The third financial statement, the Statement of Cash Flows, ties the Income Statement and Balance Sheet together. Many, considering that “cash is king,” view this as the most important of the financial statements. It is generally not even prepared, which puts a business owner in the dark about cash.
The Statement of Cash Flows, like the Income Statement, is for a period of time. There are two methods of preparation for the statement. The Indirect Method of the Statement of Cash Flows starts with the Net Income from the Income Statement, and makes many adjustments until it ends with the change in cash for the period, as shown on the Balance Sheets for the beginning and ending of the period.
These many adjustments are a lot of work for the preparer but are valuable for the savvy reader of the statements. That’s because we’re concerned about the business’ ability to generate cash, especially in the short-term. The Statement of Cash Flows gives us a lot of insight into that ability. The preparer shows the effects that changes in Balance Sheet amounts have on the cash generated or used. For example, if accounts receivable increase, that means that the amount of cash collected is less than the sales revenue. On the other hand, if accounts payable go up, that means that less cash was expended than the amounts shown on the Income Statement (vendors are providing short-term financing).
Even more useful is a Statement of Cash Flows prepared on the Direct Method. Rather than starting with the accrual basis Net Income, the Direct Method presents actual cash flows—directly. While the Income Statement provides us with accrual basis amounts, which are important, the Statement of Cash Flows provides us with cash basis amounts. For example, the Income Statement tells us the revenues earned (whether collected or not), the Statement of Cash Flows tells us the cash collected from customers (whether sold in the period or not). The Income Statement shows us the Cost of Goods Sold (regardless of when these amounts are paid), while the Statement of Cash Flows shows us the cash outflow for goods and services.
The Statement of Cash Flows, whether Indirect or Direct, is classified into Operating, Investing and Financing activities. Operating activities are related to the business’ ongoing operations. Investing activities reflects the investment of cash into long-lived assets, such as equipment. Financing activities are the raising or paying back of capital, both debt and equity.
When reading a Statement of Cash Flows, positive numbers indicate sources of cash, while negative numbers indicate uses of cash.
When trying to judge liquidity and solvency of a business, the Statement of Cash Flows provides valuable insight. This is important because a business can be profitable and still run out of cash. How could this happen? If a business is growing quickly, profits are pumped into the Balance Sheet as something other than cash, usually accounts receivable and inventory. If cash is lagging, a company may not be able to meet its obligations as they become due. While growth is usually good, too much growth with a slow cash cycle can spell doom.
There are several solutions to this problem which the business must anticipate and prepare for. Anticipate means have accurate cash flow projections to run the business. One solution is to arrange for a line of credit from a financial institution. These are typically secured by accounts receivable and inventory.
Another solution is to shorten the company’s cash cycle. This can take the form of accelerating receivable collections, arranging longer payment terms for payables, invoicing customers more frequently or use of credit cards for sales. Most likely, a combination of several of these techniques is used. The key is to anticipate the cash shortfall and have the solutions in place before the crunch comes.
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