It could be argued that the cash flow statement is the most important of all financial statements. It is also the least understood. Understanding the purpose of the cash flow statement is critical. Once you understand the purpose of the statement, understanding how to fill it out becomes much easier.
Most people find it difficult to understand the concept of accrual accounting. I think it's because most people live in a money-based world. As individuals, we do not consider income if it is earned. We realize our earnings when they are paid out. We record expenses when they are paid. It's important to remember that most businesses don't work this way. Most companies recognize revenue when work is completed, regardless of whether you were paid for the work or not. These companies recognize expenses as costs are incurred, regardless of payment status. In business, we usually record income and expenses when money has not changed hands.
This poses a problem for many people when analyzing financial reports. People think in terms of money. So when a person sees a company making $500,000 in profit, they might think there's $500,000 of extra money in the bank at the end of the year. It is likely that the money increased slightly. It might even be less! If that money is not there, the person may believe there is a problem with the income statement.
The purpose of the cash flow statement is to explain the difference between net income and cash change over the same period. If there was a gain of $500,000, the cash flow statement explains why the cash increase is not also $500,000. The list starts with net income. Each line on the statement explains where the money is coming from, which is called the source of the money, or where the money is going, which is called the use of cash. The accounting ends with the amount by which cash increased or decreased during the period and the cash balance at the end.
Each source or use of cash falls into one of three categories: operating, investing, or financing.
exploratory activities
These are activities related to operations or the income statement. That is, they are items related to income and expenses. There are two main types of transactions: non-monetary and those relating to current assets and liabilities.
Non-cash operations refer to items that appear in the income statement, but cash was not impacted by this item. The most common non-monetary item is depreciation. Remember the recorded entry for depreciation.
The transaction causes an expense that appears on the income statement, but the money does not change hands. On the income statement, the expense reduces net income, but there is no corresponding decrease in cash. This leads to one of the differences between net income and cash change.
Since depreciation was deducted on the income statement, we need to add it back to net income on the cash flow statement. Adding it back removes it from net income, which helps us get closer to the change.
Other non-monetary items include depreciation, gains and losses. Although some money may change hands when an asset is sold, the amount of money received is related to the disposal of the asset. The gain or loss from the transaction is considered the non-cash portion of the transaction. Essentially, it serves to balance the transaction.
Note that $5,000 cash was received, not $2,000. We remove the $2,000 profit from operations. Then we'll see what happens to the $5,000.
Each non-monetary item added to the income statement, such as profit, is subtracted from the cash flow statement to remove it. Non-monetary items that are deducted on the income statement are added back on the cash flow statement.
Changes in current assets and liabilities are the second type of operating item. Consider some common current assets and liabilities: accounts receivable and payable. Both elements are linked to the income statement.
Current assets and cash changes
Accounts receivable arise when a business operates and generates revenue. The work has not yet been paid. However, the income appears in the profit and loss account. This can result in a difference between net income and cash change. When trying to determine if there is an impact of change on cash, we need to look at how much has changed in accounts receivable. Let's consider three different scenarios.
Example 1
The 2012 accounts receivable balance was $230,000
The 2013 accounts receivable ending balance was $230,000
Turnover was $3,000,000
If accounts receivable were $230,000 at the end of 2012 and still $230,000 at the end of 2013, that means 2013 sales were $3,000,000.
The amount of sales and the amount of money raised are the same. So there is no time difference. The difference between net income and cash is not affected by receivables.
Example #2
The 2012 accounts receivable balance was $330,000
The 2013 accounts receivable ending balance was $230,000
Turnover was $3,000,000
In this example, claims have decreased by $100,000. Let's see how this drop affects the amount of money raised.
The company reported $3,000,000 in revenue on its income statement, but it actually took in $3,100,000 in sales-related cash. The reduction in accounts receivable leads to an increase in cash. This makes sense because when the receivables are paid (and the balance goes down), the company receives cash.
The $100,000 difference creates a positive cash shift. You could also say that the $100,000 drop in accounts receivable is a $100,000 source of cash.
Example #3
The 2012 accounts receivable balance was $230,000
The 2013 accounts receivable ending balance was $330,000
Turnover was $3,000,000
We now have a $100,000 increase in claims. How do you think this is affecting cash? If accounts receivable increase, the company runs out of cash. Let's look at the calculation.
Only $2,900,000 was raised during the year, but the income statement shows sales of $3,000,000. The $100,000 creates a negative cash flow. My cash exchange in this case is less than net income because the company has not raised these funds.
You may be concerned at this point because it seems like a lot of work to do for each line on the cash flow statement. This is just to illustrate what is going on.If accounts receivable increase, the change in cash decreases by the same amount. If accounts receivable decrease, the change in cash increases by the same amount.
Calculate the change in the account balance when completing the cash flow statement. Ask yourself who has the money resulting from this change. Go back to example #2. Claims decreased by $100,000. Who has the $100,000? The company is doing this because customers paid the extra $100,000. This leads to an increase in cash funds. In Example 3, the customers had $100,000 because they didn't pay their bills. This leads to a decrease in the company's cash. This method works for all current assets and liabilities.
All assets behave like claims. As the balance of prepaid expenses increases, more money gets stuck in that account, resulting in less money. When inventory dwindles, the company uses some of the old inventory instead of spending money to buy more. Because of this, cash increases.
Current liabilities and changes in cash
Current liabilities, like suppliers, react in the opposite way to assets. Again, we look at differences in current liabilities to determine how these changes affect the change in cash. Let's look at some examples just to understand.
