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Understanding the Statement of Cash Flows

What is the statement of cash flows?

The statement of cash flows is a financial statement that illustrates an entity’s sources (inflows) and uses (outflows) of cash and cash equivalents. The sources and uses of cash and cash equivalents are reported in three categories: operating, investing, and financing. In addition, there are two acceptable methods used to prepare and present the statement of cash flows: direct method and indirect method.

The indirect method is more commonly used because it’s much easier to prepare and includes a reconciliation to net income as part of the preparation process. For entities that choose the direct method, they need to have the processes and technology in place to track cash receipts and disbursements in ways beyond standard accounting for those transactions. In addition, a separate schedule showing a reconciliation to net income is required when using the direct method.

The investing and financing sections will appear the same regardless of the method used, but the operating section will appear differently. For the direct method, categories of cash receipts, such as “cash received from customers” or “interest received”, and cash disbursements, such as “cash paid to suppliers” or “cash paid to employees”, are listed. Each category’s total is netted together to arrive at net cash flow from operating activities. For the indirect method, preparation starts with net income (loss), and all accruals, deferrals, and non-cash income statement/statement of activities items are either added or subtracted from net income to arrive at net cash flow from operating activities.

Why is it important?

In order to comply with the generally accepted accounting principles (GAAP), the statement of cash flows needs to be included in issued financial statements. However, an entity that issues GAAP financials can elect to omit the statement of cash flows if it states the significant departure from the applicable accounting framework (GAAP) in the accountant’s compilation report. Beyond its importance in relation to compliance, the statement of cash flows can provide valuable information to investors and creditors, such as the entity’s ability to pay debt or dividends. It can also assist an entity’s management in determining the optimum cash balance and how to create excess cash, preparing cash forecasts, and creating short and long-term entity plans.

How do you read the statement of cash flows?

The line items under each section of the statement of cash flows reflect the period change for that particular item. Whether the change is reflected as a positive or negative and whether more than one item is factored into the period change calculation in the operating section is determined by the method used (direct or indirect) to prepare the statement. The period used to determine the period change is the ending balance at the entity’s prior fiscal year through the current financial statement date. It’s NOT from the prior year’s comparative balance. For example, if an entity is using the indirect method, has a fiscal year beginning January 1, 2022,  and is determining the change in the accounts receivable balance for the June 30, 2022 financial statements, it’s looking at the June 30, 2022 accounts receivable balance compared to the accounts receivable balance as of December 31, 2021, not the balance as of June 30, 2021.

A positive net cash flow total from any of the three categories indicates that cash was generated by that activity as opposed to used by it, and vice versa. A negative net cash flow total is not always a cause for concern though. For example, the financing section could be negative due to making regular, scheduled payments for a business loan. Paying down debt is a positive thing, so it is a good use of cash. Another example is purchasing property and equipment, which could cause the investing section of the statement of cash flows to be negative. Purchasing assets is also a positive thing generally, so having a negative “net cash from investing activities” balance from it wouldn’t be considered worrisome. This same ideology can be applied to positive net cash flow totals as well. A positive or negative balance in one section or a combination of them among all sections, can’t always be viewed as a positive or negative indicator of an entity’s cash situation, so it is important to know the nature of the entity’s operations when viewing its statement of cash flows.

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