A cash flow statement is a financial report that describes the source of a company's cash and how

it was spent over a specified time period. Because of the varied accrual accounting methods

companies may employ, it is possible for a company to show profits while not having enough

cash to sustain operations. A cash flow statement neutralizes the impact of the accrual entries on

the other financial statements. It also categorizes the sources and uses of cash to provide the

reader with an understanding of the amount of cash a company generates and uses in its

operations, as opposed to the amount of cash provided by sources outside the company, such as

borrowed funds or funds from stockholders. The cash flow statement also tells the reader how

much money was spent for items that do not appear on the income statement, such as loan

repayments, long-term asset purchases, and payment of cash dividends.

Cash flow statements classify cash receipts and payments according to whether they stem from

operating, investing, or financing activities. It also provides that the statement of cash flows may

be prepared under either the direct or indirect method, and provides illustrative examples for the

preparation of statements of cash flows under both the direct and the indirect methods.

CLASSIFICATIONS OF CASH RECEIPTS AND PAYMENTS 

At the beginning of a company's life cycle, a person or group of people come up with a idea for a

new company. The initial money comes from the owners, or could be borrowed. This is how the

new company is "financed." The money owners put into the company, or money the company

borrows, is classified as a financing activity. Generally, any item that would be classified on the

balance sheet as either a long-term liability or an equity would be a candidate for classification as

a financing activity.

The owners or managers of the business use the initial funds to buy equipment or other assets

they need to run the business. In other words, they invest it. The purchase of property, plant,

equipment, and other productive assets is classified as an investing activity. Sometimes a

company has enough cash of its own that it can lend money to another enterprise. This, too,

would be classified as an investing activity. Generally, any item that would be classified on the

balance sheet as a long-term asset would be a candidate for classification as an investing activity.

Now the company can start doing business. It has procured the funds and purchased the

equipment and other assets it needs to operate. It starts to sell merchandise or services and make

payments for rent, supplies, taxes, and all of the other costs of doing business. All of the cash

inflows and outflows associated with doing the work for which the company was established

would be classified as an operating activity. In general, if an activity appears on the company's

income statement, it is a candidate for the operating section of the cash flow statement.

ACCRUAL AND ITS EFFECT ON FINANCIAL STATEMENTS 

Generally accepted accounting principles (GAAP) require that financial statements are prepared

on the accrual basis. For example, revenues that were earned during an accounting period may

not have been collected during that period, and appear on the balance sheet as accounts

receivable. Similarly, some of the collections of that period may have been from sales made in

prior periods. Cash may have been collected in a period prior to the services rendered or goods

delivered, resulting in deferred recognition of the revenue. This would appear on the balance

sheet as unearned revenue.

Sometimes goods or services are paid for prior to the period in which the benefit is matched to

revenue (recognized). This results in a deferred expense, or a prepaid expense. Items such

as insurance premiums that are paid in advance of the coverage period are classified as prepaid.

Sometimes goods or services are received and used by the company before they are paid for,

such as telephone service or merchandise inventory. These items are called accrued expenses, or

payables, and are recognized on the income statement as an expense before the cash flow occurs.

When buildings or equipment are purchased for cash, the cash flow precedes the recognition of

the expense by many years. The expense is recognized over the life of the asset as depreciation.

One of the main benefits of the cash flow statement is that it removes the effect of any such

accruals or deferrals.

METHODS OF PREPARING THE CASH FLOW STATEMENT Small business owners

preparing a cash flow statement chan choose either the direct or the indirect method of cash flow

statement presentation. The operating section of a cash flow statement prepared using either

method converts the income statement from the accrual to the cash basis, and reclassifies any

activity not directly associated with the basic business activity of the firm. The difference lies in

the presentation of the information.

Companies that use the direct method are required, at a minimum, to report separately the

following classes of operating cash receipts and payments:

RECEIPTS Companies are encouraged to provide further breakdown of operating cash receipts

and payments that they consider meaningful.

Companies using either method to prepare the cash flow statement are also required to separately

disclose changes in inventory, receivables, and payables to reconcile net income (the result of the

income statement) to net cash flow from operating activities. In addition, interest paid (net of

amount capitalized) and income taxes paid must be disclosed elsewhere in the financial

statements or accompanying notes. An acceptable alternative presentation of the indirect method

is to report net cash flow from operating activities as a single line item in the statement of cash

flows and to present the reconciliation details elsewhere in the financial statements.

The reconciliation of the operating section of a cash flow statement using the indirect method

always begins with net income or loss, and is followed by an "adjustments" section to reconcile

net income to net cash provided by operating activities.

Regardless of whether the direct or the indirect method is used, the operating section of the cash

flow statement ends with net cash provided (used) by operating activities. This is the most

important line item on the cash flow statement. A company has to generate enough cash from

operations to sustain its business activity. If a company continually needs to borrow or obtain

additional investor capitalization to survive, the company's long-term existence is in jeopardy.

The presentation of the investing and financing sections is the same regardless of whether the

statement is prepared using the direct or indirect method. The final section of the cash flow

statement is always a reconciliation of the net increase or decrease in cash for the period for

which the statement is prepared, with the beginning and ending balances in cash for the period.

