For many years, the accounting profession worked to get a grip on how to report the information contained in the statement of cash flows. In the 1960s, a funds statement was developed to meet the need for public companies to report this information. It languished from lack of attention. It wasn’t until late 1987 that the Accounting Principles Board established the format for the statement of cash flows.

I had a business school professor who liked to claim, “No one went broke making a profit.” Well, the statement of cash flows shows you how it can be done. If your collections don’t keep up with your payment obligations, you’ll run out of cash and be forced into bankruptcy. All those accounts receivable propping up the balance sheet lose cash value if they can’t be collected. Creditors prefer steak to paper, but will take potatoes if that’s all you have left.

The information in the income statement and the balance sheet comes from end-state accounts. The statement of cash flows (Table 3-3) is the only report that uses “flow” information. Changes in the cash flow can often explain why balance sheet accounts changed. The statement is also useful in projecting the liquidity of a business over time. One clear thing it will show is how a business uses the profits that it generates.

The first section of the statement is for operating activities. Operating activities are those things that generate cash income. These include sales receipts as well as inventory or manufacturer purchase. Cash from operations can be negative, and often is, especially in growing companies. At the start, operating losses rise as cash is spent for expenses. As you add business, you start to book some revenue. A lot of that revenue is in the form of accounts receivable, so your cash collection rate is a bit slow. Not for nothing is it called cash burn. Without loans or personal capital coming in to feed the fire, a company can be reduced to cinders.

A lot of that cash is going to investing activities. Investments are the power tools, shop buildings, and office equipment needed to get things started. It doesn’t matter if you are buying them outright or financing them, you’ll have to account for them. How you chose to pay for your assets will affect your cash flow. Which path you choose will depend on several variables—amount, interest rate, expected payback time, and forecast of future cash flows.

If you chose to use debt financing, the financing activities section is where you’ll record the loan proceeds. This section also shows the gozintas and gozoutas of cash to the owners through stock purchases, dividend payments, or shareholder loans.

Many companies are woefully undercapitalized, sometimes by owner intent, often through ignorance of the need. To be competitive, business owners and managers must continually plan to keep the cash flowing into the company. The U. S. Small Business Administration names ineffective cash flow management as one of the top reasons why firms fail.

There are two methods used to present statement of cash flows information, the indirect method (as in Table 3-3) and the direct method. The methods are different in their treatment of operating activities only. Most companies use the indirect method, because it’s easier. Most banks prefer the direct method, as it provides more information.

The indirect method does not report the operating cash flows. Instead, the operating activities section reconciles net income and net operating cash flows. You start with the net income from your income statement. You then adjust this accrual amount for items that do not affect cash flows. There are three basic types of adjustments in the operating activities section. The first involves non-cash outlays, such as depreciation or amortization. Then, adjust for gains and loses on transactions reported in other sections of the statement of cash flows. Finally, convert all current operating assets and liabilities from the accrual to the cash basis.

Table 3-3. Statement of cash flows

A way to visualize the cash coming in is with a corollary of the accounting equation (Table 3-4).

In the direct method, the net cash flow from operations is computed directly as the net sum of the operating cash flows. Your firm will do one or the other. Ask about why the particular

Table 3-4. Accounting equation

statement form was chosen and just learn it

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