Magazine article Business Credit

The Working of the Statement of Cash Flows

Magazine article Business Credit

The Working of the Statement of Cash Flows

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Question: How does the Statement of Cash Flows tie into the other financial statements?

Answer: The Statement of Cash Flows is the cash reconciliation of the activity on both the Balance Sheet and the Income Statement.

Both laymen and accountants who do not work regularly with the Statement of Cash Flows sometimes find that of all the financial statements, the Statement of Cash Flows is the most misunderstood and confusing.

The Statement of Cash Flows was actually the last statement to be added to financial statements. In 1987, the Financial Accounting Standards Board issued the Statement of Financial Accounting Standards (FASB) No. 95 entitled "Statement of Cash Flows." The FASB initiated the requirement that audited financial statements in the US must include the Statement of Cash Flows. Even today, companies with non-audited financial statements may leave out this important statement.

Although misunderstood, it is a very insightful piece of financial information, as it converts both the Balance Sheet and Income Statement accrual activity into a cash basis. If you want to know what's going on with the cash in a company, go to the Statement of Cash Flows. The purpose of this statement is to provide relevant information about the cash receipts and cash payments of a company for the period reported.

The Statement of Cash Flows starts with the net income, then makes adjustments for all the non-cash items on the Income Statement to convert it to a cash basis. Then, it goes through the Balance Sheet and adjusts for the changes in each of the Balance Sheet accounts.

In the past, I have prepared the Statement of Cash Flows on a monthly basis (along with projecting cash movement and analyzing projections to actual). To better understand the Statement of Cash Flows, I thought it might be helpful to go through the process of how an accountant prepares the statement. The Statement of Cash Flows is prepared AFTER the Balance Sheet and Income Statement are finalized. As you know, the plusses and minuses on the Income Statement foot to "net income." Net income (the bottom line) from the Income Statement is reflected on the Balance Sheet in stockholder's equity. Finally, a Balance Sheet always balances. This means if you increase cash, you must decrease something else. If you decrease cash, you must increase something else. A "source of cash" is a positive number on the Statement of Cash Flows; a "use of cash" is a negative number.

With this in mind, here are the mechanics (at a high level) of preparing the Statement of Cash Flows. First, start with net income on the Income Statement. Look for noncash expenses on the Income Statement, such as depreciation and amortization, and add these items back to net income on the Statement of Cash Flows. For instance, I was recently analyzing the financial statements for Heilig Meyers, a company who has filed bankruptcy. On the Statement of Cash Flows, Heilig Meyers added back the reorganization charges. These were expenses on the Income Statement that have not used cash during this period. They were bookkeeping entries, primarily to reduce the book value of assets. The asset value was reduced on the Balance Sheet, with the offset as a charge on the Income Statement called "reorganization charges." No cash changed hands.

Next, look at the Balance Sheet for changes in each account, keeping in mind the Balance Sheet must balance. …

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