I recently developed a new found respect for the statement of cash flows. Perhaps it was a client telling me it was a meaningless statement that didn't accurately portray their cash flows. But it did, and I learned a thing or two in the process.
First, some background. Cash flow statements are pretty easy to do (despite what young staff accountants think). Say cash was $250,000 last year, and this year it is $150,000. Cash decreased $100,000. Since this statement is driven by the balance sheet, if cash decreased $100,000, all other accounts have increased by $100,000. That is what keeps everything in balance. Figure out the change in each other line item in the balance sheet, and you can explain how your cash decreased by $100,000.
Cash flow statements are divided into three sections:
- Cash flows from operating activities
- Cash flows from investing activities
- Cash flows from financing activities
SFAS No. 95 specifically defines what items go into investing and financing activities. Investing activities are from the asset side of the balance sheet, and generally involve cash flows from property and equipment, investments, and loans. Cash flows from financing activities involve liabilities and equity, and generally involve cash flows from debt borrowings and repayments, equity investment by owners and distributions to owners. That's it. Everything else goes in operating activities.
Practically speaking, cash flows from investing and financing activities are very quickly determined - there are only a few things that get reported there.
So, let's return to our earlier example where cash decreased $100,000. We have further determined that cash flows from investing activities was a negative $30,000 - as in the Company spent $30,000 to buy more property and equipment. Cash flows from financing activities are a positive $50,000 - the Company borrowed $90,000 on a bank note and repaid $40,000.
We now know what cash flows from operating activities must be: -$100,000 (our total negative cash flow) = x (operating cash flow) - $30,000 (investing) + $50,000 (financing). Solve for x and you see that cash flow from operating activities was a negative $20,000. A whole bunch of items make up cash flow from operating activities, but they add to a negative $20,000.
I started by saying that I have a new found respect for the statement of cash flows. In this situation, the reporting company felt there were expense items that belong in a prior year, and as a result their current year would look better. I disagreed. I also realized that even if a prior year adjustment was right, the subtotals would still be the same - cash flows from financing activities wouldn't change, cash flows from investing activities wouldn't change, and for that matter neither would beginning or ending cash. All the adjustment would do was change the makeup of the items that you added together to get operating cash.
In this case, the cash flows statement showed a true story - the company was not generating cash from operations. This was not something that could be fixed by pushing what I believed where current year expenses into a prior year.
Moral of the story: Cash is king, and the statement of cash flows can actually tell you a story about the king.