Cash Flow Statement

A cash flow statement is one of the three core financial statements, reporting the movement of cash into and out of a business over a period of time. Its formal name under U.S. accounting standards and in securities filings is the statement of cash flows; SEC Regulation S-X requires registrants to file "audited statements of comprehensive income and cash flows" for the periods it specifies. The SEC's own guide for investors puts the purpose in one sentence: "While an income statement can tell you whether a company made a profit, a cash flow statement can tell you whether the company generated cash." It does that by reordering information the balance sheet and the income statement already contain, and its bottom line "shows the net increase or decrease in cash for the period."

The three sections are the structure, and each answers a different question. Operating activities covers the cash effect of the business's ordinary trade: what customers paid, what went out to suppliers, employees, landlords and the tax authorities. Investing activities covers long-term assets, so buying a delivery van or a building is an outflow here and selling one is an inflow; the SEC's guide gives buying a piece of machinery and selling investments as the two illustrations. Financing activities covers the capital structure: money raised by borrowing or from owners is an inflow, and repaying a loan or distributing to owners is an outflow. A business can show a healthy total increase in cash for a period and be in trouble, if the operating section is negative and the financing section is what closed the gap. The sections exist so a reader can see which one did the work.

The operating section is usually built by reconciliation rather than by listing receipts. The SEC describes the standard presentation: the section "reconciles the net income (as shown on the income statement) to the actual cash the company received from or used in its operating activities," and "to do this, it adjusts net income for any non-cash items (such as adding back depreciation expenses) and adjusts for any cash that was used or provided by other operating assets and liabilities." That is the indirect method, and it is what most statements a small business sees will use. The alternative presentation lists operating cash receipts and payments directly and arrives at the same total. Under U.S. generally accepted accounting principles the statement is governed by Accounting Standards Codification Topic 230, which the Financial Accounting Standards Board publishes through its subscription Codification rather than as a free public document.

The reconciliation is where the statement earns its place, because the adjustments name exactly the things that make profit and cash diverge. Depreciation is an expense that reduced profit without any cash leaving, so it is added back. A rise in accounts receivable means sales were recorded that have not been collected, so it is subtracted. A rise in inventory means cash went into goods still sitting on the shelf. A rise in accounts payable means expenses were recorded that have not been paid, so it is added. Run those four adjustments through a growing business and the answer is often that a good year on the profit and loss statement was a bad year for the bank balance, which is not an accounting error but the arithmetic of growth.

Read alongside its two companions, the statement fills a specific gap. The balance sheet is a snapshot at one instant of what the business owns and owes. The profit and loss statement covers a period, but on the accrual basis, so it records revenue when earned and expenses when incurred rather than when the money moves. The cash flow statement covers the same period on a cash basis. A business that wants to know whether it made money reads the profit and loss statement; one that wants to know whether it can make payroll next month reads this one. Small businesses are not required to prepare a formal statement of cash flows unless a lender, an investor or an accountant asks for one, and many run an informal version instead, but the discipline of sorting last month's movements into the three sections answers a question no other statement does.

1. Start from net income for the period, taken from the profit and loss statement.

2. Add back non-cash expenses, depreciation and amortization being the usual ones, since they reduced profit without any money leaving.

3. Adjust for changes in operating assets and liabilities. Receivables and inventory rising are uses of cash; payables and accrued expenses rising are sources of it. The result is cash from operating activities.

4. List investing activities. Cash spent on equipment, vehicles or property is an outflow; proceeds from selling them are an inflow.

5. List financing activities. New borrowing and owner contributions are inflows; loan principal repayments and owner distributions are outflows.

6. Add the three sections for the net increase or decrease in cash, and check that it reconciles the opening and closing cash balances.

An example of the reconciliation. A wholesaler reports net income of $40,000 for the year. Depreciation of $8,000 is added back. Accounts receivable grew by $55,000 as sales rose, and inventory grew by $15,000, both uses of cash. Cash from operating activities is $40,000 + $8,000 − $55,000 − $15,000 = −$22,000. During the year the business bought $30,000 of equipment, so investing activities are −$30,000. It drew a $60,000 term loan and repaid $6,000 of principal, so financing activities are +$54,000. The net change in cash is −$22,000 − $30,000 + $54,000 = $2,000. The business ended the year with $2,000 more in the bank than it started with, having reported $40,000 of profit, and the statement shows precisely where the difference went: into receivables, inventory and equipment, funded by the loan.

Pros

• It answers the question a business fails on, which is running out of cash rather than failing to record a profit.
• Splitting the movements three ways shows whether the cash came from trading or from borrowing, which a single bank-balance figure never reveals.
• The reconciliation names the causes. A reader can see how much of the gap between profit and cash is receivables, inventory or capital spending.
• It is the statement lenders and buyers scrutinize most, because it is the hardest of the three to flatter.

Cons

• It is backward-looking. It explains the period that finished and forecasts nothing about the one ahead.
• Cash from operating activities can be improved for a period by paying suppliers late or deferring purchases, neither of which is an improvement.
• Building one requires a reliable balance sheet at both ends of the period, so a business with loose books cannot produce a trustworthy version.
• A small business is generally not required to prepare one, so it is the statement most often skipped, and skipped until a lender asks.