A company can report record net income and still run out of cash. The statement of cash flows reconciles accrual profit to actual cash movement, and it is the only one of the three primary statements that ties directly to the bank account.
The cash flow statement is built from the income statement and the change in balance sheet accounts. Net income (NI) comes directly from the income statement. Every working capital adjustment comes from the change in a current asset or current liability on the balance sheet. Investing activities reflect changes in long-term assets. Financing activities reflect changes in long-term debt and equity.
KEY: The cash flow statement is a derived statement. It reorganizes income statement and balance sheet information around cash. When every transaction settles in cash, its net amounts follow from the income statement and the balance sheet changes. The notes supply the rest: noncash deals (equipment bought with a note), acquisitions, currency effects, and the gross investing and financing flows (purchases versus sales, borrowing versus repayment).
Common mistakes
- Reversing the sign on working capital changes. An increase in receivables reduces cash. Trap: adding $20,000 ΔAR to net income instead of subtracting it. Asset up = cash down.
- Leaving the gain in CFO. Subtract the gain from net income and put the entire sale proceeds in CFI. In Example 3, forgetting to subtract the $8,000 gain gives a trap CFO of $183,000 instead of $175,000, and the gain is then counted twice.
- Using net PP&E for purchases. Net PP&E rose only $60,000 at Harbor, and gross PP&E rose $80,000. Neither is purchases. Purchases were $150,000, because you must add back the $70,000 cost of equipment sold. Trap answers: $60,000 or $80,000.
Bottom line
- CFO + CFI + CFF, plus any exchange rate effect, equals the change in the cash flow statement's cash and cash equivalents. Reconcile its ending balance to the corresponding balance sheet items.
- Combine the income statement, balance sheet changes and notes to derive net cash flows. Notes identify noncash movements and separate gross receipts from payments.
- Indirect CFO starts with net income, adds back non-cash items, subtracts gains, adds the DTL increase, and adjusts for working capital changes (an asset increase reduces cash).
- Direct CFO lists actual receipts and payments: cash from customers = Revenue − ΔAR + ΔDeferred Revenue; each payment = expense adjusted for its payable.
Exam shortcut
For working capital signs: "Asset up, cash down. Liability up, cash up." Apply it to every operating working capital account, never to cash or borrowings. For capital spending, never use the change in net PP&E. Roll gross PP&E forward and add back the cost of assets sold, then get proceeds as book value plus the gain. For dividends, solve the retained earnings roll-forward.
The full lesson (about 4,454 words, 30 min read) adds 8 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- analyzing cash flows I
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