Financial statements are essential for understanding a company’s performance and financial health. However, they must be carefully prepared to provide accurate and meaningful insights. One particularly important but sometimes challenging component is the statement of cash flows. Here’s an easy-to-follow explanation of its parts and why they matter.
What is the Statement of Cash Flows?
The statement of cash flows shows how cash moves in and out of a business. It’s divided into three sections:
1. Operating Activities
2. Investing Activities
3. Financing Activities
This structure provides a clear view of how a company generates and uses cash. Let’s break each section down.
Operating Activities
This section begins with the company’s net income, calculated on an accrual basis, and adjusts it to reflect actual cash transactions from everyday business operations. Adjustments include:
Noncash expenses: Depreciation and amortization, which reflect wear and tear on assets.
Working capital changes: Adjustments for shifts in accounts receivable, inventory, prepaid assets, accrued expenses, and payables.
Other factors: Items like income taxes, stock-based compensation, and gains or losses from asset sales.
The goal is to show the cash generated or used in daily operations. Persistent negative cash flows in this area could signal financial trouble or even risk of liquidation.
Investing Activities
This section tracks cash spent or earned from buying or selling long-term assets, such as property, equipment, or marketable securities. It highlights whether a company is:
Investing in growth: Acquiring new equipment or facilities.
Selling assets: Converting assets into cash during emergencies.
It also includes business acquisitions and disposals. Contingent payments related to acquisitions are classified as investing outflows only if paid soon after the acquisition. Later payments are classified differently.
Financing Activities
This section shows how a business raises funds and repays obligations. It includes:
Cash inflows: From loans, equity contributions, and the issuance of bonds or securities.
Cash outflows: For loan repayments, dividends, stock buybacks, and owner withdrawals.
This area provides insight into a company’s ability to secure funding and meet financial obligations.
Noncash Transactions
Not all transactions involve cash. Noncash activities are reported separately at the bottom of the statement or in footnotes. Examples include:
Acquiring equipment through loans.
Settling long-term debt with stock.
Converting preferred stock to common stock.
Although these don’t involve cash, they’re important for investors and lenders to understand.
Need Assistance?
Classifying transactions correctly under U.S. Generally Accepted Accounting Principles (GAAP) can be tricky. If you’re unsure about how to handle specific entries or want to enhance your financial reporting, reach out to us! Financial Statement Preparation is a service we have provided here at VAAS for over 20 years. Properly prepared financial statements build confidence and provide transparency for stakeholders. Schedule an appointment to get started!