The Statement of Cash Flows

The Statement of Cash Flows is like a business’ checking account; it shows you where the money is spent; or is a report of the cash flow generated by the firm’s operations, investments, and financial activities over an accounting period.

The Statement of Cash Flows is like a business’ checking account; it shows you where the money is spent; or is a report of the cash flow generated by the firm’s operations, investments, and financial activities over an accounting period. This statement is designed to show how the firm's operations have affected its cash position, and to help answer questions such as these: Is the firm generating the cash needed to purchase additional fixed assets for growth? Is growth so rapid that external financing is required both for maintaining operations and for investing in new fixed assets? Does the firm have excess cash flows that can be used to repay debt or to invest in new products? This information is useful both for financial mangers and analysts, so the statement of cash flows is an important part of the annual report.

This statement was mandated by the Financial Accounting Standards Board in 1987 and is sometimes called the FASB Statement No. 95.

Although the income statement and balance sheet are based on accrual methods of accounting, which means that revenues and expenses are recognized when incurred even if no cash has yet been exchanged, the statement of cash flows recognizes only transactions in which cash changes hands. For example, if goods are sold now, with payment due in 60 days, the income statement will treat the revenue as generated when the sale occurs, and the balance sheet will be immediately augmented by accounts receivable, but the statement of cash flows will not recognize the transaction until the bill is paid and the cash is in hand.

The first entry listed under cash flows from operations is net income. The next entries modify that figure by components of income that have been recognized but for which cash has not yet changed hands. Increases in accounts receivable, for example, mean that income has been claimed on the income statement, but cash has not yet been collected. Hence, increases in accounts receivable reduce the cash flows realized from operations in this period.

Another major difference between the income statement and the statement of cash flows involves depreciation, which is a major additional to income in the adjustment section of the statement of cash flows. The depreciation expense on the income statement is a way of doing this by recognizing capital expenditures over a period of many years rather than at the specific time of those expenditures.

The statement of cash flows, however, recognizes the cash implication of a capital expenditure when it occurs. It will ignore the depreciation "expense" over time, but will account for the full capital expenditure when it is paid.

The second section of the statement of cash flows is the accounting of cash flows from investing activities. These entries are investment in the capital stock necessary for the firm to maintain or enhance its productive capacity.

Finally, the last section of the statement lists the cash flows realized from financing activities. Issuance of securities will contribute positive cash flows. In, contrast, payments of dividends and repurchase of stock reduced net cash flow.

The statement of cash flows provides evidence on the well-being of a firm. If a company cannot pay its dividends and maintain the productivity of its capital stock out of cash flow from operations, for example, and it must resort to borrowing to meet these demands, this is a serious warning that the firm cannot maintain the dividend payout at its current level in the long run. The statement of cash flows will reveal this developing problem, when it shows that cash flow from operations is inadequate and that borrowing is being used to maintain dividend payments at unsustainable levels.