How to Read a Statement of Cash Flows (Part 1)

In my experience preparing and presenting financial reports, it seems that the Statement of Cash Flows is the report that causes the most confusion with management and Board members. Many small business owners, as well, often wonder why their bank account balance isn’t growing even though their Income Statement shows a profit. In this blog, we will discuss in general terms what information is provided in the Statement of Cash Flows and take an in-depth look at the operating activities section of the report.

The Statement of Cash Flows is the report that starts with the company’s accrual basis Net Income for a period and 1) factors out all non-cash transactions from the Income Statements and 2) factors in all cash transactions that are not reflected on the Income Statement. Non-cash transactions on the Income Statement would include recording depreciation expense and sales for which cash has yet to be received. Cash transactions not reflected on the Income Statement include principal payments on a note payable and shareholder/owner dividends and distributions. This information is vital to fully understanding a company’s fundamentals, because it provides a more complete picture of how a company funds its operations than the Income Statement alone.

The Statement of Cash Flows is broken up into three sections: operating activities, investing activities, and financing activities (Investing and financing activities will be explored in part two of this blog). Cash flows from operating activities represent the net cash that comes in through the company’s course of business: sales of goods and services less the costs that go into providing the goods and services. The starting point for this section is net income. Depreciation and amortization expense (if any) are added back, since they represent non-cash transactions.

The other adjustments made to arrive at operating cash flows are based on increases or decreases of current assets and liabilities during the period. An increase in an asset balance corresponds to a decrease in cash, whereas an increase in a liability corresponds to an increase in cash. For example, accounts receivable increases when a sale is made but cash is not received. This means that the sale (which is included in net income) needs to be removed to arrive at net operating cash flows. Conversely, a decrease in accounts receivable usually relates to a cash receipt from a sale made in the previous period, meaning that the sale is not included in the current period’s net income and must be added to arrive at operating cash flows for the current period. The same logic applies to liabilities, such as accounts payable. An increase means that expenses were recorded this period that haven’t been paid, meaning the increase in the accounts payable balance must be added to arrive at cash flows from operations. Generally speaking, cash flows from operating activities are expected to be positive in a successful company, but it may take a few years for a startup to make it to that point.

Of course, there are also factors outside of a company’s normal, everyday operations that affect cash flows, namely investing and financing activities. Stay tuned for part two of this blog, where we take an in-depth look at how these activities are presented in the Statement of Cash Flows.

About the Author

+Tim Peters is a consultant with Morrison, providing business valuations, business planning (including budgeting, cash flow forecasting, strategic planning), feasibility studies, interim controller services, competitive grant writing, recruitment, and special projects that don't fit into any conventional category.You can contact Tim directly at tpeters@morrisonco.net or via telephone at 530-893-4764 ext. 208.

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