Preparing Financial Statements – The Statement of Cash Flows
Statements of cash ﬂows are the most complicated reports you’ll prepare. It’s much easier when you have accounting software or an accountant to create the report for you. On the plus side, you can tell whether you’ve done it right based on the ending cash balance, which has to equal the current cash number on your balance sheet. Whether you decide to brave it and create this report manually or get some help, it’s a very important report to understand. This statement tracks your cash movement, and it’s the most critical report for keeping your new business aﬂoat.
When you use the cash accounting method, you can just pull numbers from your general ledger, because every transaction originates with cash. It gets more complicated for accrual accounting; the cash itself may be harder to track because you record transactions even when no cash changes hands.
This statement will cover the same period as your statement of proﬁt and loss. It starts with the beginning cash balance for the period (which is the same as the ending cash balance for the last period). Then, there are three categories (formatted on the report as separate sections) that track the cash ﬂowing through your company: operating activities, investing activities, and ﬁnancing activities.
Operating activities include all the day-to-day transactions that bring in or use up cash; mainly, revenues and expenses. Investing activities include buying and selling long-term assets to be used by the company; these may include things such as stocks and bonds, as well as ﬁxed assets and property improvements (for example, paying to have a building renovated). Financing activities include the things you do to raise cash for your company, such as taking out loans or bringing in more equity contributions; they also include the payments you make as you pay down debt or pay out dividends.
Of the three sections, operating activities is the most important. This category speaks to how successfully your business maintains a positive cash position solely through its daily transactions. If your company is generating enough cash to survive from its operating activities, its chances of staying aﬂoat and ﬂourishing are very good.
There are two different formats you can use to prepare your statement of cash ﬂows, but one is far easier (and more commonly used) than the other.
The two styles are direct and indirect; of the two, the indirect is simpler to prepare and much more popular for that reason. The format difference really appears only in the operating activities section; the other sections look the same either way.
The direct method focuses on grouping the major sources of cash receipts and causes of cash payments. For example, cash used to pay for inventory is listed separately from cash used to pay employees. The cash coming in and the cash going out are summed to come up with the total cash provided (or used, if it’s negative) by operating activities.
The indirect method starts with your net income (loss) for the period and converts it into cash ﬂow. For example, noncash expenses such as depreciation are added back to the bottom-line number, and accruals and deferrals (used in accrual basis accounting) are converted into their cash effect. Here’s how a conversion works: A decrease in accounts receivable from the period prior to this one indicates more cash has come in, since accounts receivable decreases based on customer payments. That converts on-account sales information into the cash effect for this period. The basic conversion strategy is this: Increases in assets, such as accounts receivable, translate to decreases in cash, and vice versa. Increases in liabilities, such as accounts payable, translate to increases in cash, and vice versa.
A Sample Statement, Indirect Method
Since statements of cash ﬂow can get pretty complicated, this example is a simpliﬁed version. To create one of your own, you’ll need the balance sheets from both the current period and the prior period, as well as a cur- rent statement of proﬁt and loss. (Note: numbers in parentheses indicate amounts that have to be subtracted.)
Statement of Cash Flows for the Year Ended December 31, 2006
Cash flows from operating activities
Net Profit $10,000
Adjustments to convert net income into net cash provided by operations:
Depreciation expense: $500
Decrease in accounts receivable: 650
Increase in prepaid expenses: (300)
Increase in accounts payable 450 $1,300
Net cash provided by operating activities: $11,300
Cash flows from investing activities
Equipment purchase: $(6,500)
Net cash used by investing activities: $(6,500)
Cash flows from financing activities
Owner withdrawals: $(3,000)
Net cash used by financing activities: $(3,000)
Net increase in cash: $1,800
Cash at beginning of period: $3,200
Cash at end of period: $5,000
Remember, the bottom line on the statement of cash ﬂows—your cash at the end of the period—must equal the cash ﬁgure on your current balance sheet.