ANALYZING AND CLASSIFYING COMMON TRANSACTIONS

Transactions on the balance sheet also must be analyzed and converted from the accrual to the

cash basis in preparation of the cash flow statement. Every balance sheet account reflects

specific activity. There are only a few distinctive transactions that affect each account. Following

are examples of some of the common transactions affecting balance sheet items:

Accounts receivable increases when the company sells merchandise or does a service on credit,

and decreases when the customer pays its bill. Accounts receivable is associated with the income

statement account Sales or Revenue. The change in accounts receivable or the cash collected

from customers is classified as an operating activity.

Inventory increases when the company buys merchandise for resale or use in its manufacturing

process, and decreases when the merchandise is sold. Inventory is associated with the income

statement account Cost of Goods Sold. The change in inventory or the cash paid for inventory

purchases is classified as an operating activity.

Prepaid insurance increases when the company pays insurance premiums covering future periods

and decreases when the time period of coverage expires. Prepaid insurance is associated with the

income statement account Insurance Expense. The change in prepaids or the amount paid for

insurance is classified as an operating activity.

The Land, Building, and Equipment accounts increase when the company purchases additional

assets. They also undergo a corresponding decrease when the assets are sold. The only time the

income statement is affected is when the asset is sold at a price higher or lower than book value,

at which time a gain or loss on sale of assets appears on the income statement. The amount of

cash used or received from the purchase or sale of such assets is classified as an investing

activity. The gain or loss is classified as an adjustment in the operating section on a cash flow

statement prepared using the indirect method.

Accumulated depreciation increases as the building and equipment depreciates and decreases

when building and equipment is sold. Accumulated depreciation is associated with depreciation

expense on the income statement. Depreciation expense does not appear on a cash flow

statement presented using the direct method. Depreciation expense is added back to net income

on a cash flow statement presented using the indirect method, since the depreciation caused net

income to decrease during the period but did not affect cash.

Goodwill increases when the parent company acquires a subsidiary for more than the fair market

value of its net assets. Goodwill amortizes over a time period not to exceed 40 years. Goodwill is

associated with amortization expense on the income statement. Amortization expense appears in

the operating section of a cash flow statement prepared using the indirect method. Amortization

expense does not appear on a cash flow statement prepared using the direct method.

Notes payable increases when the company borrows money, and decreases when the company

repays the funds borrowed. Since only the principal appears on the balance sheet, there is no

impact on the income statement for repaying the principal component of the note. Notes payable

appear in the financing section of a cash flow section.

Premiums and discounts on bonds are amortized through bond interest expense. There is no cash

flow associated with the amortization of bond discounts or premiums. Therefore, there will

always be an adjustment in the operating section of the cash flow statement prepared using the

indirect method for premium or discount amortization. Premium or discount amortization will

not appear on a cash flow statement prepared using the direct method.

Common stock and preferred stock with their associated paid in capital accounts increase when

additional stock is sold to investors, and decrease when stock is retired. There is no income

statement impact for stock transactions. The cash flow associated with stock sales and

repurchases appears in the financing section.

Retained earnings increases when the company earns profits and decreases when the company

suffers a loss or declares dividends. The profit or loss appears as the first line of the operating

section of the cash flow statement. The dividends appear in the financing section when they are

paid.

CASH INFLOWS OR RECEIPTS When preparing the cash flow statement using the direct

method, the cash collected from customers may be found by analyzing accounts receivable, as

follows: Beginning balance of accounts receivable, plus sales for the period (from the income

statement), less ending balance of accounts receivable, equals cash received from customers.

This is an extremely simplified formula, and does not take into account written off receivables or

other noncash adjustments to customer accounts. If there is no accounts receivable on the

balance sheet, the company does a cash business and cash collected from customers will equal

sales or revenue on the income statement.

If the cash flow statement is prepared using the indirect method, the adjustment to net income

may be found in a similar manner. If the cash received from customers is more than the sales

shown on the income statement, causing accounts receivable to decrease, the difference is added

to net income. If cash received from customers is less than the sales shown on the income

statement, causing accounts receivable to increase, the difference is subtracted from net income.

The amounts borrowed during the period may be found by analyzing the Liability Accounts. The

amounts received from investors during the period may be found by doing a similar analysis on

the Equity Accounts. Both of these types of transactions will be classified as financing activities.

If any land, buildings, or equipment were sold during the period, the information will be found in

the Land, Building, and Equipment Accounts and their associated accumulated depreciation. One

simple way to properly categorize the transaction is to reconstruct the journal entry. For example,

assume that equipment that had cost $8,000 and had accumulated depreciation of $6,000 was

sold during the period for $2,500. The journal entry for this transaction should indicate:

Cash $2,500

Accumulated depreciation $6,000

Equipment $8,000

Gain on sale of equipment $500

The cash received from the sale of the equipment is classified as an investing activity. If the

statement is prepared using the direct method, no other part of the journal entry is used. If the

statement is prepared using the indirect method, the gain on sale of equipment is subtracted from

net income. When the gain was recorded, net income increased. However, since the company is

not in the business of buying and selling equipment, the gain needs to be subtracted from net

income to arrive at the adjusted total related only to the proceeds from the company's direct

business activities. If the sale had resulted in a loss, the loss is added back to net income.

