The statement of cash flows might be the most underappreciated and misunderstood piece of a company’s annual report—in essence, the statement of cash flows informs you of cash entering and leaving a business. This can be important information, since even a business that reports positive net income on its statements might not have enough cash in the bank to cover its bills. You can gain significant insight into the financial health and long-term viability of your company by reviewing the statement of cash flows.
The statement of cash flows is generally organized into three sections, under Generally Accepted Accounting Principles (GAAP):
1. Operations
This first section is concerned with cash flows from selling products and services, and typically starts with accrual-basis net income. This accrual-basis net income is then adjusted for items related to the normal operation of your business, including:
- Income taxes
- Gains or losses on asset sales
- Depreciation
- Amortization
- Net changes in working capital accounts, such as:
- Inventory
- Accounts receivable
- Prepaid assets
- Accrued expenses and payables
The final result of this calculation is your cash-basis net income. A company may be better off closing than continuing to incur losses if they’ve reported several successive years of negative operating cash flows.
2. Investing activities
This section includes transactions involving the buying or selling of property, equipment, and marketable securities. It reveals if a company is reinvesting in future operations or divesting assets for emergency funds.
3. Financing activities
Finally, this last section includes cash flows from raising, borrowing and repaying capital—it helps to highlight a company’s ability to obtain cash from lenders and investors, through principal repayments, dividends paid, new loan proceeds, issuances of securities or bonds, or additional capital contributions by owners.
At the bottom of the statement of cash flows—or in a narrative footnote disclosure—capital leases and noncash transactions will be reported in a separate schedule. So, if you’ve purchased equipment directly using loan proceeds, the transaction will appear at the bottom of the statement—and not as a cash outflow from investing activities and an inflow from financing activities.
For U.S. companies entering into foreign currency transactions, the effect of exchange rate changes is generally reported as a separate item in the reconciliation of beginning and ending balances of cash and cash equivalents.
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