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The ABCs of Understanding Financial Statements (Part 4 of 4) - Statement of Cash Flows - Aug 19, 2010

Posted by: Stu Lipkin in Articles

As discussed in the first of the 4 articles (The ABC's of Understanding Financial Statements-Part 1 of 4), there are always three main components to every financial statement. They are:

Balance Sheet
Statement of Income
Statement of Cash Flows

This article will focus on the Statement of Cash Flows. For further information related to the Balance Sheet or Statement of Income, please refer to my blog page.

Similar to the Statement of Income (aka Profit & Loss Statement and P & L), The Statement of Cash Flows will reflect activity over a period of time (weeks/months/years) as opposed to an exact date. Many business owners understand the Profit and Loss Statement, can maneuver their way through a Balance Sheet, but rarely comprehend the workings of the Cash Flow Statement. Conceptually, it is difficult to explain to a novice. Fundamentally, every business owner MUST know their cash flow requirements ~ past, present and especially the future. Not understanding the components of the company’s Balance Sheet won’t severely impact the future of the company, and not having an accurate and timely P & L won't have a significant short-term impact on the growth of the business, but the lack of an accurate and timely Cash Flow Statement can put a company out of business in the blink of an eye.

Every business owner is familiar with the phrase “cash is king.” So wouldn’t it be wise to know your “KING”? Trying to steer your business without a "cash road map" is like driving across country without a map or GPS system. You can only hope that you are going in the right direction and the road does not come to an end!

So what does this financial report tell the reader?

It records the company’s cash inflows and outflows over a defined period of time.

Where cash came from, how it is used and if the company has enough cash to pay debts and continue to operate.

It does not follow the accrual basis of accounting (see Article 1 of 4 for an explanation of the cash versus accrual methods), but only actual cash transactions.

Converts the accrual based P & L into cash sources and uses. The P & L does not equal Cash Flow!

The typical Cash Flow Statement looks similar to the exhibit below.

As you see, the statement has 3 main sections.

Operations

Includes cash generated by and required for the daily operations of the business.
Inflows include cash received from the sale of products or services.
Outflows include payments to suppliers, salaries to employees, rents and taxes.

2. Investing

Includes cash used for investing in long-term assets and cash received from the sale of such investments.

Examples:

Purchase or sale of property
Sale of debt
Sale of equity of or loans to other entities
Purchase of equipment

3. Financing

Cash paid to or received from external sources:
- Lenders
- Investors
- Shareholders

Examples:

Issuance of bonds
Issuance of stock
Payment of dividends
Bank loans

Q & A:

Q: Why do I need to look at both the Income Statement and Cash Flow Statement?
A: A complete picture of the company’s profitability and cash flow can only be achieved by examining both statements (accrual accounting distorts the true picture). Each statement tells a different story about the business.
Q: Which section(s) of the cash Flow Statement are most important?
A: ALL are important. Only taken together can you get a complete picture of a company’s cash flow.
Q: Of all the three financial statements, which is most important?
A: The Cash Flow Statement. In business, cash is truly king. Without adequate cash and cash flow, a business will not survive.

While this article just touches on the Statement of Cash Flows, I hope the reader now has a new appreciation for the importance of developing and understanding the components. If you have any questions, or would like to have further information about developing this report for your company, please feel free to contact me @ slipkin@b2bcfo.com.