CASH PAYMENTS Cash payments are found using similar methods to those used for

determining cash received. Cash payments for the purchase of inventory are found by analyzing

accounts payable. The following formula can be used to find the cash paid for inventory

purchases: beginning balance of accounts payable, plus inventory purchases during the period,

less ending balance of accounts payable, equals payments made for inventory during the period.

This is a simplified formula and does not take into account any noncash adjustments.

If the cash paid for inventory is greater than the inventory purchased during the period, the

difference between the amount purchased and the amount paid is deducted from net income if

preparing the cash flow statement using the indirect method. If cash paid for inventory is less

than the inventory purchased during the period, the difference between the amount purchased

and the amount paid is added to net income if preparing the cash flow statement using the

indirect method. Cash payments for land, building, and equipment purchases, repayments of

loans, purchases of treasury stock, and payment of dividends may be found by performing

similar analysis on the appropriate accounts.

SIGNIFICANT NONCASH TRANSACTIONS Noncash transactions are not to be

incorporated in the statement of cash flows. Examples of these types of transactions include

conversion of bonds to stock and the acquisition of assets by assuming liabilities. If there are

only a few such transactions, it may be convenient to include them on the same page as the

statement of cash flows, in a separate schedule at the bottom of the statement. Otherwise, the

transactions may be reported elsewhere in the financial statements, clearly referenced to the

statement of cash flows.

Other events that are generally not reported in conjunction with the statement of cash flows

include stock dividends, stock splits, and appropriation of retained earnings. These items are

generally reported in conjunction with the statement of retained earnings or schedules and notes

pertaining to changes in capital accounts.

Cash flow analysis is a method of analyzing the financing, investing, and operating activities of a

company. The primary goal of cash flow analysis is to identify, in a timely manner, cash flow

problems as well as cash flow opportunities. The primary document used in cash flow analysis is

the cash flow statement. Since 1988, the Securities and Exchange Commission (SEC) has

required every company that files reports to include a cash flow statement with its quarterly and

annual reports. The cash flow statement is useful to managers, lenders, and investors because it

translates the earnings reported on the income statement—which are subject to reporting

regulations and accounting decisions—into a simple summary of how much cash the company

has generated during the period in question. "Cash flow measures real money flowing into, or out

of, a company's bank account," Harry Domash notes on his Web site, WinningInvesting.com.

"Unlike reported earnings, there is little a company can do to overstate its bank balance."

THE CASH FLOW STATEMENT

A typical cash flow statement is divided into three parts: cash from operations (from daily

business activities like collecting payments from customers or making payments to suppliers and

employees); cash from investment activities (the purchase or sale of assets); and cash from

financing activities (the issuing of stock or borrowing of funds). The final total shows the net

increase or decrease in cash for the period.

Cash flow statements facilitate decision making by providing a basis for judgments concerning

the profitability, financial condition, and financial management of a company. While historical

cash flow statements facilitate the systematic evaluation of past cash flows, projected (or pro

forma) cash flow statements provide insights regarding future cash flows. Projected cash flow

statements are typically developed using historical cash flow data modified for anticipated

changes in price, volume, interest rates, and so on.

To enhance evaluation, a properly-prepared cash flow statement distinguishes between recurring

and nonrecurring cash flows. For example, collection of cash from customers is a recurring

activity in the normal course of operations, whereas collections of cash proceeds from secured

bank loans (or issuances of stock, or transfers of personal assets to the company) is typically not

considered a recurring activity. Similarly, cash payments to vendors is a recurring activity,

whereas repayments of secured bank loans (or the purchase of certain investments or capital

assets) is typically not considered a recurring activity in the normal course of operations.

In contrast to nonrecurring cash inflows or outflows, most recurring cash inflows or outflows

occur (often frequently) within each cash cycle (i.e., within the average time horizon of the cash

cycle). The cash cycle (also known as the operating cycle or the earnings cycle) is the series of

transactions or economic events in a given company whereby:

1. Cash is converted into goods and services.

2. Goods and services are sold to customers.

3. Cash is collected from customers.

To a large degree, the volatility of the individual cash inflows and outflows within the cash cycle

will dictate the working-capital requirements of a company. Working capital generally refers to

the average level of unrestricted cash required by a company to ensure that all stakeholders are

paid on a timely basis. In most cases, working capital can be monitored through the use of a cash

budget.

THE CASH BUDGET

In contrast to cash flow statements, cash budgets provide much more timely information

regarding cash inflows and outflows. For example, whereas cash flow statements are often

prepared on a monthly, quarterly, or annual basis, cash budgets are often prepared on a daily,

weekly, or monthly basis. Thus, cash budgets may be said to be prepared on a continuous rolling

basis (e.g., are updated every month for the next twelve months). Additionally, cash budgets

provide much more detailed information than cash flow statements. For example, cash budgets

will typically distinguish between cash collections from credit customers and cash collections

from cash customers.

A thorough understanding of company operations is necessary to reasonably assure that the

nature and timing of cash inflows and outflows is properly reflected in the cash budget. Such an

understanding becomes increasingly important as the precision of the cash budget increases. For

example, a 360-day rolling budget requires a greater knowledge of a company than a two-month

rolling budget.

