The cash flow statement is used to analyze the cash income and expenditures during a designated time period. There are three major components of cash flow: operations, investing and financing.
If you regularly do a monthly profit and loss (income) statement, you will be aware that there are certain items that may not affect your profit and loss statement for some time, such as:
- Substantial increase in inventory purchases;
- Increase in accounts receivable (money owed to you by customers);
- Reduction of credit by suppliers;
- Purchase of equipment;
- Unrecognized obsolescence of inventory (stale items);
- Bank's refusal to renew or extend loan; and
- Lump sum payment of debt.
A cash flow statement will highlight these activities in a way that an income statement will not. And certainly your banker will want to see a cash flow statement showing how you have used the funds from a previous loan before they approve an extension or a new one. Without the cash flow statement, you will have an incomplete picture of your business.
To determine operating cash flow, you start with net income and add back expenses which did not result in inflows or outflows of cash. The most common non-cash expense is depreciation. When working with historical figures, adjusting net income with depreciation and other non-cash expenses is much simpler than determining all the revenues and expenses which require or provide funds. Next, you identify all the balance sheet accounts that are associated with operations and determine the change in the account from the end of the last period to the end of the current period.
Purchasing inventory or paying salaries is an obvious use of cash. In accounts receivables when you collect from your customers, you will receive cash, so a decrease is a source of cash. The opposite is true when you increase accounts receivable; it is a decrease in cash. Growing businesses need to closely watch their inventory and receivables so they don't find themselves in a cash crunch at a time when business is booming.
Operating cash flow will include all the balance sheet accounts that are a part of normal operations. Trade receivables and payables as well as accrued expenses, prepaid expenses and other current assets that are a part of day-to-day operations are included in operating cash flow.
The remaining balance sheet accounts will either be investing activities or financing activities. You need to determine the change in each balance sheet account from the beginning of the period to the end of the period, and tally them up. That completes all the information that is needed to put together the cash flow statement.
More about cash flow:
Cash Flow Example
Cash Flow Worksheet
Cash Flow Projections
Techniques for Improving Your Cash Flow
Managing Cash Shortages