Cash flow statement

A cash flow statement is a vital financial document used in accounting. It tracks how changes in balance sheet accounts and income affect cash and cash equivalents. Cash equivalents are assets that can be quickly converted into cash. This statement focuses entirely on the movement of money in and out of a business. It serves as a key analytical tool for determining short-term viability. Specifically, it helps people see if a company can pay its immediate bills. While an income statement shows profit, a company might still lack the cash needed to operate. The cash flow statement reveals the true quality of a company's earnings. It shows if money comes from actual cash or just accounting treatments.

To understand how this works, one must look at the three main activity categories. The first category is operating activities. These involve the core production, sale, and delivery of products. They also include collecting payments from customers and paying suppliers. The second category is investing activities. These track cash used for the purchase or sale of assets and loans. The third category is financing activities. These record cash moving between the company and its investors. This includes things like net borrowings or the repayment of debt principal. By breaking data into these three parts, the statement shows exactly where money originates and where it is spent.

Operating activities require specific adjustments to reflect real cash movement. Accountants must account for non-cash items like depreciation. Depreciation is the loss of value in a tangible asset over time. They also adjust for amortization, which is the loss of value in an intangible asset. Other adjustments include deferred taxes and write-offs on bad debts. For example, sales made on credit are recorded as revenue, but they are not yet cash. The cash flow statement subtracts these receivables to show the actual cash on hand. This process ensures that the report reflects liquidity rather than just theoretical profit.

The history of these statements traces back to the 19th century. In 1863, the Dowlais Iron Company faced a significant problem. The company had recovered from a slump and showed a profit. However, it had no cash to invest in a new blast furnace. To explain this, a manager created a "comparison balance sheet." This document showed the company held too much inventory instead of cash. This discovery was the genesis of the modern cash flow statement. Later, in 1973, the Financial Accounting Standards Board (FASB) in the United States began defining rules for reporting funds. By 1987, FASB Statement No. 95 made these statements mandatory in the US.

International rules also provide a framework for these reports. In 1992, the International Accounting Standards Board (IASB) issued International Accounting Standard 7, or IAS 7. This standard became effective in 1994 and mandates cash flow reporting globally. While US GAAP and IAS 7 are similar, they have important differences. IAS 7 requires reporting changes in both cash and cash equivalents. US GAAP permits using cash alone or including equivalents. Additionally, IAS 7 allows interest paid to be reported as either operating or financing activities. In contrast, US GAAP requires interest paid to be in operating activities.

There are two primary methods used to prepare these statements. The direct method is often considered easier to understand. It reports major classes of gross cash receipts and gross cash payments. However, the indirect method is almost universally used by businesses. The indirect method starts with net income as a base. It then makes a series of additions and deductions to adjust for non-cash items. For instance, an increase in a current asset is subtracted from net income. Conversely, an increase in a current liability is added back to net income. This method converts accrual-basis net income into actual cash flow.

Many different groups rely on these statements to make critical decisions. Accounting personnel use them to ensure the company can cover payroll. Potential lenders and creditors examine them to judge a company's ability to repay loans. Potential investors use the data to decide if a firm is financially sound. Even employees and contractors look at these reports to see if compensation is affordable. Company directors use them for governance to ensure the company is not trading while insolvent. Ultimately, the statement helps predict future cash flows and a firm's financial flexibility.