Statement of Cash Flows | Reviewing the Common Financial Statements

Statement of Cash Flows

Now I come to the one tricky financial statement: the statement of cash flows.

Before I begin, I have one comment to make about the statement of cash flows: As an accountant, I've worked with many bright managers and business people. No matter how much handholding and explanation I or other accountants provide, some of these smart people never quite get some of the numbers on the statement of cash flows. In fact, many of the students who major in accounting never (in my opinion, at least) quite understand how a statement of cash flows really works.

For this reason, don't spend too much time spinning your wheels on this statement or trying to understand what it does. QuickBooks does supply a statement of cash flows, but you don't need to use this statement. In fact, QuickBooks produces cash basis income statements, which give you almost the same information — and in a more easy-to-understand format.

Now take a look at Table 1, which shows the balance sheet at the end of the day, after operations for the hot dog stand have ended. Notice that at the start of the day, cash equals $1,000, and at the end of the day, cash equals $5,000. The statement of cash flows explains why cash changes from the one number to the other number over a period of time. In other words, a statement of cash flows explains how cash goes from $1,000 at the start of the day to $5,000 at the end of the day.

Table 1: Another Simple Balance Sheet

Assets
Cash	$5,000
Inventory	0
Total assets	$5,000
Liabilities
Accounts payable	$0
Loan payable	0
Owner's equity
S. Nelson, capital	5,000
Total liabilities and owner's equity	$5,00

Table 2, not coincidentally, shows a statement of cash flows that explains how cash flowed for your imaginary hot dog stand business. If you're reading this book, presumably, you need to understand this statement. I start at the bottom of the statement and work up.

Table 2: A Simple Statement of Cash Flows

Operating activities
Net income	$4,000
Decrease in accounts payable	(2,000)
Adjustment: decrease in inventory	3,000
Net cash provided by operating activities	$5,000
Financing activities
Decrease in notes payable	(1,000)
Net cash provided (used) by financing activities	(1,000)
Increase in cash	4,000
Cash balance at start of period	1,000
Cash balance at end of period	$5,000

Remember

By convention, accountants show negative numbers inside parentheses. These parentheses more clearly flag negative values than a simple minus sign would.

The last three lines of the statement of cash flows are all easily understandable. The cash balance at the end of the period, $5,000, shows what cash the business holds at the end of the day. The cash balance at the start of the period, $1,000, shows the cash that the business holds at the beginning of the day. Both the cash balance at the start of the period and the cash balance at the end of the period tie to the cash balance values reported on the two balance sheets. (Look at Table 1 to corroborate this assertion.) Clearly, if you start the period with $1,000 and end the period with $5,000, cash has increased by $4,000. That's an arithmetic certainty. No question there, right?

The financing activities of the statement of cash flows show how firm borrowing and firm debt repayment affect the firm cash flow. If the hot dog stand business uses its profits to repay the $1,000 loan payable — and, in this case, this is what happened — this $1,000 cash outflow shows up in the financing activities portion of the statement of cash flows as a negative $1,000.

The top portion of the statement of cash flows is often the trickiest to understand. Note, however, that I've talked about everything else in this statement. So, with a strong push, you can fight your way through to understanding what's going on here.

The operating activities portion of the statement of cash flows essentially shows the cash that comes from the profit. If you look at Table 2, for example, you see that the first line in the operating activities portion of the statement of cash flows is net income of $4,000. This is the net income amount reported on the income statement for the period. However, the net income or operating profit reported on the business's income statement isn't necessarily the same thing as cash income or cash profit. A variety of factors must be adjusted in order to convert this net income amount to what's essentially a cash operating profit amount.

For example, in the case of the hot dog stand business, if you use some of the profits to pay off all the accounts payable, this payoff uses up some of your cash profit. This is exactly what Table 2 shows. You can see that the decrease in the accounts payable from $2,000 to $0 over the day required, quite logically, $2,000 of the net income. Another way to think about this is that essentially, you used up $2,000 of your cash profits to pay off accounts payable. Remember that the accounts payable is the amount that you owed your vendors for hot dogs and buns.

Another adjustment is required for the decrease in inventory. The decrease in inventory from the start of the period to the end of the period produces cash. Basically, you're liquidating inventory. Another way to think about this is that although this inventory — the hot dogs and buns in our example — shows up as an expense for the day's income statement, it isn't purchased during the day. It doesn't consume cash during the day; it was purchased at some point in the past.

When you combine the net income, the accounts payable adjustment, and the inventory adjustment, you get the net cash provided by the operating activities. In Table 2, these three amounts combine to $5,000 of cash provided by the operations.

After you understand the details of the financing and operating activities areas of the statement of cash flows, the statement makes sense. Net cash provided by the operating activities equals $5,000. Financing activities reduce cash by $1,000. This means that cash actually increased over the period by $4,000, which explains why cash starts the period at $1,000 and ends the period at $5,000.