11.2: Preparing the Statement of Cash Flows
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- LO1 – Explain the purpose of the statement of cash flows.
Cash flow is an important factor in determining the success or failure of a corporation. It is quite possible for a profitable business to be short of cash. As discussed in Chapter 7, a company can have liquidity issues because of large amounts of cash tied up in inventory and accounts receivable, for instance. Conversely, an unprofitable business might have sufficient cash to pay its bills if it has access to enough financing from loans or by issuing share capital.
We know that the financial activities of a corporation are reported through four financial statements: a balance sheet, an income statement, a statement of changes in equity, and a statement of cash flows (SCF). Statement of cash flowsThis chapter discusses the statement of cash flows in detail.
The SCF identifies the sources (inflows) and uses (outflows) of cash during the accounting period. It explains why the cash balance at the end of the accounting period is different from that at the beginning of the period by describing the enterprise's financing, investing, and operating activities.
Cash flow information is useful to management when making decisions such as purchasing equipment, plant expansion, retiring long-term debt, or declaring dividends. The SCF is useful to external users when evaluating a corporation's financial performance.
The SCF, together with the income statement, provides a somewhat limited means of assessing future cash flows because these statements are based on historical, not prospective data. Nevertheless, the ability to generate cash from past operations is often an important indication of whether the enterprise will be able to meet obligations as they become due, pay dividends, pay for recurring operating costs, or survive adverse economic conditions.
For SCF purposes, cash includes cash and cash equivalents — assets that can be quickly converted into a known amount of cash, such as short-term investments that are not subject to significant risk of changes in value. For our purposes, an investment will be considered a cash equivalent when it has a maturity of three months or less from the date of acquisition.
Because of differences in the nature of each entity and industry, management judgment is required to determine what assets constitute cash and cash equivalents for a particular firm. This decision needs to be disclosed on the SCF or in a note to the financial statements as shown in the following example:
Note X
Cash and cash equivalents consist of cash on deposit and short-term investments held for the purposes of meeting cash commitments within three months from the balance sheet date. Cash and cash equivalents consist of the following:
| ($000s) | |||
| 2024 | 2023 | 2022 | |
| Cash on Deposit | $20 | $30 | $50 |
| Short-term Investments | 36 | 31 | 37 |
| $56 | $61 | $87 | |
For simplicity, examples throughout this chapter involving cash and cash equivalents will include only cash.
Cash flows result from a wide variety of a corporation's activities as cash is received and disbursed over a period of time. Because the income statement is based on accrual accounting that matches expenses with revenues, net income most often does not reflect cash receipts and disbursements during the time period they were made. As we will see, the statement of cash flows converts accrual net income to a cash basis net income.