KPMG Accounting Basics Video Series Statement of Cash Flow

Developed by Dr. Gia Chevis, Baylor University

KPMGUniversityConnection.com

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Did you hit your earnings target? What kind of margin are you
getting? Many people focus on the income statement.





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The statement of cash flows is sometimes viewed as the more
mysterious cousin. This is a shame, because it can be extremely
informative and is important to monitor.





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After all, without the ability to generate cash, a company cant pay
its bills. And that doesnt usually turn out well.





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Think about it. You start the period with an opening balance
sheet a list of what you own (your assets), what you owe
(your liabilities), and the equity residual. There are three types of
transactions that account for the changes between the opening
and closing balance sheets.





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The first is a shuffling of the balance sheet components. If you
receive inventory and havent paid your supplier, you have more
asset inventory and more liability accounts payable. No
expense has been incurred on the income statement, reducing the
equity account retained earnings, and no cash has changed hands.





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The second is an accrual change affecting the income statement
and balance sheet. If you perform a service for a customer who will
pay you later, you have more asset accounts receivable and more
revenue on the income statement, increasing retained earnings.
But again, no cash has changed hands.





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The third is a cash flow change. When you pay your bill, you have
less cash and less accounts payable; there is no income statement
effect. When you receive the customer payment, you have more
cash and less accounts receivable; again no income statement
effect. When you pay your accountants their well-deserved salary,
you have less cash and more wage expense on the income
statement, reducing retained earnings the balance sheet, income
statement, and statement of cash flows are ALL affected.




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Picture the income statement and the statement of cash flows
dropping into the balance sheet, explaining how you got from
where you started to where you ended up. The statement of cash
flows contains three main sections. Each links to particular parts
of the income statement and balance sheet. The first is Cash Flows
from Operating Activities.





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No, not that kind of operation.





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These are cash flows from the day-to-day operation of your
company. The section links revenues and expenses with the
related current assets and liabilities. Remember, changes in the
balance sheet can be explained by the income statement and
statement of cash flows together. Comparing the profit and loss
from operations to changes in working capital balance sheet
accounts show what the operating cash flows were.





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The second is Cash Flows from Investing Activities. This shows
how your company has used cash for capital purposes to buy
and sell land, equipment, and other long-term assets that provide
the production capacity to handle operations.





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The third is Cash Flows from Financing Activities. This shows
your companys cash flows from the long-term business financing
needed to obtain capacity, such as paying dividends, taking out
long-term loans, issuing stockall the cash flows associated with
the long-term liability and equity sections of the balance sheet.





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Theres a bonus section at the bottom of the statement of cash flows
that details major non-cash investing and financing transactions,
such as the settling of a long-term loan with newly-issued common
stock, or with assets, instead of cash. Even the statement of cash
flows presents some non-cash information!





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All companies need to present each section. And everybodys
investing, financing, and bonus sections follow the same format.
But for the operating section, you can choose one of two ways to
present the information: the direct method or the indirect method.





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The most popular, because it is the easiest to create, is the indirect
method. It starts with net income and proceeds through two
steps. First, you adjust income for all of the non-cash items:
adding back depreciation and amortization; adding back losses
and subtracting gains from disposals and investments; and so on.
Then the changes in current assets and current liabilities are added
and subtracted as appropriate: decreases in current assets and
increases in current liabilities are added because they represent
net cash in; increases in current assets and decreases in current
liabilities are subtracted because they represent net cash out.



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For example, if the balance in accounts receivable decreases
over the period, you have a net cash inflow because more old
customers paid you than new ones owed you money. If the
balance in accounts payable is lower at the end of the year, on
net you must have paid more old bills than incurred new ones
a net cash outflow.





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In the other, direct method, each income statement item is linked
with the specific current assets or current liabilities that relate to
it. For example, revenue has two related balance sheet current
accounts: accounts receivable and unearned revenue. This is because
of the potential for a timing difference between when the company
recognizes revenue and when it collects cash. A company could be
paid in advance, at the same time as they deliver on their promise,
or after the task is completed. If theyre paid in advance, they have
a cash flow that isnt included in revenue. If theyre paid afterwards,
they have revenue that isnt cash yet. So to figure out how much
cash is actually collected from customers, the company needs to
adjust the revenue amount for changes in unearned revenues and
accounts receivable.

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Another group includes cost of goods sold with inventory and
accounts payable. We find appropriate groups for the rest of the
operating expenses, current assets, and current liabilities. The direct
method is more complicated to produce, but it more clearly provides
useful information about cash collected from customers, cash paid
to suppliers, and other components of operating cash flow.





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The cash flow statement is an important part of financial reporting.
Companies might have a lot of profits but not a lot of cash flow
and vice versa. This could be a signal of trouble on the horizon or
of fraud. Dont ignore this statement. Looking at all the statements
will give you a better sense of how a company is doing and
provide valuable insights into its future performance.





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