Statement of Cash Flows

The statement of cash flows is a financial statement that shows the changes in a company’s cash balance during a particular period. It reflects the inflows and outflows of cash and cash equivalents, including revenue, expenses, investments, and financing activities.

Cash flow statement is one of the three main financial statements, along with the balance sheet and income statement. While the balance sheet reports a company’s financial position at a specific point in time and the income statement reports its profitability over a period of time, the statement of cash flows focuses on the movement of cash in and out of the company.

It provides investors and creditors with critical information about the cash flow generated during an accounting period and how it was utilized.

Structure of the Cash Flow Statement

The components of the cash flow statement are divided into three main sections:

  1. Cash Flow from Operating Activities: Cash flow from operating activities highlights the cash inflows and outflows that result from normal business operations. It includes cash received from customers, cash paid to suppliers and employees, and other cash expenses related to operating the business.
  2. Cash Flow from Investing Activities: Cash flow from investing activities details the revenues and expenses related to investments in long-term assets like property, plant, and equipment, and the sale or acquisition of equity securities.
  3. Cash Flow from Financing Activities – Cash flow from financing activities covers cash inflows and outflows related to equity and debt financing. It includes the issuance of stock, the repayment of loans, and the payment of dividends.

Direct and Indirect Cash Flow Methods

There are two main methods of calculating operating cash flows: direct and indirect.

  • Direct Method 

The direct cash flow method reports actual cash inflows and outflows from operating activities, providing a more detailed and accurate picture of a company’s cash flows from operating activities. It directly reports the cash receipts and payments from customers, suppliers, and other operating activities.

Under the direct method, the cash inflows from operating activities are reported by subtracting the cash payments made to suppliers, employees, and other operating expenses from the cash received from customers. This method allows for a more granular understanding of the sources and uses of cash within a company’s operating activities.

For example, if a company receives $100,000 from customers during a period, but pays $50,000 to suppliers and $30,000 to employees, the cash inflow from operating activities under the direct method would be $20,000 ($100,000 – $50,000 – $30,000).

The direct method also requires the reporting of interest and dividends received and paid, as well as income taxes paid. These items are typically reported separately from the cash flows from operating activities in the statement of cash flows.

  • Indirect Method 

The indirect method adjusts the net income for non-cash items and changes in operational accounts to provide the net cash flow from operating activities. It is more widely used and requires less detailed information to prepare.

The indirect cash flow method is a method of preparing the statement of cash flows that starts with net income and adjusts for non-cash transactions and changes in current assets and liabilities to arrive at the cash flow from operating activities. It is a simpler and less time-consuming method compared to the direct method of preparing the statement of cash flows.

Under the indirect method, the net income reported on the income statement is adjusted for non-cash items such as depreciation and amortization, and gains or losses on the sale of assets. It is then adjusted for changes in current assets and liabilities, such as accounts receivable, accounts payable, and inventory.

For example, if a company had net income of $100,000 for the period, and the accounts receivable balance increased by $30,000 during the period, the indirect method would deduct $30,000 from the net income to arrive at the cash flow from operating activities. This is because the increase in accounts receivable indicates that cash was not received during the period for some of the revenue that was earned.

The direct method provides a more detailed and accurate picture of a company’s cash flows from operating activities, it can be more time-consuming and resource-intensive to prepare. As a result, many companies opt for the indirect method.

While the indirect method provides a simpler and less time-consuming way to prepare the statement of cash flows, it may not provide as much detail or accuracy as the direct method. However, it is widely used and accepted by companies and investors and is a useful tool for understanding a company’s cash flows and liquidity.