This article will explain the cash flow statement and how it can help you analyze a company for investing. There are two forms of accounting that determine how cash moves within a company's financial statements.
They are accrual accounting and cash accounting. Accrual accounting is used by most public companies and is the accounting method where revenue is reported as income when it's earned rather than when the company receives payment. Expenses are reported when incurred, even though no cash payments have been made.
For example, if a company records a sale, the revenue is recognized on the income statement, but the company may not receive cash until a later date. From an accounting standpoint, the company would be earning a profit on the income statement and be paying income taxes on it. However, no cash would have been exchanged. Also, the transaction would likely be an outflow of cash initially, since it costs money for the company to buy inventory and manufacture the product to be sold.
It's common for businesses to extend terms of 30, 60, or even 90 days for a customer to pay the invoice. The sale would be an accounts receivable with no impact on cash until collected. Cash accounting is an accounting method in which payment receipts are recorded during the period they are received, and expenses are recorded in the period in which they are paid. In other words, revenues and expenses are recorded when cash is received and paid, respectively.
Earnings and cash are two completely different terms. Earnings happen in the present when a sale and expense are made, but cash inflows and outflows can occur at a later date. It is important to understand this difference when managing any business payments. A company's profit is shown as net income on the income statement. Net income is the bottom line for the company. However, because of accrual accounting, net income doesn't necessarily mean that all receivables were collected from their customers.
From an accounting standpoint, the company might be profitable, but if the receivables become past due or uncollected, the company could run into financial problems. Even profitable companies can fail to adequately manage their cash flow , which is why a cash flow statement is a critical tool for analysts and investors.
A cash flow statement has three distinct sections, each of which relates to a particular component—operations, investing, and financing—of a company's business activities. Below is the typical format of a cash flow statement. This section reports the amount of cash from the income statement that was originally reported on an accrual basis.
A few of the items included in this section are accounts receivables , accounts payables , and income taxes payable. If a client pays a receivable, it would be recorded as cash from operations.
Changes in current assets or current liabilities items due in one year or less are recorded as cash flow from operations. This section records the cash flow from sales and purchases of long-term investments like fixed assets that include property, plant, and equipment.
Items included in this section are purchases of vehicles, furniture, buildings, or land. Typically, investing transactions generate cash outflows, such as capital expenditures for plant, property, and equipment ; business acquisitions; and the purchase of investment securities. Cash inflows come from the sale of assets, businesses, and securities.
Investors typically monitor capital expenditures used for the maintenance of, and additions to, a company's physical assets to support the company's operation and competitiveness. In short, investors can see how a company is investing in itself. Debt and equity transactions are reported in this section.
Any cash flows that include payment of dividends, the repurchase or sale of stocks, and bonds would be considered cash flow from financing activities. Cash received from taking out a loan or cash used to pay down long-term debt would be recorded in this section. For investors who prefer dividend-paying companies, this section is important since it shows cash dividends paid since cash, not net income, is used to pay dividends to shareholders.
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In computing cash flow, Incoming cash takes the form of: Sales of goods and services. Sales of assets. Loan proceeds. On the outgoing side, cash flows out through: Operating expenses.
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