While cash budgets are primarily concerned with operational issues, there may be strategic issues

that need to be considered before preparing the cash budget. For example, predetermined cash

amounts may be earmarked for the acquisition of certain investments or capital assets, or for the

liquidation of certain indebtedness. Further, there may be policy issues that need to be considered

prior to preparing a cash budget. For example, should excess cash, if any, be invested in

certificates of deposit or in some form of short-term marketable securities (e.g., commercial

paper or U.S. Treasury bills)?

Generally speaking, the cash budget is grounded in the overall projected cash requirements of a

company for a given period. In turn, the overall projected cash requirements are grounded in the

overall projected free cash flow. Free cash flow is defined as net cash flow from operations less

the following three items:

1. Cash used by essential investing activities (e.g., replacements of critical capital assets).

2. Scheduled repayments of debt.

3. Normal dividend payments.

If the calculated amount of free cash flow is positive, this amount represents the cash available to

invest in new lines of business, retire additional debt, and/or increase dividends. If the calculated

amount of free cash flow is negative, this amount represents the amount of cash that must be

borrowed (and/or obtained through sales of nonessential assets, etc.) in order to support the

strategic goals of the company. To a large degree, the free cash flow paradigm parallels the cash

flow statement.

Using the overall projected cash flow requirements of a company (in conjunction with the free

cash flow paradigm), detailed budgets are developed for the selected time interval within the

overall time horizon of the budget (i.e., the annual budget could be developed on a daily, weekly,

or monthly basis). Typically, the complexity of the company's operations will dictate the level of

detail required for the cash budget. Similarly, the complexity of the corporate operations will

drive the number of assumptions and estimation algorithms required to properly prepare a budget

(e.g., credit customers are assumed to remit cash as follows: 50 percent in the month of sale; 30

percent in the month after sale; and so on). Several basic concepts germane to all cash budgets

are:

1. Current period beginning cash balances plus current period cash inflows less current

period cash outflows equals current period ending cash balances.

2. The current period ending cash balance equals the new (or next) period's beginning cash

balance.

3. The current period ending cash balance signals either a cash flow opportunity (e.g.,

possible investment of idle cash) or a cash flow problem (e.g., the need to borrow cash or

adjust one or more of the cash budget items giving rise to the borrow signal).

RATIO ANALYSIS

In addition to cash flow statements and cash budgets, ratio analysis can also be employed as an

effective cash flow analysis technique. Ratios often provide insights regarding the relationship of

two numbers (e.g., net cash provided from operations versus capital expenditures) that would not

be readily apparent from the mere inspection of the individual numerator or denominator.

Additionally, ratios facilitate comparisons with similar ratios of prior years of the same company

(i.e., intracompany comparisons) as well as comparisons of other companies (i.e., intercompany

or industry comparisons). While ratio analysis may be used in conjunction with the cash flow

statement and/or the cash budget, ratio analysis is often used as a stand-alone, attention-directing,

or monitoring technique.

ADDITIONAL BENEFITS

In his book, Buy Low, Sell High, Collect Early, and Pay Late: The Manager's Guide to Financial

Survival, Dick Levin suggests the following benefits that stem from cash forecasting (i.e.,

preparing a projected cash flow statement or cash budget):

1. Knowing what the cash position of the company is and what it is likely to be avoids

embarrassment. For example, it helps avoid having to lie that the check is in the mail.

2. A firm that understands its cash position can borrow exactly what it needs and no more,

there by minimizing interest or, if applicable, the firm can invest its idle cash.

3. Walking into the bank with a cash flow analysis impresses loan officers.

4. Cash flow analyses deter surprises by enabling proactive cash flow strategies.

5. Cash flow analysis ensures that a company does not have to bounce a check before it

realizes that it needs to borrow money to cover expenses. In contrast, if the cash flow

analysis indicates that a loan will be needed several months from now, the firm can turn

down the first two offers of terms and have time for further negotiations.

LOAN APPLICATIONS

Potential borrowers should be prepared to answer the following questions when applying for

loans:

1. How much cash is needed?

2. How will this cash help the business (i.e., how does the loan help the business accomplish

its business objectives as documented in the business plan)?

3. How will the company pay back the cash?

4. How will the company pay back the cash if the company goes bankrupt?

5. How much do the major stakeholders have invested in the company?

Admittedly, it is in the best interest of the potential borrower to address these questions prior to

requesting a loan. Accordingly, in addition to having a well-prepared cash flow analysis, the

potential borrower should prepare a separate document addressing the following information:

1. Details of the assumptions underpinning the specific amount needed should be prepared

(with cross-references to relevant information included in the cash flow analysis).

2. The logic underlying the business need for the amount of cash requested should be

clearly stated (and cross-referenced to the relevant objectives stated in the business plan

or some other strategic planning document).

3. The company should clearly state what potential assets would be available to satisfy the

claims of the lender in case of default (i.e., the company should indicate the assets

available for the collateralization of the loan).

4. Details of the equity interests of major stakeholders should be stated.

In some cases, the lender may also request personal guarantees of loan repayment. If this is

necessary, the document will need to include relevant information regarding the personal assets

of the major stakeholders available to satisfy the claims of the lender in case of default.

