FINANCIAL STATEMENT LITERACY (4 of 4): What is a Cash Flow Statement?
The cash flow statement is the third of three major financial statements.?As the title suggests, the cash flow statement shows where your cash came from, and where it went, over a period of time.
Have you ever reviewed your company income statement and said, “How could I have made that much income, if I don’t have any money?”?The cash flow statement answers that question by starting with your net income and adding and subtracting cash transactions affecting accounts on your balance sheet.?Huh??Clear as mud, right??Keep reading, you know more about a cash flow statement than you think.
First, let’s get something out in the open, net income is NOT net cash flow.?Net income does not represent how much “cash” you made during a period of time.?Net income is merely the difference between income and expenses (need a refresher on what is considered income and expenses, click here.).
For example, each month when you make a loan payment, the payment represents interest paid on the loan and the principal payment on the loan.?The interest expense is reported on the income (reducing net income), but the principal portion of the payment is reported as a reduction of the loan balance on the balance sheet (not affecting net income).?The principal payment IS cash flow (out), but not an expense.
On the flipside, if you receive a loan from the bank (cash flow in), the loan proceeds are not reported as income (increasing net income).?Instead loan proceeds are reported on the balance sheet as an increase in a liability (need a refresher on the components of a balance sheet, click here).
Now let’s go over the structure of the cash flow statement.?As mentioned before, the cash flow statement begins with the net income, which is adjusted for non-cash operating income and expenses, adjusted for investment activities, adjusted for financing activities, to arrive at net cash provided/(used) during the period, which is combined with cash at the beginning of the period, to give you your cash balance at the end of the period.?If your cash flow statement is accurate, then the “cash balance at the end of the period”, shown on the bottom of the statement, should agree with your cash balance as reported on your balance sheet (at the end of the cash flow statement period).
I know, I’m starting to lose you with the accounting techno-terminology. ?So that you don’t lose focus, remember the purpose of the cash flow statement is to determine the effect of all your balance sheet and income statement activities, during a period, on your cash balance.?In other words, how do you reconcile your net income during a period with your change in cash during that period.?Thereby answering your question on how you could report net income (not a loss) and still have less cash.
The first adjustment to net income on the cash flow statement is for operating activities.?Why do you make these adjustments??Because there are non-cash transactions reported on your income statement that increase and/or decrease your net income.?For example, if you’re an accrual basis company (for more information on the difference between cash and accrual accounting, click here) and made sales during the period for which you are still awaiting customer payments, these sales have increased your net income, but have not yet increased your cash balance.?Which means the increase in net income must be subtracted to reflect cash flow.
The opposite is true when it comes to “charged” expenses.?An increase in accounts payable means you have included expenses in your net income (reducing net income) that have not yet been paid for (non-cash expenses reducing net income but not affecting cash flow).
The next adjustment to net income is for your investment activities.?Or the cash you’ve spent on fixed assets that will benefit your company beyond one year (and therefore not an expense on the income statement, but an increase in assets on the balance sheet).
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The last adjustment on the cash flow statement represents how you financed your investment activities, and transactions affecting the owner equity in the company.
While you may have spent cash on your investing activities (purchasing new equipment and vehicles), the cash used to purchase these new assets may have come from bank loans.?The financing activities of the cash flow statement reflect these transactions.?For instance, on the example cash flow statement shows $15,000 in equipment purchases, and $35,000 in vehicle purchases.?So, in the investment section of the cash flow statement, net income is being reduced by $50,000 for these purchases.?Suggesting your cash flow went down by $50,000.?The financing section of the cash flow statement makes adjustments to reflect the cash used for these purchased came from “financing” by increasing cash flow by $50,000 for the loans received.
Also included in the financing section of the cash flow statement are transactions with the company owners.?When a company distributes cash to owners, this “cash flow” (out) transaction affects cash (reduction) but is not an “expense” on the income statement.?Instead, it is a reduction in equity reported on the balance sheet.
After adjusting for operating, investment, and financing activities on net income your cash flow statement now shows the net change in cash for the period.?Combining this net change with beginning cash of the period will reconcile your cash balance at the end of the period.
For those of you that have continued to read through this article, here’s a bonus for your efforts.?If you are applying for a loan, your financial institution will want to see your balance sheet, income statement, and cash flow statement.?Your balance sheet will show how old your assets are (the net value of fixed assets after accumulated depreciation) and the amount of your business that is financed through third parties (financial institutions) and the owners (equity section of the balance sheet).?Your income statement will show whether you are operating profitably (positive net income). ?And your cash flow statement will show if you have positive cash flow (excess cash) available to fund a new loan.
Knowing that there are three major financial statements that define your business (each presenting different information), and understanding how to read these statements is essential to every business owner, you should spend some time learning this information.
If you’re interested in operating a profitable and successful company, contact ARI.?We’re all about providing you with more information to achieve your goals!
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