The Basis of the Cash Flow Statement

Think of cash flow this way: each inflow and outflow makes a change on the balance sheet. Even inflows from net income increase retained earnings. Really, all the cash flow statement does is show you the change in each of the balance sheet accounts, including the cash account.

Each change in the balance sheet represents either a net source or use of cash. For example, your accounts payable decreased by $26,745, meaning that you had to find the cash to pay it down. It is a use of cash. However, your accounts receivable increased by $5,268. This means that you did not have that extra $5,268 in your bank account, because it has not been collected yet. It is also a use of cash.

There are a few things to keep in mind while preparing your cash flow statement:

Non-cash items: Because the cash flow statement is concerned only with cash inflows and outflows, you will want to make sure that you do not take into consideration any non-cash items that appear on the balance sheet. The major one is the change in retained earnings due to depreciation expense for the year. The actual cash flow from the capital asset happened when the asset was purchased. Depreciation only tries to bring that original cost into expenses over time. No cash changes hands. Depreciation, therefore, must be excluded from your cash flow statement. You do this by starting with the net income number and adding the depreciation expense back into it. Doing so gives you what the net income would have been if it didn't have any depreciation (but not the income on a cash basis - that comes from the calculation of cash flow from operating activities).

Capital assets: A related issue is the change in capital assets on the balance sheet. This change could include three things: increases in the account due to capital asset purchases, decreases due to capital asset sales, and depreciation expense for the current year. As explained above, you must exclude the depreciation from the calculation, as no cash changed hands. Your cash flow statement will include only purchases and disposals of capital assets.

Retained earnings: Although your cash flow statement looks at the changes in the balance sheet accounts, you must handle the change in retained earnings in a different manner than changes in the other accounts. You'll remember from precvious session that retained earnings increases by the net income after taxes for the year (or decreases by the net loss) and decreases by dividends paid to the shareholders. The format of the cash flow statement breaks these elements into two pieces: the net income (or loss) is considered to be cash flow from operating activities, and dividend payments are cash flow from financing activities.