Financial statements paint a detailed picture of a company's financial health, but

many business owners pay attention to the net income statement and balance
sheet and ignore the cash flow statement. A profitable company that uses accrual
accounting could even have a negative cash flow. To clearly understand if a
company can cover expenses and liabilities, its owner must regularly assess the
cash flow statement.
The Cash Flow Statement
A cash flow statement records a company's cash inflows and outflows -- the amount
of cash and cash equivalents entering and leaving a company during a specified
period. The cash flow statement enables the owner, managers, bankers and
suppliers to view the companys operations from a cash perspective so they better
understand how smoothly the operations are running, where growth funding is
coming from and how wisely the money is spent. The cash flow statement shows
sources of cash, including operations, financing and investing.
Operational Cash Flow
Operational cash flow measures cash inflows and outflows from core business
activities. This section clearly shows whether a companys revenue structure can
cover all expenditures. If the revenues cannot, the net operating cash flow will be
negative. If a company has a problem collecting on its receivables or is amassing
unsold inventory, that will be reflected in operational cash flow. Cash flow may also
vary depending on the monitoring period. Monitoring the cash and projecting
operating cash flow out of the business can identify potential shortfalls in advance.
Financing Cash Flow
When a company has insufficient operating cash, it must generate cash through
financing or investing activities. Financing cash flow measures cash generated by
financing activities, including new debt and equity plus repayments and dividends.
Changes in the liabilities and shareholders equity section of the balance sheet are
reflected here. For example, a tech company that received a venture capital
investment round will show the proceeds in the financing cash flow section. New
financing done solely to replace old financing could be a warning sign.
Investing Cash Flow
Investing cash flow measures cash generated from investing activities, including
purchases or sales of equipment, property or a subsidiary. Changes in items
reflected in the asset section of the balance sheet are recorded here. Growing
companies typically show a negative investment cash flow due to all the capital
expenditures. Struggling, asset-rich companies often show continual asset sales
that offset negative or low operational cash flow.
Periodic Review of the Cash Flow Statement
Generally, the higher the operational cash flow, the stronger the company. By
periodically reviewing the cash flow statement, rapidly growing companies can
identify the need for cash and use financing to cover the shortfalls. A troubled

company could head off financial distress by noticing negative operating cash,
minimal investing cash and significant financing cash flow. The owner who sees this
could restructure operations and revamp the financing structure
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Importance Of Cash Flow Statement

The cash flow statement provides information regarding inflows and outflows of
cash of a firm for a period of one year. Therefore cash flow statement is important
on the following grounds.
1.Cash flow statement helps to identify the sources from where cash inflows have
arisen within a particular period and also shows the various activities where in the
cash was utilized.
2. Cash flow statement is significant to management for proper cash planning and
maintaining a proper matching between cash inflows and outflows.
3. Cash flow statement shows efficiency of a firm in generating cash inflows from its
regular operations.
4.Cash flow statement reports the amount of cash used during the period in various
long-term investing activities, such as purchase of fixed assets.
5. Cash flow statement reports the amount of cash received during the period
through various financing activities, such as issue of shares, debentures and raising
long-term loan.
6. Cash flow statement helps for appraisal of various capital investment
programmes to determine their profitability and viability.
End
Basic Accounting:
The Importance of the Cash Flow Statement

Let's take a moment to catch our breath in the discussion of the cash flow
statement, and look at all the information we've absorbed so far and the importance
of the cash flow statement in fulfilling the financial picture for the state of a
business.
The Statement of Cash Flows is the new kid on the block as a member of the
Financial Statement set. This wasn't a required piece of the financial statement set

