Accounting in a Nutshell 5
The Cash Flow Statement
Joel Shapiro has been an
accounting instructor at Ryerson
University in Toronto, Canada for
20 years. Previously, he developed
an accounting and inventory
management software system for
small businesses. In his spare time,
he enjoys working on Kakuro and
cryptic crossword puzzles and travels
throughout Ontario as a bridge
tournament director.
Joel Shapiro
Abstract: This short article explains how the cash flow state-
ment is prepared (both the indirect and direct methods)
with a comprehensive example. In addition, guidance is
provided with respect to the analysis and interpretation
of the cash flow statement.
Keywords: accruals, financing cash flow, investing, and
operating
Introduction
When most non-accountants think of financial state-
ments, the ones that come to mind are usually the in-
come statement and balance sheet. However, there is
another statement that is at least as important, if not
more sothe cash flow statement. Many years ago, it
was called the statement of source and use of funds,
funds being defined as cash and cash equivalents such
as highly liquid short-term financial instruments such
as certificates of deposit and government-issued trea-
sury bills. (Henceforth we will just use the term cash
for simplicity.)
The modern cash flow statement recognizes the
activities that increase and decrease a companys cash
(i.e. the sources and uses of its cash) can be classified
into three, and only three, categoriesoperating, in-
vesting, and financing. The statement shows the details
within each, thus providing a link between the open-
ing and closing cash balances on the companys balance
sheets for two successive years.
Operating Cash Flow
Cash flow is the lifeblood of all businesses. Without ad-
equate cash flow, a business will not survive for very
long. Profit is not the same thing as cash flow, because
companies are required by generally accepted ac-
counting principles (GAAP) and most tax laws to use
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 Accounting in a Nutshell 5
accrual accounting. Accrual accounting
counts some transactions as income be-
fore the cash is actually received (hence
accounts receivable), and counts some
transactions as expenses before the cash
is actually paid (hence accounts payable).
Also, outflows of cash are frequently not
expenses until much laterfor example,
purchases of inventory and long-term
assets, and prepayments. Inflows of cash,
such as deposits from customers for work
to be performed or goods to be delivered
later, are unearned revenue (a liability)
and not revenue. Actual cash flow may
resemble profit, but is clearly not the
same thing.
Of the three components of total cash
flow, operating cash flow is the most im-
portant, because it is the only one of the
three that occurs every day and is sustain-
able in the long run. Any transaction that
affects current assets, current liabilities,
revenues, or expenses would be part of op-
erating cash flow. The most widely-used
form of the cash flow statement starts with
net income and reconciles that figure to
operating cash flow. A detailed example
of this procedure will be found below. The
operating cash flow section of the cash flow
statement is always the first section, signi-
fying its overall importance.
Investing Cash Flow
This is the second of the three sections of
the cash flow statement. It contains infor-
mation about cash transactions that affect
long-lived assets, such as property, plant
and equipment, intangible assets, and in-
vestments other than those which are held
for short-term trading. Investing cash out-
flow is the cash used to purchase these
long-lived assets, while investing cash out-
flow is the cash proceeds received from
their sale. These transactions are not con-
sidered operating because they are not part
of a companys day-to-day business activ-
ity. Note that only the cash proceeds from
dispositions appear as cash inflows in this
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sectionaccounting gains and losses on dis-
positions do not. Bookkeeping a djustments
such as depreciation, amortization, and im-
pairment write-downs do not a ppear here
either.
Financing Cash Flow
In the third section of the cash flow state-
ment we find the cash effect of transac-
tions that involve long-term debt and
shareholders equity. For the former, new
borrowings are cash inflows and repay-
ments are cash outflows. For the latter, the
proceeds from share issues is a cash inflow,
while cash outflows would be amounts
paid to repurchase or redeem shares,
and dividends.
Interest is a special case. For the pur-
pose of US and Canadian GAAP, all interest
payments and receipts are considered to
be operating cash flows. For International
Financial Reporting Standards (IFRS), in-
terest received can be either operating
or investing cash flow, depending on its
source; and interest paid can be either op-
erating or financing cash flow, depending
on its purpose. This treatment is probably
more correct in theory, but is often too dif-
ficult to put into practice.
Reconciling Cash Balances
The bottom of the cash flow statement is
quite simple. The three totalsoperating,
investing, and financing cash floware
added together to give the total change in
cash for the year. This is then added to the
opening balance (on the prior years bal-
ance sheet) to get the ending balance (on
this years balance sheet). The ending cash
balance is really the only link between the
cash flow statement and the other financial
statements.
The Format of the Cash Flow
Statement
There are two ways to present the operat-
ing section of the cash flow statement
the indirect method and the direct method.
 Accounting in a Nutshell 5

The indirect method starts with net in- sheet at the current year-end and the previ-
come and then (1) eliminates from that ous year-end.
figure all non-cash items included, such Condensed income statement for cur-
as depreciation; and (2) adjusts all cur- rent year:
rent assets and liabilities other than
cash itself from the accrual-basis figures Sales 500
shown on the balance sheet to the figures
Cost of goods sold 300
that would have been shown had the cash
basis of accounting been used. On the Gross profit 200
other hand, the direct method does not Operating expenses 65
attempt to compare net income to oper- Depreciation 25
ating cash flow, but simply lists cash re- Interest expense 10
ceived from customers and cash paid to
Profit before tax 100
suppliers. In both methods, interest and
income taxes must be shown separately. Income tax 30
Either way, the total operating cash flow is Net income 70
the same.
Although GAAP prefers (but does not
require) that companies use the direct Condensed balance sheets:
method, very few do, because the accrual Current Previous
method of accounting makes the figures Cash 100 80
required for the direct method difficult
Receivables 150 125
to track. Not-for-profit entities do use the
direct method. Inventory 235 200
The investing and financing sections of Long-lived assets 185 200
the cash flow statement, as well as the cash Total assets 670 605
balance reconciliation, are identical under
Accounts payable 125 140
both methods.
Long-term debt 225 200
Financing and Investing Share capital 200 185
Transactions That Do Not Retained earnings 120 80
InvolveCash Total liabs & eq. 670 605
This is quite common. An example might
be the acquisition of a long-lived asset such
as a factory, financed in whole or in part by Note that long-lived assets and receivables
issuing shares or long-term debt. Another are presented net of accumulated depre-
example would be a stock dividend, or the ciation and the allowance for doubtful
conversion of debt into shares (or vice- accounts.
versa). These transactions do not appear The cash flow statement is essentially an
in the body of the cash flow statement, but attempt to explain, in terms of cash, the dif-
are disclosed in detail in the notes. ference between one balance sheet and the
next; in other words, how cash was used
How to Prepare the Indirect-Method and from where it was received in order to
Cash Flow Statement effect the changes in assets and liabilities
The following is a simple example, illus- from one year to the next. So the first step
trating both methods. The preliminary in preparing the cash flow statement is
information required is the income state- simply to calculate the difference between
ment for the current year and the balance the two balance sheets.

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