Example #4
The final balance of accounts payable for 2012 was $150,000
The final balance of accounts payable for 2013 was $105,000
The cost was $2,500,000
Business accounts payable decreased by $45,000. Why did liabilities decrease? Because the company paid all current expenses and canceled part of the previous year's balance. The company paid the debt. This has a negative impact on the exchange rate. Let's see the complete calculation for confirmation.
The company paid $45,000 more in cash than it recorded as an expense. This leads to a decrease in cash. It can also be said that the decrease in liabilities is a use of cash.
Example #5
The final balance of accounts payable for 2012 was $150,000
The final balance of accounts payable for 2013 was $175,000
The cost was $2,500,000
Now the liability is increasing. The company charged more on its accounts payable during the year than it paid. The $25,000 difference is a source of cash. The company has been able to cancel expenses that it has not yet paid.
The company's income statement shows expenses of $2,500,000, but the company only spent $2,475,000. He kept the $25,000. Due to the $25,000 increase in accounts payable, cash flow increased by $25,000.
All current liabilities behave like liabilities.As liabilities decrease, cash decreases because cash has been used to pay off liabilities. When accounts payable increase, cash also increases, as the company used debt rather than cash to fund its operations.
Steps to Complete the Operations Section
- First calculate the change in the account balance.
- Ask yourself who has the money for this change. If the company has cash, it's a cash increase. If someone else has the money, e.g. B. customers or suppliers, this is a reduction in cash.
- As you go through the balance sheet, be sure to look for non-monetary items: depreciation, amortization, profit and loss.
investment activity
In this section, we look at the investments the company has made. What do companies invest in? Long-term assets that help the company increase sales. This includes buildings, machinery, intangible assets, interests in other companies and other long-term investments.
In the 'Investments' section, we cannot explain a difference in account balance by stating 'change in fixed assets'. In the investment section, we need to explain each change. Let's look at an example.
Example 1
Final credit for vehicles in 2012 was $250,000
Final credit for vehicles in 2013 was $235,000
In 2013, the company sold a vehicle originally purchased for $35,000 for $5,000. The vehicle has accumulated depreciation of $33,000 at the time of sale.
When it comes to assets, we may not have listed all transactions, but we always have all the necessary information for the calculation. Let's start with the opening balance and review the information we have so far.
This makes no sense as the account balance was $235,000. Obviously, something else happened that wasn't in the data. What would cause the vehicle account credit to increase? The company must have purchased another vehicle. How much did the new vehicle cost? It must have been $20,000.
We have now identified all the activity on the vehicle account and are able to reconcile the balance change. Now we need to figure out what to record. We should forget about vehicles for a moment and turn our attention to money that has changed hands.
The company sold a vehicle. How much money was received? $5,000. Never mind that the vehicle originally cost $35,000. Now we only care about money. The company also purchased a vehicle. How much was paid in cash? $20,000. On the cash flow statement, we record these two items.
Please note that we have listed each item separately. We must explain to the reader what happened.
You may have noticed that there was a profit when the vehicle was sold. The vehicle had a book value of $2,000 ($35,000 cost - $33,000 accumulated depreciation). If $5,000 was received, there was a profit of $3,000. Remember when we talked about non-cash items in the operations section. This gain would be included in the business section and deducted from net income.
You must perform this procedure for all non-current assets on the balance sheet.
- Reconcile the account opening and closing balances with the information you have on the issue.
- If the balance matches your reconciliation, you're done. Note the items listed.
- If the balance does not match your reconciliation, additional activities may not be listed. This activity must be an asset purchase. Calculate how much was the purchase of the asset.
- On the cash flow statement, list all transactions separately as shown above.
financing activity
In our balance sheet analysis, we consider current assets, current liabilities and non-current assets. Only long-term liabilities and equity remain. Both positions go to finance.
The financing area is similar to the investment area. We need to explain what happened, not just list the balance changes for each account.
Example 1
The 2012 ending balance on promissory notes was $95,000
Ending 2013 balance of debentures payable $75,000
The company took out $35,000 in additional loans
Looking at this example, it's clear that some information is missing. The company borrowed additional money, but the debt balance on bills of exchange declined. This just doesn't make sense with the information we're getting. There are two ways to do this calculation. We can reconcile the balance similarly to the investments section.
What causes the balance to be $55,000 less than expected? Consider why the balance on the promissory note would decrease. Debts decrease when they are paid. The company must have paid $55,000 of the debt.
Here's how we would add this to the cash flow statement in the financing section:
You must perform this procedure for all long-term liabilities on the balance sheet.
- Reconcile the account opening and closing balances with the information you have on the issue.
- If the balance matches your reconciliation, you're done. Note the items listed.
- If the balance does not match your reconciliation, additional activities may not be listed. Calculate the missing value and the reason for the change.
- On the cash flow statement, list all transactions separately as shown above.
Completing the cash flow statement
When I'm working on a cash flow statement, I use the balance sheet as a guide.
First, calculate how much each account has changed from the previous year.
Starting at the beginning of the balance sheet, I analyze each account. The first account must be in cash. We can omit it, as the purpose of the cash flow statement is to compensate for the change in cash. The next account will likely be an account receivable. Determine which section the claims would fall under: operations, investments, or finance (if you said operations, you're right). Next, ask yourself whether the change in balance is a source of cash or a use of cash. Add it to your statement.
Using the same procedure, explain any differences and add them to the correct section of the cash flow statement. After explaining all the differences, add up each section and then all three sections to calculate your change. The monetary variation calculated should be the difference between the opening and closing balances.
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