until 1988. As a result, there are still some areas that need fine tuning; such as the
format used to report the cash flows.
The Statement of Cash Flows is the final document prepared in the
Financial Report set, and provides information that is a direct flow of information
from the Income Statement, Owner Equity Statement and Balance Sheet; therefore,
this report adds validity and accountability to the Financial Statements.
Analysts, investors, stockholders, potential investors and lenders use these reports
in order to assess the financial health of a business. Therefore, it is tremendously
advantageous to use the standard method for generating the Statement of Cash
Flows and provide the additional credibility to the financial information.
A sample Statement of Cash Flows was provided in the first article in this series.
The importance of this report and the ability to accurately read and analyze the
information is invaluable to an accountant. So, take the time to become familiar
with this report, as well as the other 3 that complete the Financial Statement set.
There are 3 major categories for the information that is reported on the
Statement of Cash Flows and they are operating activities, investing
activities, and financing activities. Between the three major areas, every
aspect of a business' transactions is covered. The resulting totals on this report are
direct flows of financial information totals from the other 3 reports in the financial
statement set. The only variance in reporting is in the operating activity area,
concerning the cash transactions. A business may choose to use an indirect or
direct method for reporting cash transactions. If a business chooses to use the
direct method, there must also be a schedule attached that is basically also the
indirect method in order to reconcile the information given in the direct method.
When we read the Statement of Cash Flows there are some basic numbers
that will help you to assess a business; they are:

Net earnings or profit and loss information

Depreciation expense

Changes in inventory

Changes in accounts receivable

Changes in accounts payable

Changes in the "net cash from financing activities" that doesn't reflect
equipment or building additions.

A general knowledge and good grasp of these Financial Statements, especially the
Statement of Cash Flows will provide volumes of information to the reader, and if
you're a potential investor or lender, you cannot know enough about a business
before placing your money or that of your depositors in the operations of that
business. As an accountant, general knowledge will not be enough, but it's a step in
the right direction!

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Cash Flow Statement

A cash flow statement is a financial report that describes the sources of a

company's cash and how that cash was spent over a specified time period. It does
not include non-cash items such as depreciation. This makes it useful for
determining the short-term viability of a company, particularly its ability to pay bills.
Because the management of cash flow is so crucial for businesses and small
businesses in particular, most analysts recommend that an entrepreneur study a
cash flow statement at least every quarter.
The cash flow statement is similar to the income statement in that it records a
company's performance over a specified period of time. The difference between the
two is that the income statement also takes into account some non-cash accounting
items such as depreciation. The cash flow statement strips away all of this and
shows exactly how much actual money the company has generated. Cash flow
statements show how companies have performed in managing inflows and outflows
of cash. It provides a sharper picture of a company's ability to pay creditors, and
finance growth.
It is perfectly possible for a company that is shown to be profitable according to
accounting standards to go under if there isn't enough cash on hand to pay bills.
Comparing amount of cash generated to outstanding debt, known as the "operating
cash flow ratio," illustrates the company's ability to service its loans and interest
payments. If a slight drop in a company's quarterly cash flow would jeopardize its
ability to make loan payments, that company is in a riskier position than one with
less net income but a stronger cash flow level.
Unlike the many ways in which reported earnings can be presented, there is little a
company can do to manipulate its cash situation. Barring any outright fraud, the
cash flow statement tells the whole story. The company either has cash or it does
not. Analysts will look closely at the cash flow statement of any company in order to
understand its overall health.
PARTS OF THE CASH FLOW STATEMENT
Cash flow statements classify cash receipts and payments according to whether
they stem from operating, investing, or financing activities. A cash flow statement is
divided into sections by these same three functional areas within the business:

Cash from Operationsthis is cash generated from day-to-day business

operations.

Cash from Investingcash used for investing in assets, as well as the

proceeds from the sale of other businesses, equipment, or other long-term
assets.

Cash from Financingcash paid or received from issuing and borrowing of

funds. This section also includes dividends paid. (Although it is sometimes
listed under cash from operations.)

Net Increase or Decrease in Cashincreases in cash from previous year

will be written normally, and decreases in cash are typically written in
(brackets).

