There’s a common saying I always use when I’m trying to figure out an accounting issue – Cash is king!
Generally, this saying means that cash is the most valuable asset in a company. From an accounting perspective, I usually mirror that thinking with the rationale that we need to fully understand our cash movements in any transaction. Cash, being the most liquid asset a company owns, is the most easily misappropriated or stolen, and so we need strong controls over our company’s cash. By liquid, we don’t mean it is literally liquid. We mean that it can be used with ease.
The statement of cash flows is the financial statement used by accountants, management and investors to understand how cash came into the company and how it went out in a given period. Since a lot of stakeholder are concerned with cash, it’s extremely important that we accountants understand exactly what happened with our cash in the period, so we can confidently answer questions that are asked to us. In this blog, I’ll go over the basics of the statement of cash flows, as well as some of the key things I look at when I’m reviewing a cash flow prepared by someone on my team.
As we know, the statement of cash flows is broken down into three sections:
Cash provided by / used in operations
This section shows the cash ins and outs that relate to the company’s core operations. Typically, this section starts with net income (pulled directly from the income statement) and then we adjust for non-cash items. What are non-cash items? They are the accounting entries that impact our net income but don’t have a cash impact.
Here are a couple common examples:
- Depreciation: Although this is a valid expense in the period (the value of the asset has decreased because we’ve used it), there is no cash movement associated with the expense. We need to remove depreciation and amortization.
- Changes in accounts payables: When a vendor invoices us for a service or good they provided in the period, we typically debit the related expense and credit accounts payable, since we often don’t pay immediately. Again, these are expenses that need to be recorded, but no cash has left the company.
- Changes in accounts receivable: On the other side, when we invoice a client but they do not pay us immediately, our accounts receivable increase. In this case, we need to recognize revenue and the AR asset, but no cash has come into the company yet. In the case where accounts receivable decrease in the period, it means clients have paid us and cash has come in – we need to show this in the cash flow statement.
Generally, I always look at the cash from operations to determine the health of the business. If we have a positive figure here, it means our core operations are bringing in enough cash to pay our expenses and run the business – that’s the first step in a profitable company!
Cash provided by / used in investing activities
This section shows the cash ins and outs that relate to investments made by the company. Things like buying buildings or equipment would be examples of cash used in investing activities. These purchases are made to keep building the business. Cash provided by investing activities would be the opposite – if we make sales of assets we invested in.
Typically, when I see a negative balance here, it means the company is growing, as they’re investing in themselves. If I see a positive balance, it might mean the opposite, the company is selling off assets in order to downsize or maybe restructure their operations.
Cash provided by / used in financing activities
This section shows how the company supports its operations if it is not earning positive cash flows. A positive balance in this section means cash is coming in from external sources (banks providing loans, investors buying shares). A negative balance means those external sources are being repaid. This section is a bit trickier to analyze in terms of health of the company. A large positive balance may mean huge expansion plans for a company, or it may mean the company is struggling to sustain operations and needs more cash to keep the lights on.
Any other things you look at when you review a cashflow, or key lines you like to dig into? Let us know in the comments below!