Finance Essentials: Cash Flow Statement

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The cash flow statement is showing how much cash is generated by the company’s activities and starts with the bottom line from the income statement – net income. Net income should approximate  the cash that the company earned or lost during last period, but there are some adjustments that has to be made to arrive to the correct number.

In order not to overcomplicate  our example we will not take into consideration accounting details like depreciation, amortization, accrued and deferred expenses, and we will assume that the inventory bought during the period is sold in the same period.

When a company sells a product, the customer has to pay for it. Very often this payment is deferred in time and until the actual payment is completed, the company will register this amount as account receivable in the balance sheet. This will indicate the money customer owes to the company. The company recognizes the revenue from the sale of the product in the income statement, but has yet to receive the cash from it. So the net income in the cash flow statement has to be corrected with the change of accounts receivable balance.

Opposite to the accounts receivable of the company stay accounts payable. That’s the money that company owes to its vendors. Again as with accounts receivable the payments to the vendors could be deferred and so there will not be an actual cash outflow from the company. This change should be adjusted in the cash flow statement as well.

Accounts receivable and payable are critically important for cash flow management. If collecting money from customers for example slows down, some companies will slow down payments to their vendors in order to manage their liquidity.

So net income from the Income Statement, adjusted with the changes in accounts receivable and accounts payable should represent the cash flow from operations (with the assumption made in the beginning of the article). That is the core cash flow of the business. This number is different from the net income and you, as an entrepreneur, should be able to understand what is driving the difference, are there any issues and how could they be solved.

When you subtract from your cash flow from operations capital expenditures, such as purchases of machinery and equipment, and adjust for financing activities, such as raise of equity or debt pay off, you arrive at your net cash. These cash flows from investing and financial activities are separated in order to have clear view over the cash flow from operating activities.

That net cash line, from the Cash Flow statement, flows to the Balance Sheet cash line and this is how the three separate statements tie up all together at the end.

It is very important for you as an entrepreneur to understand the difference between the net income and the actual cash flow. That requires that you really know how to manage your accounts receivable, accounts payable and inventory.

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