Although cash flow statements may vary slightly, they all present data in the four
sections listed here.
CLASSIFICATIONS OF CASH RECEIPTS AND PAYMENTS
Cash from Financing
At the beginning of a company's life cycle, a person or group of people come up
with an idea for a new company. The initial money comes from the owners or is
borrowed by the owners. This is how the new company is "financed." The money
that owners put into the company is classified as a financing activity. Generally, any
item that would be classified on the balance sheet as either a long-term liability or
an equity would be a candidate for classification as a financing activity.
Cash from Investing
The owners or managers of the business use the initial funds to buy equipment or
other assets they need to run the business. In other words, they invest it. The
purchase of property, plant, equipment, and other productive assets is classified as
an investing activity. Sometimes a company has enough cash of its own that it can
lend money to another enterprise. This, too, would be classified as an investing
activity. Generally, any item that would be classified on the balance sheet as a longterm asset would be a candidate for classification as an investing activity.
Cash from Operations
Now the company can start doing business. It has procured the funds and
purchased the equipment and other assets it needs to operate. It starts to sell
merchandise or services and make payments for rent, supplies, taxes, and all of the
other costs of doing business. All of the cash inflows and outflows associated with
doing the work for which the company was established would be classified as an
operating activity. In general, if an activity appears on the company's income
statement, it is a candidate for the operating section of the cash flow statement.
Methods of Preparing the Cash Flow Statement

In November 1987, the Financial Accounting Standards Board (FASB) issued a

"Statement of Financial Accounting Standards" which required businesses to issue a
statement of cash flow rather than a statement of changes in financial position.
There are two methods for preparing and presenting this statement, the direct
method and the indirect method. The FASB encourages, but does not require, the
use of the direct method for reporting. The two methods of reporting affect the
presentation of the operating section only. The investing and financing sections are
presented in the same way regardless of presentation methods.
Direct Method
The direct method, also called the income statement method, reports major classes
of operating cash receipts and payments. Using this method of preparing a cash
statement starts with money received and then subtracts money spent, to calculate
net cash flow. Depreciation is excluded altogether because, although it is an
expense that affects net profits, it is not money spent or received.
Indirect Method
This method, also called the reconciliation method, focuses on net income and the
net cash flow from operations. Using this method one starts with net income, adds
back depreciation, then calculates changes in balance sheet items. The end result is
the same net cash flow produced by the direct method. The indirect method adds
depreciation into the equation because it started with net profits, from which
depreciation was subtracted as an expense.
Regardless of whether the direct or the indirect method is used, the operating
section of the cash flow statement ends with net cash provided (used) by operating
activities. This is the most important line item on the cash flow statement. A
company has to generate enough cash from operations to sustain its business
activity. If a company continually needs to borrow or obtain additional investor
capitalization to survive, the company's long-term existence is in jeopardy.
FINANCING AND INVESTING SECTIONS
The cash flows, in and out, resulting from financing and investing activities are
listed in the same way whether the direct or indirect method of presentation is
employed.
Cash Flows from Investing
The major line items in this section of the cash flow statement are as follows:

Capital Expenditures. This figure represents money spent on items that last a
long time such as property, plant, and equipment. When capital spending
increases, it often means the company is expanding.

Investment Proceeds. Companies will often take some of their excess cash
and invest it in an effort to get a better return than they could in a savings
account or money market fund. This figure shows how much the company
has made or lost on these investments.

Purchases or Sales of Businesses. This figure includes any money the

company made from buying or selling subsidiary businesses and will
sometimes appear in the cash flows from operating activities section, rather
than here.

Cash Flows from Financing

The major line items in this section of the cash flow statement include such things
as:

Dividends Paid. This figure is the total dollar amount the company paid out in
dividends over the specified time period.

Issuance/Purchase of Common Stock. This is an important number because it

indicates how a company is financing its activities. New, rapidly growing
companies will often issue new stock and dilutes the value of existing shares
in so doing. This practice does, however, give a company cash for expansion.
Later, when the company is more established it will be in a position to buy
back its own stock and in this way increase the value of existing shares.

Issuance/Repayments of Debt. This number tells you whether the company

has borrowed money during the period or repaid money it previously
borrowed. Borrowing is the main alternative to issuing stock as a way for
companies to raise capital.

