Cash is the blood of a business – it has to flow evenly. Holding plenty of cash is never a bad thing but there are exceptions to this as well. On the other hand, too much outflow in one area is the equivalent of getting shot and seeing blood pour out from the hole. The basic and key idea is that cash is what a company needs to be healthy and generate earnings. What Is Statement of Cash Flows?
The Statement of Cash Flows (SCF) is distinct from the Statement of Comprehensive Income (IS) and Statement of Financial Position (BS) because it does not include the amount of future incoming and outgoing cash that has been recorded on credit. Therefore, cash is not the same as net income, which, on the IS and BS, includes cash sales and sales made on credit. The SCF, a mandatory part of a company's financial reports since 1987, records the amounts of cash and cash equivalents entering and leaving a company. The SCF allows investors to understand how a company's operations are running, where its money is coming from, and how it is being spent.
Cash flow is determined by looking at three components by which cash enters and leaves a company:
1) Core operations
2) Investing activities
3) Financing activities
Measuring the cash inflows and outflows caused by core business operations, the operations component of cash flow reflects how much cash is generated from a company's products or services. Generally, changes made in cash, accounts receivable, depreciation, inventory and accounts payable are reflected in cash from operations.
Cash flow is calculated by making certain adjustments to net income by adding or subtracting differences in revenue, expenses and credit transactions (appearing on the balance sheet and income statement) resulting from transactions that occur from one period to the next. These adjustments are made because non-cash items are calculated into net income (Statement of Comprehensive Income) and total assets and liabilities (Statement of Financial Position). So, because not all transactions involve actual cash items, many items have to be re-evaluated when calculating cash flow from operations.
For example, depreciation is not really a cash expense; it is an amount that is deducted from the total value of an asset that has previously been accounted for. That is why it is added back into net sales for calculating cash flow. The only time income from an asset is accounted for in CFS calculations is when the asset is sold.
Changes in accounts receivable on the balance sheet from one accounting period to the next must also be reflected in cash flow. If accounts receivable decreases, this implies that more cash has entered the company from customers paying off their credit accounts - the amount by which AR has decreased is then added to net sales. If accounts receivable increase from one accounting period to the next, the amount of the increase must be deducted from net sales because, although the amounts represented in AR are revenue, they are not cash. An increase in inventory, on the other hand, signals that a company has spent more money to purchase more raw materials. If the inventory was paid with cash, the increase in the value of inventory is deducted from net sales. A decrease in inventory would be added to net sales. If inventory was purchased on credit, an increase in accounts payable would occur on the balance sheet, and the amount of the increase from one year to the other would be added to net sales. The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something has been paid off, then the difference in the value owed from one year to the next has to be subtracted from net income. If there is an amount that is still owed, then any differences will have to be added to net earnings.
Changes in equipment, assets or investments relate to cash from investing. Usually cash changes from investing are a "cash...