The balance sheet, income statement, and cash flow statement are the three generally accepted financial statements used by most businesses for financial reporting.  All three statements are prepared from the same accounting data, but each statement serves its own purpose.  The purpose of the cash flow statement is to report the sources and uses of cash during the reporting period. 

Structure of the Cash Flow Statement

The most commonly used format for the cash flow statement is broken down into three sections:  cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.

Cash flows from operating activities are related to your principal line of business and include the following:

• Cash receipts from sales or for the performance of services
• Payroll and other payments to employees
• Payments to suppliers and contractors
• Rent payments
• Payments for utilities
• Tax payments

Investing activities include capital expenditures – disbursements that are not charged to expense but rather are capitalized as assets on the balance sheet.  Investing activities also include investments (other than cash equivalents as indicated below) that are not part of your normal line of business.  These cash flows could include:

• Purchases of property, plant and equipment
• Proceeds from the sale of property, plant and equipment
• Purchases of stock or other securities (other than cash equivalents)
• Proceeds from the sale or redemption of investments

Financing activities include cash flows relating to the business’s debt or equity financing:

• Proceeds from loans, notes, and other debt instruments
• Installment payments on loans or other repayment of debts
• Cash received from the issuance of stock or equity in the business
• Dividend payments, purchases of treasury stock, or returns of capital

Cash for purposes of the cash flow statement normally includes cash and cash equivalents.  Cash equivalents are short-term, temporary investments that can be readily converted into cash, such as marketable securities, short-term certificates of deposit, treasury bills, and commercial paper.  The cash flow statement shows the opening balance in cash and cash equivalents for the reporting period, the net cash provided by or used in each one of the categories (operating, investing, and financing activities), the net increase or decrease in cash and cash equivalents for the period, and the ending balance.

There are two methods for preparing the cash flow statement – the direct method and the indirect method.  Both methods yield the same result, but different procedures are used to arrive at the cash flows.

Direct Method

Under the direct method, you are basically analyzing your cash and bank accounts to identify cash flows during the period.  You could use a detailed general ledger report showing all the entries to the cash and bank accounts, or you could use the cash receipts and disbursements journals.  You would then determine the offsetting entry for each cash entry in order to determine where each cash movement should be reported on the cash flow statement.

Another way to determine cash flows under the direct method is to prepare a worksheet for each major line item, and eliminate the effects of accrual basis accounting in order to arrive at the net cash effect for that particular line item for the period.  Some examples for the operating activities section include:

Cash receipts from customers:

• Net sales per the income statement
• Plus beginning balance in accounts receivable
• Minus ending balance in accounts receivable
• Equals cash receipts from customers

Cash payments for inventory:

• Ending inventory
• Minus beginning inventory
• Plus beginning balance in accounts payable to vendors
• Minus ending balance in accounts payable to vendors
• Equals cash payments for inventory

Cash paid to employees:

• Salaries and wages per the income statement
• Plus beginning balance in salaries and wages payable
• Minus ending balance in salaries and wages payable
• Equals cash paid to employees

Cash paid for operating expenses:

• Operating expenses per the income statement
• Minus depreciation expenses
• Plus increase or minus decrease in prepaid expenses
• Plus decrease or minus increase in accrued expenses
• Equals cash paid for operating expenses

Taxes paid:

• Tax expense per the income statement
• Plus beginning balance in taxes payable
• Minus ending balance in taxes payable
• Equals taxes paid

Interest paid:

• Interest expense per the income statement
• Plus beginning balance in interest payable
• Minus ending balance in interest payable
• Equals interest paid

Under the direct method, for this example, you would then report the following in the cash flows from operating activities section of the cash flow statement:

• Cash receipts from customers
• Cash payments for inventory
• Cash paid to employees
• Cash paid for operating expenses
• Taxes paid
• Interest paid
• Equals net cash provided by (used in) operating activities

Similar types of calculations can be made of the balance sheet accounts to eliminate the effects of accrual accounting and determine the cash flows to be reported in the investing activities and financing activities sections of the cash flow statement.

Indirect Method

In preparing the cash flows from operating activities section under the indirect method, you start with net income per the income statement, reverse out entries to income and expense accounts that do not involve a cash movement, and show the change in net working capital.  Entries that affect net income but do not represent cash flows could include income you have earned but not yet received, amortization of prepaid expenses, accrued expenses, and depreciation or amortization.  Under this method you are basically analyzing your income and expense accounts, and working capital.  The following is an example of how the indirect method would be presented on the cash flow statement:

• Net income per the income statement
• Minus entries to income accounts that do not represent cash flows
• Plus entries to expense accounts that do not represent cash flows
• Equals cash flows before movements in working capital
• Plus or minus the change in working capital, as follows:
• An increase in current assets (excluding cash and cash equivalents) would be shown as a negative figure because cash was spent or converted into other current assets, thereby reducing the cash balance.
• A decrease in current assets would be shown as a positive figure, because other current assets were converted into cash.
• An increase in current liabilities (excluding short-term debt which would be reported in the financing activities section) would be shown as a positive figure since more liabilities mean that less cash was spent.
• A decrease in current liabilities would be shown as a negative figure, because cash was spent in order to reduce liabilities.

The net effect of the above would then be reported as cash provided by (used in) operating activities.

The cash flows from investing activities and financing activities would be presented the same way as under the direct method.