The cash flow statement is the newest of the three fundamental financial
statements prepared by most companies and required to be filed with the Securities
and Exchange Commission by all publicly traded companies. Most of the
components it presents are also reported, although often in a different format, in
one of the other statements, either the Income Statement or the Balance Sheet.
Nonetheless, it offers the manager, investor, lender, and supplier of a company a
view into how it is doing in meeting its short-term obligations, regardless of whether
or not the company is generating income.
End

Difference Between Accrual and CashBasis Accounting

Accrual accounting does not record revenues and expenses based on the exchange
of cash, while the cash-basis method does.
LEARNING OBJECTIVE

Differentiate between accrual and cash basis accounting

KEY POINTS

Accrual accounting does not consider cash when recording revenue; in most
cases, goods must be transferred to the buyer in order to
recognize earnings on the sale. An accrual journal entry is made to record the
revenue on the transferred goods as long as collection of payment is
expected.

In accrual accounting, expenses incurred in the same period that revenues

are earned are also accrued for with a journal entry. Same as revenues, the
recording of the expense is unrelated to the payment of cash.

For a seller using the cash method, revenue on the sale is not recognized
until payment is collected and expenses are not recorded until cash is paid.

The cash model is only acceptable for smaller businesses for which a majority
of transactions occur in cash and the use of credit is minimal.

TERMS

liability

An obligation, debt or responsibility owed to someone.

accrue

To increase, to augment; to come to by way of increase; to arise or spring as a

growth or result; to be added as increase, profit, or damage, especially as the
produce of money lent

Definition of Accural Accounting

Under the accrual accounting method, the receipt of cash is not considered when
recording revenue; however, in most cases, goods must be transferred to the buyer
in order to recognize earnings on the sale. An accrual journal entry is made to
record the revenue on the transferred goods even if payment has not been made. If
goods are sold and remain undelivered, the sales transaction is not complete and
revenue on the sale has not been earned. In this case, an accrual entry for revenue
on the sale is not made until the goods are delivered or are in transit. Expenses
incurred in the same period in which revenues are earned are also accrued for with
a journal entry. Just like revenues, the recording of the expense is unrelated to the
payment of cash. An expense account is debited and a cash or liability account is
credited.
Definition of Cash-Basis Accounting
The cash method of accounting recognizes revenue and expenses when cash is
exchanged. For a seller using the cash method, revenue on the sale is not
recognized until payment is collected. Just like revenues, expenses are recognized
and recorded when cash is paid. The Financial Accounting Standards Board (FASB),
which dictates accounting standards for most companiesespecially publicly traded
companiesdiscourages businesses from using the cash model because revenues

and expenses are not properly matched. The cash model is acceptable for smaller
businesses for which a majority of transactions occur in cash and the use of credit is
minimal. For example, a landscape gardener with clients that pay by cash or check
could use the cash method to account for her business' transactions .
end

Cash basis vs. accrual basis accounting

The cash basis and accrual basis of accounting are two different methods used to
record accounting transactions. The core underlying difference between the two
methods is in the timing of transaction recordation.

When aggregated over time, the results of the two methods are approximately the
same. A brief description of each method follows:

Cash basis. Revenue is recorded when cash is received from customers, and
expenses are recorded when cash is paid to suppliers and employees.

Accrual basis. Revenue is recorded when earned and expenses are recorded
when consumed.

The timing difference between the two methods occurs because revenue
recognition is delayed under the cash basis until customer payments arrive at the
company. Similarly, the recognition of expenses under the cash basis can be
delayed until such time as a supplier invoice is paid. To apply these concepts, here
are several examples:

Revenue recognition. A company sells $10,000 of green widgets to a

customer in March, which pays the invoice in April. Under the cash basis, the
seller recognizes the sale in April, when the cash is received. Under the
accrual basis, the seller recognizes the sale in March, when it issues the
invoice.

Expense recognition. A company buys $500 of office supplies in May, which it

pays for in June. Under the cash basis, the buyer recognizes the purchase in
June, when it pays the bill. Under the accrual basis, the buyer recognizes the
purchase in May, when it receives the supplier's invoice.

