Purpose of the statement of cash flows

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Purpose of the Statement of Cash Flows
The objective of providing a statement of cash flows is to assist users in understanding the cash inflows and outflows that support a firm’s primary activities. This information is sometimes difficult to extract from the accrual accounting information on the balance sheet and income statement. Just as the income statement gives you an understanding of how the business changed during the period through the perspective of profits or losses, the statement of cash flows gives you an understanding of how the businesschanged during the period through the lens of the Cash account.
 

Under the frequently used indirect method for both U.S. GAAP and IFRS, the first line of the statement of cash flows is net income, which is reconciled to the net change in cash during the period. An oversimplification of the statement of cash flows is that it reports all of the sources and uses of cash during a period. However, the statement of cash flows provides numerous insights not available from either the balance sheet or the income statement. The statement of cash flows:

•  reconciles the change in cash on the balance sheet and net income reported in the income statement.
• is logically organized in three sections (operating activities, investing activities, and financing activities), which correspond to the primary pursuits necessary to generate profits. Provides information about cash flows to and from entities, such as customers, suppliers, creditors, and investors, with whom the firm conducts business.
• assists analysts with numerous other tasks, such as uncovering accounting discretion, calculating free cash flows and identifying other information unavailable elsewhere in the financial reports

It is cash flows that precede the recognition of most balance sheet and income statement line items. The accountant’s job is to take observed cash flows, along with other events, employ accrual accounting procedures, and prepare the income statement and balance sheet under accrual accounting principles. As noted in the previous chapter, accrual accounting exists to help investors better predict the nature, amount, and timing of future cash flows. Thus, we emphasize that the statement of cash flows is essentially an ‘‘unraveling’’ of the accrual accounting procedures employed in the preparation of the balance sheet and income statement, in order to reveal the underlying cash flows

Cash Flows versus Net Income
A firm’s cash flows will differ from net income each period because:

•  cash receipts from customers do not necessarily occur in the same period revenue is recognized.
• cash expenditures do not necessarily occur in the same period expenses are recognized.
• cash inflows and outflows from investing and financing activities do not immediately flow through the income statement. Recall that a primary objective in preparing an income statement is the matching of economic resources used or consumed (expenses) during the period with economic resources earned (revenues) during the period. Under accrual accounting, the timing of the inflow and outflow of cash is ignored. However, cash is essential for operating,investing, and financing activities. Thus, firms must provide the statement of cash flows, a financial statement that reports the flows of cash in and out of the firm each period

Cash Flows and Financial Analysis
An understanding of a firm’s cash flows is an integral part of each of the six steps in financial

• Identify the Economic Characteristics of a Business: You will see dramatic differences in the pattern of cash flows from operating, investing, and financing activities among various types of businesses as well as within a firm throughout various stages of the firm’s life cycle. For example, high-growth, capital-intensive firms generally experience insufficient cash flow from operations to finance capital expenditures (investing activities); thus, they require external sources of capital (financing activities). In contrast, mature companies usually can use cash flows from operations to finance capital expenditures and to repay debt, pay dividends, or repurchase common stock (financing activities)
•  Identify the Strategy of the Firm: The statement of cash flows will reveal to you the overall strategy of a firm, especially how the firm is generating and using cash to execute its operating, investing and financing strategies, as well as its trajectory of growth. For example, a firm opting for organic growth will exhibit large positive cash flows from operations, which are funneled into investing activities. On the other hand, a firm pursuing a strategy of growth by acquiring other firms will report significant cash outflows for corporate acquisitions (investing activities) and, perhaps, large cash inflows from financing activities. The statement of cash flows provides a ‘‘reality check’’ on the firm’s stated strategies, by showing you how the firm is actually generating and using cash.

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