The Cash Flow Statement - Part II

Another simple test of the accuracy of the financial accounts is the cash flow statement, because if a completed cash flow statement shows changes in cash which when added to the opening cash balance (cash balance on the prior period balance sheet) does not add back to the closing cash balance (cash balance on this period's balance sheet), then it is clear that something went wrong when the Cash Flow Statement was prepared.

After completing your cash flow statement, you should close it by ensuring that the cash balance reconciles back to the cash balance on the balance sheet.

There are two main method of preparation for the cash flow statement. The Indirect method is the more common of the two, but the Direct method has been gaining exposure over the years. In the example shown above (part 1), the cash flow statement was prepared using the Indirect method, and as you can see the approach used is to reconcile net income to cash.

The need for a cash flow statement arise from the fact that financial accounts is prepared on what is known as the accrual basis, matching expenses to revenue in the period in which they are incurred and not when they're paid. This accrual basis accounting process leads to the calculation of net income (revenue less expenses), which bears no relationship to the actual flow of cash.

In adjusting the accrual-based financials, the cash flow statement seeks first to adjust net income and then to calculate cash flow from investing and financing activities. Net income is adjusted in the Cash Flow from Operations section of the cash flow, adding back to net income all non-cash charges and subtracting all non-cash income.

Net Income/(Loss)			$100,000
     Add non-cash charges:
Plus depreciation 			  $5,000
Bad Debt write-off		 	  $2,000
     Less non-cash gains:
Gain on sale of business		 $10,000
Equity - earnings of affiliates		  $1,000
	Adjusted Net Income		 $96,000

"Adjusted net income" as shown above is sometimes referred to as Funds Flow and represents the adjusted net income on the Cash Flow Statement before the effects of changes in working capital is factored in. Assessing and applying changes in working capital is the necessary final step to completely convert accrual base net income to cash base net income.

The main working capital items are Accounts Receivable, Inventory and Trade Payable. These are not the only working capital items, but they are the main ones, and the next balance sheet you review will quite likely have these three items listed among a few others.

Why would the change in a working capital item, Accounts Receivable for instance, be relevant to the determination of cash based net income? Relevancy comes from knowing what is Accounts Receivable, and where it comes from. Accounts receivable is the unpaid (customers have not yet paid their invoices) portion of the company's revenue, and should therefore be removed from net income to determine cash-base net income. The example below should add some clarity:
Go to: Cash Flow Example
Go To: Cash Flow - part I