INADEQUATE CAPITALIZATION

Many businesses fail due to inadequate capitalization. Inadequate capitalization basically implies

that there were not enough cash and/or credit arrangements secured prior to initiating operations

to ensure that the company could pay its debts during the early stages of operations (when cash

inflows are nominal, if any, and cash outflows are very high). Admittedly, it is extremely

difficult to perform a cash flow analysis when the company does not have a cash flow history.

Accordingly, alternative sources of information should be obtained from trade journals,

government agencies, and potential lenders. Additional information can be solicited from

potential customers, vendors, and competitors, allowing the firm to learn from others's mistakes

and successes.

UNCONSTRAINED GROWTH

While inadequate capitalization represents a front-end problem, unconstrained growth represents

a potential back-end problem. Often, unconstrained growth provokes business failure because the

company is growing faster than their cash flow. While many cash flow problems are operational

in nature, unconstrained growth is a symptom of a much larger strategic problem. Accordingly,

even to the extent that cash flow analyses are performed on a timely basis, such analyses will

never overcome a flawed strategy underpinning the unconstrained growth.

BANKRUPTCY

A company is said to be bankrupt when it experiences financial distress to the extent that the

protection of the bankruptcy laws is employed for the orderly disposition of assets and settlement

of creditors's claims. Significantly, not all bankruptcies are fatal. In some circumstances,

creditors may allow the bankrupt company to reorganize its financial affairs, allowing the

company to continue or reopen. Such a reorganization might include relieving the company from

further liability on the unsatisfied portion of the company's obligations. Admittedly, such

reorganizations are performed in vain if the reasons underlying the financial distress have not

been properly resolved. Unfortunately, properly-prepared and timely cash flow analyses can not

compensate for poor management, poor products, or weak internal controls.

A cash flow statement is a financial report that tells the reader the source of a company's cash

and how it was spent over a specified time period. This is an important indicator of financial

soundness because it is possible for a company to show profits while not having enough cash to

sustain operations. A cash flow statement counters the ambiguity regarding a company's

solvency that various accrual accounting measures create. It also categorizes the sources and uses

of cash to provide the reader with an understanding of the amount of cash a company generates

and uses in its operations, as opposed to the amount of cash provided by sources outside the

company, such as borrowed funds or funds from stockholders. The cash flow statement also tells

the reader how much money was spent for items that do not appear on the income statement,

such as loan repayments, long-term asset purchases, and payment of cash dividends.

DEVELOPMENT OF THE REPORTING STANDARD

In November 1987, the Financial Accounting Standards Board (FASB) adopted Statement of

Financial Accounting Standards No. 95—Statement of Cash Flows. FASB 95 requires that a full

set of financial statements includes a cash flow statement as the fourth required financial

statement (along with a balance sheet, income statement, and statement of retained earnings).

This statement established standards for cash flow reporting, and superseded the Accounting

Principles Board (APB) Opinion No. 19, Reporting Changes in Financial Position.

APB Opinion No. 19, adopted in March 1971, had permitted, but did not require, enterprises to

report cash flow information in a statement of changes in financial position, also commonly

known as a funds statement. There was no required format or universally accepted definitions for

categories in the statement, however, and the term "funds" itself was not sufficiently defined.

Hence, the statement referred to changes in funds, but what constituted those funds differed

across companies. Among the ambiguities, some firms defined funds as cash, some used cash

and short-term investments, some used quick assets, and some used working capital.

While it was widely recognized that the funds statement provided valuable and relevant

information, the lack of consistency in format and focus from one firm to another was part of the

reason that the FASB eventually took up the matter and, with extensive commentary from

accountants and other interested parties, adopted the standards espoused in FASB 95. The

standard, which took effect in 1988, discouraged use of the word "funds" in cash flow statements

because the term had been cl6aked in so much ambiguity.

REQUIREMENTS FOR CASH FLOW STATEMENTS

FASB 95 requires that a statement of cash flows classify cash receipts and payments according

to whether they stem from operating, investing, or financing activities. It also provides that the

statement of cash flows may be prepared under either the direct or indirect method, and provides

examples of how to prepare statements using each method.

Under the FASB standard, the core concept, cash, is defined as "cash and cash equivalents."

Cash includes currency and bank deposits, whereas cash equivalents include other highly liquid

investments like U.S. Treasury bills, money market accounts, and commercial paper. Other sorts

of investments such as stocks, bonds, futures contracts, and so forth are not considered cash.

CLASSIFICATIONS OF CASH RECEIPTS AND PAYMENTS

Nearly all business transactions completed during the fiscal year impact cash flow in one way or

another, and in summary form they are factored into the year's cash flow statement. Exactly

where on the statement depends on the nature of the transaction. As noted, the three essential

categories of cash flow are operating activities, investing activities, and financing activities. The

components of each of these will be addressed separately.

OPERATING ACTIVITIES.

Operating activities are the bread-and-butter transactions that keep the business running. Most

notably, they include incoming revenue from the sale of goods or services and most kinds of

outgoing payments. Cash flow from operating activities doesn't include principal paid on or

received from loans, and only includes transactions that were completed during the period. This

simply means that an operating transaction is not considered cash flow until the cash is actually

received or paid, as opposed to just being recorded as accounts receivable or payable. In general,

if an activity would appear on the company's income statement, it would be a candidate for the

operating section of the cash flow statement. Net changes in balance sheet categories from period

to period also represent cash flow; thus, a net decrease in accounts receivable from year to year

normally suggests an increase in cash flow for that period.

