What is a Statement of Cash Flow? 

The statement of cash flow, or cash flow statement, details the enterprise's cash flow - the inflows and outflows of our cash. 

This statement tells managers and owners what is happening with cash in the business. It reveals how cash is generated and from where. How is cash expend expended during a specific period of time. 

What are the Sections of the Statement of Cash Flows?

There are three unique sections to the statement of cash flow. It's broken down into:

• Operating activity - Operating activities include cash activities related to net income. For example, cash generated from the sale of goods (revenue) and cash paid for merchandise (expense) are operating activities because revenues and expenses are included in net income.
• Investing Activities - Investing activities include cash activities related to noncurrent assets. Noncurrent assets include (1) long-term investments; (2) property, plant, and equipment; and (3) the principal amount of loans made to other entities. For example, cash generated from the sale of land and cash paid for an investment in another company are included in this category. (Note that interest received from loans is included in operating activities.)
• Financing Activities- Financing activities include cash activities related to noncurrent liabilities and owners’ equity. Non-current liabilities and owners’ equity items include (1) the principal amount of long-term debt, (2) stock sales and repurchases, and (3) dividend payments. (Note that interest paid on long-term debt is included in operating activities.)

  
  

The statement of cash flows provides cash receipt and cash payment information and reconciles the change in cash for a period of time. 

Cash receipts and cash payments are summarized and categorized as operating, investing, or financing activities. Simply put, the statement of cash flows indicates where cash came from and where cash went for a period of time.

Rather than showing every single transaction in a formal report, the statement of cash flows summarizes these transactions. For example, all cash receipts from paychecks are added together and shown as one line item, all cash payments for rent are added together and shown as one line item, all cash payments for food are added together and shown as one line item, and so on. 

The goal is to start with the beginning of the year cash balance, add all cash receipts for the year, subtract all cash payments for the year, and find the resulting end-of-year cash balance. 

Preparing a Cash Flow Statement

The statement of cash flows is based on cash flows only, and thus adjustments must be made to convert accrual basis information to a cash basis. 

Several pieces of information are required to make these adjustments in preparing the statement of cash flows:

Balance sheets for the end of last year and end of the current year are needed to calculate the amount of change in each balance sheet account. These changes in balance sheet accounts are needed to prepare certain parts of the statement of cash flows.

Income statement information for the current year is needed as the starting point for converting net income from an accrual basis to a cash basis, which is shown in the operating activities section of the statement of cash flows.

Other information is needed to complete the statement of cash flows, such as cash dividends paid and the original cost of long-term investments sold.

The four steps required to prepare the statement of cash flows are described as follows:

Step 1. Prepare the operating activities section by converting net income from an accrual basis to a cash basis.

This step can be done using one of two methods—the direct method or the indirect method. The indirect method links net income to cash flows from operating activities by reconciling the two amounts.Those using the direct method are also required to provide a supplemental schedule using the indirect method. It is less costly to simply prepare the statement using the indirect method.)

The indirect method begins with net income from the income statement and makes several adjustments related to changes in current assets, current liabilities, and other items to arrive at cash provided by operating activities(or used by operating activities if the result is a cash outflow). 

Cash provided by operating activities represents net income on a cash basis. It tells the reader how much cash was received from the daily operations of the business.

Using the Direct Method to Prepare the Statement of Cash Flows

With the direct method, rather than adjusting net income from an accrual basis to a cash basis using the indirect method, the direct method simply presents the income statement on a cash basis. 

Operating Activities Format Using the Direct Method - Adjustments must be made to each income statement item to convert income statement information from an accrual basis to a cash basis. 

• Converting Sales to Cash Receipts - The adjustment rule used to convert sales to cash receipts from customers is as follows: increases in accounts receivable are deducted from sales revenue, and conversely, decreases in accounts receivable are added to sales revenue. 
• Converting Cost of Goods Sold to a Cash Basis - Two adjustments must be made to cost of goods sold to calculate cash paid to suppliers. First, increases in inventory are added to cost of goods sold, and conversely, decreases in inventory are deducted from cost of goods sold.
• Converting Operating Expenses to a Cash Basis - Two adjustments must be made to operating expenses (also called selling and administrative expenses) to calculate cash payments for operating expenses.  First, increases in prepaid expenses are added to operating expenses, and conversely, decreases in prepaid expenses are deducted from operating expenses. 
• Depreciation Expense - Since depreciation is a non-cash expense, it is not included in the statement of cash flows using the direct method.
• Converting Interest Expense to a Cash Basis - The adjustment rule used to convert interest expense to cash payments for interest expense is as follows: increases in interest payable are deducted from interest expense, and conversely, decreases in interest payable are added to interest expense. 
• Loss on Sale of Equipment - Because the loss on sale of equipment is included as part of the proceeds from the sale of equipment in the investing activities section, this item is not included in the operating activities section. This holds true for both the direct and indirect methods.
• Converting Income Tax Expense to a Cash Basis - The adjustment rule used to convert income tax expense to cash payments for income taxes is: Increases in income taxes payable are deducted from income tax expense, and conversely, decreases in income taxes payable are added to income tax expense. (The same rules apply to companies that have deferred income taxes.) 

Step 2. Prepare the investing activities section by presenting cash activity for noncurrent assets.

This step focuses on the effect changes in noncurrent assets have on cash. 

Noncurrent asset balances found on the balance sheet, coupled with other information (e.g., cash proceeds from sale of equipment) are used to perform this step.

Step 3. Prepare the financing activities section by presenting cash activity for noncurrent liabilities and owners’ equity.

This step focuses on the effect changes in noncurrent liabilities and owners’ equity have on cash. 

Noncurrent liabilities and owners’ equity balances found on the balance sheet, coupled with other information (e.g., cash dividends paid) are used to perform this step.

Step 4. Reconcile the change in cash.

Each section of the statement of cash flows described in steps 1, 2, and 3, will show the total cash provided by (increase) or used by (decrease) the activity. 

Step 4 simply confirms that the net of these changes equates to the change in cash on the balance sheet.

Related Topics

• What are Financial Statements? – Financial Accounting
  • Consolidated Financial Statements
• What is the Income Statement? – Financial Accounting
  • What are Revenues? – Financial Accounting
  • What are Expenses? – Financial Accounting
• What is the Statement of Retained Earnings – Financial Accounting
• What is a Balance Sheet? – Financial Accounting
  • Accounting Equation Definition
  • What are Assets? – Financial Accounting
  • What are Liabilities? – Financial Accounting
  • What is Equity? – Financial Accounting
• What is the Statement of Cash Flow? – Financial Accounting

• Analysis and Creating Financial Statement