Statement of Cash Flows
There are three major financial statements: income statement, balance sheet and statement of cash flows. If I could only choose one of those three financial statements to evaluate the ability of a company to pay dividends and meet obligations (indicating a healthy business) I would pick the statement of cash flows. The statement of cash flows takes aspects of the income statement and balance sheet and kind of crams them together to show cash sources and uses for the period.
There are two ways to prepare the statement of cash flows:
- direct method - reports cash receipts and cash disbursement. This method is preferred by the Financial Accounting Standards Board (FASB). For more info on this see Statement of Financial Accounting Standards No. 95 (Stanford, CN: FASB 1987)
- indirect method - begins with net income and adjusts for cash and non cash items. Most publicly traded companies use the indirect method in their corporate annual report.
There are three components of a statement of cash flows:
- operating - uses income statement items
- investing - usually contains the sale and purchase of long term assets
- financing - usually reflects long term liability (paying or securing loans) and equity items (sale of company stock and payment of dividends).
Check out this very simple balance sheet:
| Assets: | 12/31/2004 | 12/31/2005 | Change |
| Cash | 10,000 | 15,000 | 5,000 increase |
| Accounts Receivable | 20,000 | 18,000 | 2,000 decrease |
| Total Assets | 30,000 | 33,000 | 3,000 increase |
| Liabilities and Equity: | |||
| Accounts Payable | 5,000 | 0 | 5,000 decrease |
| Common Stock | 4,000 | 4,000 | no effect |
| Retained Earnings | 21,000 | 29,000 | 8,000 increase |
| Total Liabilities and Equity | 30,000 | 33,000 | 3,000 increase |
Given facts: Cash Received from customers was $100,000 and cash paid to suppliers was $92,000. Net Income for the year is $8,000 (this ties into the difference in retained earnings).
Using the Direct Method this is how the Statement of Cash Flows would be prepared:
| cash received from customers | +100,000 |
| cash paid to suppliers | -92,000 |
| decrease in Accounts Receivable | +2,000 |
| decrease in Accounts Payable | -5,000 |
| = Increase in cash @ 12/31/2005 | 5,000 |
| + Cash at 12/31/2004(1/1/2005) | 10,000 |
| Cash at 12/31/2005 | 15,000 |
I tell my students if an asset account increases the amount of the increase is subtracted; if an asset decreases the amount of the decrease is added. This rule is vice versa for liability accounts - that is why the 5,000 decrease in accounts payable is subtracted.
Also - it is no magic trick that 12/31/2005 cash in the statement of cash flows is exactly the same as 12/31/2005 cash in the balance sheet. This is a good way to check your work - if you have done everything correctly the two should be the same ALWAYS.