Sometimes goods or services are paid for prior to the period in which the benefit is matched to

revenue (recognized). This results in a deferred or prepaid expense. Items such as insurance

premiums that are paid in advance of the coverage period are classified as prepaid. Sometimes

goods or services are received and used by the company before they are paid for, such as

telephone service or merchandise inventory. These items are called accrued expenses, or

payables, and are recognized on the income statement as an expense before the cash flow occurs.

INVESTING ACTIVITIES.

Investment cash flow results from (1) the purchase or sale of property and equipment, (2) the

purchase or sale of securities and related investments, and (3) loans made to other businesses. It

includes only the principal or book value of the investment. Interest and depreciation are

classified as operating cash flow, as are net gains or losses on investments. Because of these

distinctions, cash flow from investment activities is typically more complex to calculate than that

from other categories.

FINANCING ACTIVITIES.

Financing activities consist of transactions affecting a company's liabilities and shareholder

equity. Mainly involving how the company obtains capital and enhances the value of its stock,

they include such things as issuing bonds, payments on debt, paying dividends, and issuing and

buying back stock.

METHODS OF PREPARING A CASH FLOW STATEMENT

FASB Statement No. 95 allows the preparer a choice of the direct or the indirect method of cash

flow statement presentation, although the FASB prefers the direct method. The difference lies in

the presentation of the operating cash flow information.

DIRECT METHOD.

Companies that use the direct method are required, at a minimum, to report separately the

following classes of operating cash receipts and payments:

Receipts:

1. Cash collected from customers

2. Interest and dividends received

3. Other operating cash receipts, if any

Payments:

1. Cash paid to employees and suppliers of goods or services (including suppliers of

insurance, advertising, etc.)

2. Interest paid

3. Income taxes paid

4. Other operating cash payments, if any

Companies are encouraged to further break down any operating cash receipts and payments that

they consider meaningful.

INDIRECT METHOD.

The indirect method, by contrast, reports operating cash flow based on changes in the balance

sheet (the distribution of assets and liabilities) from period to period as they relate to net income.

Thus, instead of reporting the total cash received from customers, an indirect statement only lists

the change in cash received from the previous period. The net cash flow reported should be the

same as in the direct method, but in the indirect method the level of detail tends to be less.

The key elements of the operating activities section using the indirect method are as follows:

1. Net income

2. Depreciation and amortization

3. Deferred income taxes

4. Interest income

5. Change in accounts receivable

6. Change in accounts payable

7. Change in inventories

8. Net gains from sale of investments or assets

A few additional categories are used in some circumstances. Each category is either added or

subtracted from net income depending on whether it corresponds to an inflow or outflow of cash.

When all of these factors are combined, they equal the net operating cash flow for the period.

As an alternative, some cash flow statements using the indirect method report operating cash

flow as a single line item and present the reconciliation details elsewhere in a supplementary

schedule. According to FASB standards, the direct method also requires a supplementary

schedule that essentially incorporates the indirect measures into the statement. Due to this added

burden, the majority of companies tend to use the indirect method only, despite the FASB's

stated preference for the direct. Figure I shows a modified statement of cash flows from the

Coca-Cola Company using the indirect method.

Regardless of whether the direct or the indirect method is used, the operating section of the cash

flow statement ends with net cash provided (used) by operating activities. This is the most

important line item on the cash flow statement. A company has to generate enough cash from

operations to sustain its business activity. If a company continually needs to borrow or obtain

additional investor capitalization to survive, the company's long-term existence is in jeopardy.

The presentation of the investing and financing sections of the statement is the same in each

method.

BALANCE SHEET ACCOUNTS AND CASH FLOW

Every balance sheet account reflects specific activity. There are only a few distinctive

transactions that affect each account. Following are examples of some of the common changes in

balance sheet accounts that register as cash flow.

Accounts receivable increases when the company sells merchandise or does a service on credit,

and decreases when the customer pays its bill. Accounts receivable is associated with sales or

revenue on an income statement. The change in accounts receivable or the cash collected from

customers is classified as an operating activity.

Inventory increases when the company buys merchandise for resale or use in its manufacturing

process, and decreases when the merchandise is sold. Inventory is associated with the income

statement account cost of goods sold (COGS). The change in inventory or the cash paid for

inventory purchases is classified as an operating activity.

Prepaid insurance increases when the company pays insurance premiums covering future periods

and decreases when the time period of coverage expires. The change in prepaids or the amount

paid for insurance is classified as an operating activity.

Land, building, and equipment accounts increase when the company purchases additional assets

and decrease when the assets are sold. The only time the income statement is affected is when

the asset is sold at a price higher or lower than book value, at which time a gain or loss on sale of

assets appears on the income statement. The amount of cash used or received from the purchase

or sale of such assets is classified as an investing activity. The gain or loss is reported as

operating cash flow.

Accumulated depreciation increases as the building and equipment depreciates and decreases

when building and equipment is sold. Depreciation expense does not appear on a cash flow

statement presented using the direct method. Depreciation expense is added back to net income

on a cash flow statement presented using the indirect method, since the depreciation caused net

income to decrease during the period but did not affect cash.

