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Cash flow statement
The statement of cash flows shows the sources and uses of cash for your business over a certain period of time. This period coincides with the reporting period of the income statement. For example, if a cash flow statement covers the 12 months ended on Dec. 31, 2006, the associated income statement covers the same period.
A cash flow statement shows you how your business performs on a cash basis. An income statement shows how your business performs on an accrual basis. In this respect, a cash flow statement generally supplements the information provided in an income statement.
In an effort to increase sales, you may decide to offer your customers trade credit. Your suppliers and vendors may offer you trade credit as well. As a result, your business will set up accounts receivable for cash owed you, and accounts payable for cash that you owe.
Because you use these accrual accounts, your income and cash flow amounts are different. A cash flow statement keeps track of the net change in cash during a reporting period. An income statement shows revenues and expenses for the same period but relies on accrual accounting. For a business that depends on cash for its ongoing success, a cash flow statement is often the more important of the two statements.
The following income statement is a simplified version for the year ended Dec. 31, 2006 for Alpha Beta, a fictitious company. Alpha Beta offers trade credit to its customers, which creates accounts receivable. At the same time, it pays some of its bills on trade credit, which creates accounts payable.
The table shows total amounts for revenues and expenses. It also shows revenues and expenses that are received and paid in cash, respectively. The difference represents transactions earned and paid in trade credit. The far-right column shows the account that is affected from the credit transaction:
Alpha Beta Co.
Income Statement
(12 Mos. Ended 12/31/2006) |
| |
Totals |
Cash |
Credit |
Account
affected |
| Net sales |
$1,000,000 |
$750,000 |
$250,000 |
Accounts receivable |
| Cost of goods sold |
600,000 |
550,000 |
50,000 |
Accounts payable |
Gross
profit |
400,000 |
200,000 |
200,000 |
-- |
| Operating expenses |
150,000 |
100,000 |
50,000 |
Accounts payable |
| Operating profit |
250,000 |
100,000 |
150,000 |
|
| Other income |
25,000 |
10,000 |
15,000 |
Accounts receivable |
Pretax
income |
275,000 |
110,000 |
165,000 |
-- |
| Taxes |
110,000 |
85,000 |
25,000 |
Taxes
payable |
Net
Income |
$165,000 |
$25,000 |
$140,000 |
-- |
|
For example, Alpha Beta has $1 million in sales but only $750,000 of this total is cash sales; the remaining $250,000 is sales made on trade credit. As a result of these transactions, accounts receivable is $250,000. Since sales made on credit don't generate cash immediately, they are omitted from the statement of cash flows. Similarly, Alpha Beta pays some of its expenses with trade credit. For example, it pays $50,000 of its cost of goods with trade credit.
The statement of cash flows is also related to the balance sheet. While the balance sheet can be prepared at any given point in time, the major reporting dates coincide with the period that is measured in the cash flow statement.
For Alpha Beta, the beginning date of the period covered by the cash flow statement is Jan. 1, 2007. This date coincides with the date that Alpha Beta's last major balance sheet was prepared: Dec. 31, 2006 or Jan. 1, 2007. (Note: a balance sheet prepared for December 31 is exactly the same balance sheet at the start of the following day, January 1.) The next major reporting date for Alpha Beta's balance sheet is Dec. 31, 2007. This date coincides with the end of the 12-month period covered by the statement of cash flows.
In fact, the balance sheet and cash flow statement are even more closely articulated. It turns out that the increase or decrease in cash between the beginning and ending reporting dates of the balance sheet matches the net increase or decrease in cash that is shown in the statement of cash flows. For example, if the two balance sheets show the firm's net cash has increased by $100,000, the cash flow statement will show the same net increase.
The statement of cash flows shows the sources and uses of cash from three distinct activities of your business: operations, investing, and financing:
- Operating activities. Operating activities include cash that is received and spent on managing your regular business operations. Operating cash flows include cash-based revenues and expenses that are directly related to the sale and distribution of your product.
Operating activities also include non-cash expenses such as depreciation and changes in operating assets and liabilities. Most notably, these accounts include changes in accounts receivable, inventories, accounts payable, taxes payable, and prepaid assets and liabilities.
- Investing activities. Investing activities include the investments made in your fixed assets. Most of the time, investments in cash flows are a cash outflow: you spend cash in order to invest in capital equipment.
If you sell or divest a piece of equipment or business division, however, you would receive a cash inflow. This kind of transaction is a disinvestment, or deliberate decision to eliminate certain fixed assets.
- Financing activities. Financing activities are those activities that deal with how you raise capital for your investing and operating activities. Financing activities include the sale of equity and debt, as well as payment of dividends and interest.
Hundreds of Internet companies began going out of business at a rapid pace in mid- to late-2000. Many of these companies had relied on capital they had raised as part of their financing activities to fund operating activities. Unable to generate enough cash flow from their operating activities, their supply of cash began to dry up. Facing a severe liquidity crunch, the troubled firms began to lay off much or all of their staff. Some companies filed for bankruptcy while others simply ceased business operations.
Perhaps the biggest lesson learned from the wave of "dot-com" failures in 2000-2001 is that a business must generate enough cash from its operating activities to remain a viable enterprise. Over-reliance on financing activities to raise cash was the death knell for many of these companies.
Incidentally, you can apply the same principles used for reporting cash flows to forecasting cash flows. Because of its focus on cash rather than accrual accounting, the statement of cash flows is a very useful financial statement looking either at a period just ended or the current reporting period.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
Next Topic: Cash management options
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