The cash basis is only available for use if a company has no more than $5 million of
sales per year. It is easiest to account for transactions using the cash basis, since no
complex accounting transactions such as accruals and deferrals are needed. Given
its ease of use, the cash basis is widely used in small businesses. However, the
relatively random timing of cash receipts and expenditures means that reported
results can vary between unusually high and low profits.
The accrual basis is used by all larger companies, for several reasons. First, its use
is required for tax reporting when sales exceed $5 million. Also, a company's

financial statements can only be audited if they have been prepared using the
accrual basis. In addition, the financial results of a business under the accrual basis
are more likely to match revenues and expenses in the same reporting period, so
that the true profitability of an organization can be discerned. However, unless a
statement of cash flows is included in the financial statements, this approach does
not reveal the ability of a business to generate cash.
End
The difference between cash and accrual accounting is important to understand,
whether you plan to handle your own financial statements, or hire an outside
professional. The difference lies in the timing of when sales and purchases are
recorded in your accounts. Read on to understand the implications of using each
accounting method.
Cash Based Accounting
The cash basis of accounting recognizes revenues when cash is received, and
expenses when they are paid. This method does not recognize accounts receivable
or accounts payable. Many small businesses opt to use the cash basis of accounting
because it is simple to maintain. Its easy to determine when the transaction has
occurred (the money is in the bank or out of the bank) and there is no need to track
receivables or payables. The cash method is also beneficial in terms of tracking how
much cash the business actually has at any given time; you can look at your bank
balance and understand the exact resources at your disposal. Also, since
transactions arent recorded until the cash is received or paid, the income isnt
taxed until its in the bank.
Accrual Based Accounting
Under the accrual basis, revenues and expenses are recorded when they are
earned, regardless of when the money is actually received or paid. This method is
more commonly used than the cash method. The upside is that the accrual basis
gives a more realistic idea of income and expenses during a period of time,
therefore providing a long-term picture of the business that cash accounting cant
provide. The downside is that accrual accounting doesnt provide any awareness of
cash flow; a business can appear to be very profitable while in reality it has empty
bank accounts. Accrual based accounting without careful monitoring of cash flow
can have potentially devastating consequences.
The Effects of Cash and Accrual Accounting
Understanding the difference between cash and accrual accounting is important,
but its also necessary to put this into context by looking at the direct effects of
each method. Lets look at an example of how cash and accrual accounting affect
the bottom line differently. Consider the following transactions for a month of
business:
1. Sent out an invoice for $5,000 for a web design project completed this month
2. Received a bill for $1,000 in developer fees for work done this month

3. Paid $75 in fees for a bill you received last month

4. Received $1,000 from a client for a project that was invoiced last month
The Effect on Cash Flow: Under the cash basis of accounting, the profit for this
month would be $925 ($1,000 in income minus $75 in fees). On the other hand,
under the accrual method, the profit for this month would be $4,000 ($5,000 in
income minus $1,000 in developer fees). This example displays how the appearance
of income stream and cash flow can be affected by the accounting process that is
used.
The Effect on Taxes: Now imagine that the above example took place between
November and December of 2013. One of of the differences between cash and
accrual accounting is that they affect which tax year income and expenses are
recorded in. Under the cash basis, income is recorded when you receive it, whereas
with the accrual method, income is recorded when you earn it. Following the above
example, under the accrual basis, if you invoice a client for $5,000 in December of
2013, you would record that transaction as a part of your 2013 income (and thus
pay taxes on it), regardless of if you actually receive the payment in January of
2014.
At the end of the day, both methods only give you part of the business picture, and
deciding on the most beneficial method will likely be an ongoing process as your
business continues to grow. Another important consideration is that some
businesses are required to use the accrual method.
The Bottom Line
While neither method is perfect, you can make the most of the option you choose
by understanding what the numbers produced mean, and using them to answer
your businesss specific financial questions. When it comes to significant accounting
decisions like selecting the cash or accrual method, consulting a professional can
help you feel confident that youve made the best choice for your business, as well
as afford you valuable, strategic advice going forward.
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