Consolidated Statements of Cash Flows The Coca-Cola Company and Subsidiaries Year

Ended December 31,1997 (In Millions)

Goodwill increases when the parent company acquires a subsidiary for more than the fair market

value of its net assets. Goodwill amortizes over a time period not to exceed 40 years. Goodwill is

associated with amortization expense on the income statement. Amortization expense appears in

the operating section of a cash flow statement prepared using the indirect method. Amortization

expense does not appear on a cash flow statement prepared using the direct method.

Notes payable increases when the company borrows money, and decreases when the company

repays the funds borrowed. Since only the principal appears on the balance sheet, there is no

impact on the income statement for repaying the principal component of the note. Notes payable

appears in the financing section of a cash flow section.

Premiums and discounts on bonds are amortized through bond interest expense. There is no cash

flow associated with the amortization of bond discounts or premiums. Therefore, there will

always be an adjustment in the operating section of the cash flow statement prepared using the

indirect method for premium or discount amortization. Premium or discount amortization will

not appear on a cash flow statement prepared using the direct method.

Common stock and preferred stock increase when additional stock is sold to investors, and

decrease when stock is retired. There is no income statement impact for stock transactions. The

cash flow associated with stock sales and repurchases appears in the financing section.

Retained earnings increase when the company earns profit and decreases when the company

suffers a loss or declares dividends. The profit or loss appears as the first line of the operating

section of the cash flow statement. The dividends appear in the financing section when they are

paid.

SIGNIFICANT NONCASH TRANSACTIONS

Noncash transactions aren't incorporated in the statement of cash flows, but often they need to be

disclosed elsewhere in financial statements. Examples of these types of transactions include

converting bonds to stock

acquiring assets by assuming liabilities

If there are only a few such transactions, it may be convenient to include them on the same page

as the statement of cash flows, in a separate schedule at the bottom of the statement. Otherwise,

the transactions may be reported elsewhere in the financial statements, clearly referenced to the

statement of cash flows.

Other events that are generally not reported in conjunction with the statement of cash include

stock dividends, stock splits, and appropriation of retained earnings. These items are generally

reported on a statement of retained earnings or schedules and notes pertaining to changes in

capital accounts.

How to Understand a Statement of Cash Flow

There are three primary financial statements, they are the income statement, the balance sheet,

and the cash flow statement. Each one provides the analyst or investor with additional

knowledge about the performance of the company. The cash flow statement is a combination of

the income statement and the balance sheet. It provides information about the sources and uses of

cash and categorizes cash flow based on three different cash flow activities: cash flow from

operations, cash flow from investing and cash flow from financing activities.

Instructions

1. Understand cash flow notations. The cash flow statement shows inflows and outflows.

Outflows are shown with "()". For instance, an outflow of $100 is shown as ($100).

2. Review the section titled cash flow from operations. Cash flow from operations is the first

section on the cash flow statement. It provides an overview of the cash flow generated by

company operations. Go through each line item to determine the inflows and outflows of cash

from operations.

3. Walk through the segment titled cash flow from investing. Companies may purchase items

which can be sold for a profit in the future and that profit or loss is not related to operations. This

cash flow is referred to as cash flow from operations. Investments in securities or real estate are

examples of items which may fall into cash flow from investments.

4. Review cash flow from financing. Cash flow from financing is the cash flow received from

investors such as stock and bond holders. A cash outflow is the money paid for the use of funds

such as interest and dividends. A cash inflow represents the money raised from a stock or bond

issuance.

How to Prepare a Cash Flow Statement

Preparing a cash flow statement: A cash flow statement is a document that shows how much cash

(or cash equivalents) comes into a business and how much goes out. A cash flow statement is

considered a necessary companion to an income statement and a balance sheet when evaluating

the financial condition of a business. A cash flow statement can be presented in several different

formats. However, complete, concise and clear disclosure of the movement of cash is the only

true requirement for a cash flow statement.

Cash flow statements commonly cover periods of one year or more, with more or less detail,

depending on the intended use of the cash flow statement. This example of a first-quarter cash

flow statement for a new construction company, has been made very simple to illustrate the

principles and components of the cash flow statement. Statement of Cash Flows Methods How to

Prepare a Cash Flow Statement using the Direct Method

Instructions

1. Gather the records you will need for your cash flow statement.

2. Verify that your ending cash balances for each accounting period agree with your reconciled

bank statements.

3. Set up your spreadsheet for your cash flow statement. Open a new file in your spreadsheet

program and give it a name. Example: "Acme Construction, First-Quarter 2010 Cash Flow

Statement."

4. Name the columns of your cash flow statement. Example: Acme Construction First-Quarter

2010 Cash Flow Statement will have five columns with the following headings: (the first column

heading is blank, for now), "January," "February," "March," "Net First-Quarter Cash Flow."

5. Examine your cash accounts and make a list of all sources from which you have received cash

during the periods that will be covered by your cash flow statement. Then make a list of all types

of cash disbursements for the same periods.

6. Use the list you prepared in Step 5 to label the rows of your cash flow statement spreadsheet.

Cash Receipts will be the first section, Cash Disbursements will be the second section. Each

section will have a subtotal. The final row will contain the Net Cash Flow for each period.

