Understanding the Cash Flow Statement
The cash flow is a required statement for a complete financial statement package.
There are two methods to the cash flow reporting in the operating section: Direct vs. Indirect method.
The direct method deducts the sales that were actually received in cash and only the operating expenses where cash was paid. This method provides the users of financial statements with the information they are looking for to make informed decisions. The direct method assumes each item on the income statement is listed in an accrual basis of accounting and therefore converts the items into a cash basis.
Example of the direct method
The indirect method starts off with a net income in an accrual basis and indirectly adjusts non-cash items to come to the actual cash received or paid during the course of business. This method provides a more detailed description and breaks down each type of addition or deduction in the operating activities of the cash flow statement.
Example of the indirect method:
Both sections will yield the same results no matter which type of method is used.
The cash flow's consist of three sections.
- Operating Activities
- Financing Activities
- Investing Activities
We will get into each section below.
Cash flow statement example
Get a Cash Flow Statement template here
The cash flows from operating activities provides information about the company's main revenue generating activities listed on the income statement. The cash flows from operations generally includes the cash collected from the sale of products, purchases, and other expenses related to the operation.
The cash flows from financing activities are the changes of capital or borrowings in a company. Long term borrowings to repaying debt borrowed from banks are reported here. Also, issuing, buying stocks (treasury stock) and payment of dividends are reported in this section.
The cash flows from investing activities include the disposal or acquisition of fixed assets, investments (marketable securities) or other non current assets. Also listed in the investment activities are the purchase or sale of a business or a part of a business, like a franchise.
Where do the numbers come from?
The cash flow statements uses the balance sheet's current year and prior year and the differences between the two. It also uses the income statement for the net income and to add or remove any non-cash items.
What is the preferred method?
The International Accounting Standards Board (IASB) prefers the direct method because it provides useful information compared to the indirect method. However, approximately 98% of companies use the indirect method since the direct method converts each item on the income statement to a cash basis since it assumes the accrual basis is used.
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