The How & Why
Direct vs. Indirect method
Net Income & adjustments
Cash from Operations
a. Sources & uses of cash
b. Prepaid expenses
c. Accrued expenses
d. Accounts Payable
e. Accounts Receivable
Example: think about a $150 invoice from an electrician to fix a light switch. The work is performed in March and you have net 30 terms. In the Statement of Cash Flows, the effect of the $150 in March is to reduce net income by $150 and, because you have net 30 terms, it would be a source of cash in Accounts Payable because you didn’t pay for the expense. The effect on cash in March is zero and is shown by a “use” in the reduced net income and a “source” in the increased Accounts Payable. In April, when the bill is paid, Accounts Payable is reduced which becomes a use of cash on the Statement of Cash Flows.
Cash From Investing
Cash related to investing activities is the change in long-lived assets
Cash from Financing
Cash from financing reflects any activity in the equity (excluding retained earnings) section of the Balance Sheet or changes in any long term liabilities such as notes or bonds payable.
Change in Cash
Ending cash balance in your general ledger minus beginning cash balance. All cash accounts should be included – general accounts, Accounts Payable accounts, Payroll accounts, petty cash – all accounts that had any balance.
Example: Cash Flow Through a Retailer
From a cash flow perspective, it doesn’t usually get any better than retailing. In a perfect world, everything purchased from suppliers would be on net 30 terms and inventory would turn more than 12 times per year. In this scenario, the customer would be buying the product (usually in cash) from the company before the company paid for it.
At -15 days (fifteen days prior to the sale) $20 is paid – this could be phone expense, wages (related to purchasing or receiving the product), etc.. At 0 days (the day the sale happens) another $17.50 is paid out in expenses related to this sale. Once again, this could be wages, advertising, or any other non-product expense. The sale was in cash, so $150 is received from the customer, putting the retailer at a $112.50 positive cash position (150-20-17.50). At +15 days (fifteen days after the sale) the product that was sold is paid for at $75 and another $7.50 is paid in related expenses, leaving a net cash increase of $30, which is equal to the net profit on the sale.
As you can see, in an ideal situation, only minor expenses are paid for prior to the sale. This example is only an example – many retailers have significantly lower turns and have to carry those costs in advance of a sale. This is the reason that the Finance Department is always pressuring Operations to reduce inventory and many deep discounts can be found on slow moving inventory. It is also the reason that many retailers fail – too much cash was tied up in slow moving inventory and the business found itself undercapitalized.