Example: Acme Construction First-Quarter Cash Flow Statement will have the following row

labels: "Cash Received" (a label for the cash receipts section); "Beginning Cash"; "Payments

from Customers"; "Loans"; "Contributed Capital"; "Total Cash Received" (a label for the

subtotal); "Cash disbursements" (a label for the cash disbursements section); "Salaries";

"Construction Expenses"; "Other Operating Expenses"; "Total Cash Disbursements" (a subtotal

for the section); "Ending Cash Balance" (a sum of Beginning Cash, Total Cash Received and

Total Cash Disbursements); "Net Cash Flow" (a sum of Total Cash Received and Total Cash

Disbursements).

7. Record your Beginning Cash figures in the appropriate cells of your Cash Flow Statement

spreadsheet: Consult your cash account details and find the beginning cash balance for each

period that will be reported on your Cash Flow Statement. Record these numbers in the

appropriate cells of your Cash Flow Statement. Example, for Acme Construction: Beginning

Cash balances obtained from Acme's accounting records are---January, $0; February, $180,000;

March, $50,000.

8. Record and subtotal the cash receipts for each accounting period that will be reported on your

Cash Flow Statement: Consult your cash account records and compile totals, per period, for each

Cash Receipt category. Record these figures in the appropriate cells on your Cash Flow

Statement. Place subtotals for each accounting period In the "Total Cash Receipts" row. Use

formulas to figure these sums, so that they will update automatically if you change the data on

your spreadsheet.

Example, for Acme Construction: January--Payments from Customers, $50,000; Loans, 150,000;

Contributed Capital, $200,000; Total Cash Receipts, $400,000; February--Payments from

Customers, $125,000; Loans, $0; Contributed Capital, $0; Total Cash Receipts, $125,000;

March-- Payments from Customers, $315,000; Loans, $0; Contributed Capital, $0; Total Cash

Receipts, $315,000.

9. Record and subtotal the Cash Disbursements for each accounting period that will be reported

on your Cash Flow Statement: Consult your cash account records and compile totals, per period,

for each Cash Disbursement category. Record the totals in the appropriate cells on your Cash

Flow Statement. Place subtotals for each accounting period in the "Total Cash Disbursements"

row. As in Step 8, use formulas to figure these sums. Example, for Acme Construction: January--

Salaries, $80,000; Construction Expenses, $125,000; Other Operating Expenses, $15,000; Total

Cash disbursements, $220,000; February--Salaries, $80,000; Construction Expenses, $157,000;

Other Operating Expenses, $18,000; Total Cash disbursements, $255,000; March--Salaries,

$85,000; Construction Expenses, $185,000; Other Operating Expenses, $18,000; Total Cash

disbursements, $288,000.

10. Compute your Ending Cash Balance for each accounting period: In the row labeled "Ending

Cash Balance," record the sum of your Beginning Cash, Total Cash Receipts and Total Cash

Disbursements for each accounting period. Once again, use formulas to figure these sums.

11. Compute your Net Cash Flow for each period that will be reported on your Cash Flow

Statement: In the row labeled "Net Cash Flow", record the sum of your Total Cash Receipts and

Total Cash disbursements for each accounting period. As in Step 10, use formulas to figure these

sums.

12. Record your Beginning Cash balance for the entire date range covered by your Cash Flow

Statement in the last column of your spreadsheet. Example: Acme Constructions Beginning Cash

balance for the First Quarter is $0.

13. In the last column of your Cash Flow Statement, compute the totals for each row. Here again,

use formulas to figure these sums. Label this column.

Example: The last column in Acme Construction's Cash Flow Statement is labeled "Net First-

Quarter Cash Flow." The calculated figures are "Payments from Customers," $490,000; "Loans,"

150,000; "Contributed Capital," 200,000; "Total Cash Receipts," $850,000; "Salaries," $245,000;

"Construction Expenses," $467,000; "Other Operating Expenses," $51,000; "Total Cash

Disbursements," $763,000.

14. Save your Cash Flow Statement spreadsheet to your computer. Double-check all your figures

for accuracy and print your Cash Flow Statement.

How to Interpret a Cash Flow Statement

Whether you are the manger of a business or a potential investor, interpreting the cash flow

statement is important to knowing the health of the company. The cash flow statement can

quickly give you an idea of how the company is doing. Here are some tips for interpreting a cash

flow statement.

Instructions: Instructions on Interpreting a Cash Flow Statement

1. Understand what makes up the cash flow statement. The cash flow statement is comprised of

three parts: the operations, investing and financing sections. Each section examines the

company's cash flow from a different angle.

2. Examine the operations section first. This shows the incoming and outgoing cash form the

company's core operations. Ideally, this figure should be positive, and most of the company's

cash should be from this area. That would indicate that the company's core operation is

generating a healthy cash flow and the company is stable.

3. Review the investing section of the cash flow statement. This section reveals the changes in

cash due to equipment, assets or company investments. For example, cash goes out when new

equipment is bought and cash comes into the company when an asset is sold.

4. Examine the financing section of the cash flow statement. This section will show you the

changes in cash due to the financing activities of the company, such as loans or dividends.

5. Look for positive cash flow. Positive cash flow is the lifeblood of any company. A strong cash

flow is a sign that the company is healthy.