Read Understanding Business Accounting For Dummies, 2nd Edition Online
Authors: Colin Barrow,John A. Tracy
Tags: #Finance, #Business
Understanding Business Accounting For Dummies, 2nd Edition (53 page)
Presenting the Cash Flow Statement
The cash flow statement
is one of the three primary financial statements that a business must report to the outside world, according to generally accepted accounting principles
(GAAP). To be technical, the rule says that whenever a business reports a profit and loss account, it should also report a cash flow statement. The
profit and loss account
summarises sales revenue and expenses and ends with the bottom-line profit for the period. The
balance sheet
summarises a business's financial condition by reporting its assets, liabilities, and owners' equity. (Refer to Chapters 5 and 6 for more about these reports.)
You can probably guess what the
cash flow statement
does by its name alone: This statement tells you where a business got its cash and what the business did with its cash during the period. We prefer the name given in the old days in the US to the predecessor of the cash flow statement, the
Where Got, Where Gone
statement. This nickname goes straight to the purpose of the cash flow statement: asking where the business got its money and what it did with the money.
To give you a rough idea of what a cash flow statement reports, we repeat some of the questions we asked at the start of the chapter: How much money did you earn last year? Did you get all your income in cash (did some of your wages go straight into a pension plan or did you collect a couple of IOUs)? Where did you get other money (did you take out a loan, win the lottery, or receive a gift from a rich uncle)? What did you do with your money (did you buy a house, support your out-of-control Internet addiction, or lose it playing bingo)?
The history of the cash flow statement
The cash flow statement was not required for external financial reporting until the late 1980s. Until then, the accounting profession had turned a deaf ear to calls from the investment community for cash flow statements in annual financial reports. (Accountants had presented a
funds flow statement
prior to then, but that report proved to be a disaster - the term
funds
included more assets than just cash and represented a net amount after deducting short-term liabilities from short-term, or current, assets.)In our opinion, the reluctance to require cash flow statements came from fears that the
cash flow from profit
figure would usurp net income - people would lose confidence in the net income line.Those fears have some justification - considering the attention given to cash flow from profit and what is called ‘free cash flow' (discussed later in the chapter). Although the profit and loss account continues to get most of the fanfare (because it shows the magic bottom-line number of net income), cash flow gets a lot of emphasis these days.
Getting a little too personal for you? That's exactly why the cash flow statement is so important: It bares a business's financial soul to its lenders and owners. Sometimes the cash flow statement reveals questionable judgment calls that the business's managers made. At the very least, the cash flow statement reveals how well a business handles the cash increase from its profit.
As explained at the start of the chapter, the cash flow statement is divided into three sections according to the three-fold classification of cash flows for a business:
Cash flow from
operating activities
(which we also call
cash flow from profit
in the chapter):
The activities by which a business makes profit and turns the profit into cash flow (includes depreciation and changes in operating assets and liabilities).
investing activities:
Investing in long-term assets needed for a business's operations; also includes money taken out of these assets from time to time (such as when a business disposes of some of its long-term assets).
financing activities:
Raising capital from debt and owners' equity, returning capital to these capital sources, and distributing profit to owners.
The cash flow statement reports a business's net cash increase or decrease based on these three groupings of the cash flow statement. Figure 7-2 shows what a cash flow statement typically looks like - in this example, for a
growing
business (which means that its assets, liabilities, and owners' equity increase during the period).
The trick to understanding cash flow from profit is to link the sales revenue and expenses of the business with the changes in the business's assets and liabilities that are directly connected with its profit-making activities. Using this approach earlier in the chapter, we determine that the cash flow from profit is £1.1 million for the year for the sample business. This is the number you see in Figure 7-2 for cash flow from operating activities. In our experience, many business managers, lenders, and investors don't fully understand these links, but the savvy ones know to keep a close eye on the relevant balance sheet changes.
