many clients. It is very true since it is the deciding factor for many business decisions. Many small companies, however, are not required to ever produce a Statement of Cash Flows so it tends to be a neglected financial statement. It is quite a shame since it can reveal a great deal about the financial position of a company, and it can certainly tell an owner exactly how their cash is being created and how it is being spent.

The general concept of a Statement of Cash Flows is to show a summary of how much a company’s cash account has increased or decreased since the beginning of the year as well as breaking down how much cash has been “used” or “provided” by 3 different activities: operating, investing, and financing. The terms “used” and “provided” basically mean where cash came from and where it is being spent in a neat little summary.

Let me define the different activities displayed on a Cash Flows Statement.  An operating activity simply includes the activity that occurs in accounts your company uses on a daily basis - your operating accounts. This is cash, inventory, receivables, and payables among other common accounts. An investing activity encompasses the things you invest in, obviously, like your major equipment and securities. Lastly, financing activities deal with the equity section of the balance sheet: dividends, common stock, preferred stock, as well as long-term loan activity. Many small businesses do not have very much activity here especially since many do not possess stock.

There are two different ways to prepare a Statement of Cash Flows: the indirect method and the direct method. I will demonstrate the indirect method to show how the statement works.  One would think the direct method would be more “direct” but the indirect is easier to do. You start with your net income number and adjust it for items in your operating accounts that do not actually involve the movement of cash like depreciation and the recording of receivables and payables that are accruals and deferrals. Once you have adjusted for those items, you see how much money has been “used” or “provided” by your operating accounts. The same principle is applied to the investing and financing activity sections by adjusting those sections for cash inflows or outflows that are not reflected on the income statement for example, purchases of equipment that are capitalized, loan payments that are applied to a bank loan, and shareholder distributions. After you determine the cash used or provided by each activity, you add each section together to get the net increase or decrease in cash. You know you calculated your numbers correctly when you add the net increase/decrease to the beginning cash and it ties to your ending cash balance. This tool is very useful for owners who are not heavily involved in the day-to-day cash activities to get an idea of just where their money is going. After all, cash is really what drives the actions and decisions of a company.