In accrual-based accounting, all the credit and cash transactions are recorded collectively. The financial statements of the business entity also represent the financial data corresponding to credit and cash transactions. It is an accurate method of preparing financial statements because it shows the actual income the company has earned regardless of how much cash payments are received.

Although the principle of a true and fair view of financial health is followed in accrual-based accounting, there is a need for a true statement to show the effect of cash flows. Investors, creditors, and other stakeholders look forward to analyzing the cash flows of a business entity to understand the making and spending patterns of the company.

Therefore, a corporation and public companies must prepare the cash flow statement and other financial statements. This article will take you through the basics of the cash flow statement and its understanding. Besides, the preparation of the cash flow statement by using the indirect method will also be covered.

What Is Statement Of Cash Flows

Statement of cash flow is one of the five financial statements prepared by business entities for every financial period. It is a statement that shows the cash position of the business entity.

It can be defined as,

The statement of cash flows is a financial statement that records and consolidates all the cash operations of the business entity. It records the internal cash transactions related to operating activities and external cash transactions related to investment and financing activities. The net effect of cash inflows and outflows is represented at the end of the statement.

What Does  A Cash Flow Statement Tell?

The positive amount represents that the company has surplus cash or net cash inflow as a result of cash activities. Whereas a negative balance shows cash shortage or net cash outflow from the cash activities.

The negative cash flow balance is usually considered as a bad sign representing poor management of expenses and income. However, it does not necessarily signal the financial weakness of the company. There might be a certain financial period when the company has made a major investment representing huge outflow and negative cash flow balance.

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The cash flow balance of operating activities is usually a point of concern when the cash position or cash management ability is in question.

What Is Included?

The cash flow statement records the aggregate effect of all the cash-related activities incurred by a business entity. The cashflows statement is divided into three broader categories based on the activity type.

Operating Activities

The operating activities are ongoing activities of a business entity that relates to normal business operations. The cash flow from operating activities represents the cash paid or received from the regular business operations.

The example of operating activities varies from business to business. For instance, the retail business will record the purchase and sale of inventory as an operating activity. For a services firm, the provision of services and marketing costs are operating activities.

Investing Activities

The second category in the cash flow statement is cash from investing activities. The investing activities cover all the sources where a company used its cash to gain a return in the future. The cash used for return in the future is a cash outflow from investing activities. On the other hand, if a company has received cash from the investments made(return on investment) is positive cash flow.

The cash flow from investing activities can include purchasing marketable securities, acquiring a property, plant, or equipment for business, or mergers & acquisitions. Similarly, the loan collection from vendors, proceeds of insurance sold, return on marketable securities are also examples of cash flow from investing activities.

Financing Activities

Financing activities fall in the third category of the cash flow statement. The cash flow from financing activities entails the cash inflows from shareholders or creditors and the outflows due to financing costs and payments to shareholders.

Raising share capital, paying out the dividends, stock repurchases, loan proceedings from a bank, etc., are examples of financing activities in the cash flow statement. Payment of the interest on the loan is cash out, and the receiving cash from capital raising is cash in.

Methods To Prepare Statement Of Cash Flows

The statement of cash flow for a company is usually prepared by two methods. The Financial Accounting Standards Board(FASB) prefers the direct method for preparing the cash flow statement. However, many business entities go with the indirect method. Either of the methods used, the end result is the net cash flow of the business entity during a financial period.

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Direct Method

The direct method of preparing the cash flow statement starts from net cash from operating activities. The operating activities corresponding to receipts and payments from normal business operations are recorded. The cash inflows are recorded first. The cash outflows are subtracted to get the net cash from operating activities.

The investing and financing activities are also recorded in the respective sections.

Indirect Method

In the indirect method, data from the accrual accounting system is used and derived to get net cash flow from operating activities. The net profit or loss from the income statement is taken. Necessary adjustments for non-cash expenses and credit purchases or sales are made to reach the net cash from operating activities.

The cash flows from investing, and financing activities are identical regardless of which method you’re using.

Indirect Method Of Preparing Cash Flow Statement

The indirect method is adopted by many companies for the preparation of cash flow statements because it is simple, and less work is required. Unlike the direct method, there is no need to start from point zero and gather receipts & payments for computing operating cash flow.

The implications of the indirect method are more useful for the business entity. The data is readily available in the accounting software and financial statements. The accounting experts don’t have to refer back to the bookkeeping records to consolidate cash payments and receipts. The comparative income statement is enough to start with when using the indirect method.

Preparation Of Cashflow Statement Under Indirect Method

The operating activities section of the cash flow statement starts from net income for the indirect method. The net income is derived from the statement of profit and loss or income statement.

  1. The adjustments are made regarding the non-cash expenses, gains, and losses. The most common types of activities excluded or added to the net income are:
    • Depreciation
    • Depletion
    • Amortization
    • Capital gains on sales of assets
    • Losses from account receivables
    • Discounts availed for credit purchases
  2. The next step of the cash flow from operating activities deals with the assets accounts that have impacted cash levels. Usually, the following asset accounts are involved:
    • Inventory
    • Account receivables
    • Prepaid expenses
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   As a general rule, the following actions are taken for increase or decrease in asset account:

#1 Asset account increase: Subtract the amount from net income

#2 Asset account decrease: Add the amount to net income

3. After adjusting for assets accounts, step number 3 is adjusting net income for the liability accounts impacting cash levels. The following liability accounts are typically involved:

  • Account payables
  • Accrued expenses

As a general rule, the following actions are taken for increase or decrease in asset account:

  • Liability account increase: Add the amount to net income
  • Liability account decrease: Subtract the amount from net income

After making all the adjustments, the net cash flow from operating activities results from the process.

Example

Let’s understand it will the help of an example.

Here is the income statement of Imaginative Co. Ltd, a retailer of goods.

Additional Information:

  • Account payables increase from 2019 to 2020 was recorded as USD 1,000.
  • Account receivables decrease from 2019 to 2020 was recorded to be USD 1,180.
  • Prepaid insurance decreased from 2019 to 2020 was recorded to be USD 1,200.

The sections for cash flow from investing and financing activity will be the same as for the direct method.

Conclusion

The indirect method of preparing the cash flow statements is cost-effective, easy, requires less work, and consumes less time. The direct method is usually preferred by the accounting bodies because it is simpler to understand for the external users. However, it is not mandatory to follow the direct method for the companies.

Therefore, most companies prefer the reconciliation of income statements to calculate net cash flow from operating activities. Small businesses can adopt the indirect method of cash flow statements with the freedom to save their time and costs.