Cash Flow Statements for Accrual: A Comprehensive Guide
The economy functions based on the flow of money. If you think of economic crises, like the 2008 bubble or the Great Depression, they all occurred because of stagnant movement of the dollar. So let’s learn about the financial statement that gives us the most insight on this!
An Introduction
The cash flow statement is like a detailed snapshot of the money coming in and out of a business in a given period, which we call the accounting period. This statement entails all activities that would affect the cash account of the business and reconciles the net income account with the company’s cash. Before the cash flow statement is made, the money a company earns is essentially stored but not recognized so the company can’t spend it on other things.
The cash flow statement is also important for business owners and executives to see the general health of their company. If there is more money coming out than coming in, it is often a red flag in terms of financial health, but this may not always be the case. For example, investments may be made or there might be emergencies.
Direct vs Indirect Method
The direct method of making a cash flow statement is more popular with the cash basis accounting. The method essentially accounts for the cash flow using receipts and invoices, which is why it is only compatible with cash basis accounting, which recognizes income when cash is received. However, most companies do not use the cash basis accounting because it is less accurate. Since this accounting basis isn’t popular, let’s look at one that might be more relevant to understanding the cash flow statement!
The indirect method of the cash flow statement calculates things in a bit of a “reverse” order and holds everything against net income. If something accounts for cash coming out of the business, it will be calculated against net income. If something constitutes for money coming in, it will be added. The indirect method is a little more complicated and counterintuitive than the direct method, so let’s work through a couple of examples to get a better understanding.
I need you to imagine a river, this is going to be your cash. Now, we’re going to add action to it. Your accounts receivable decreases, this means people have paid you off and you receive money. So this branch leads into the river because it adds water (in this case money). Now what if account receivables increased since the last accounting period? In this case, it is revenue but it’s not cash — money you earned but haven’t received. This means it is a branch that leads out of the river because it represents the money that needs to join the river at a later date.
Still a little unsure? That’s ok — I was the first time around too! Let’s try again with accounts payable this time. Say I paid of an account and my total accounts payable decreases. This suggests I used money. Coming back to the river reference, this is a branch that flows out of net income. If accounts payable increases, this is money should have paid but instead we haven’t yet. This may seem counterintuitive but because we gained something from these accounts without using cash, they would add to net income. It’s adding to the river and amount of water that can later be drawn from when we do pay off the account.
The same logic applies to other accounts too! It may be tough to understand at first, but stick to the knowledge you already have. There must be a debit and credit to a transaction, so if one action by an account causes an increase in net income, the counteraction must cause a decrease. Choose whatever is easier to determine and reverse it if you need to! For example, I was extremely confused with what to do when inventory decreases. If I think about it, inventory increasing = using money = less cash. If an increase in inventory is held against net income, then a decrease in inventory must add to it.
Understanding the Cash Flow Statement
Great, so now we can make a statement — but that’s not always helpful in understanding them. Money leaves, so what? Well, let’s take a look at what different numbers and factors may mean when deciphering this complex statement. As much as I’d like to say it’s clean cut, it really isn’t. But there’s some popular indicators we can go through!
A negative cash flow isn’t always a red flag, but in some cases, it can be. If the cash flow is negative and the company has a high debt-to-asset ratio, chances are that’s not looking too good. The company’s operations is at a net loss and they have a lot of debt that they may be potentially unable to pay off! Additional red flags can be constant losses, bad acid ratios, and low earnings per share. I’ve written an article on these ratios, you can check them out here!
What about the times where a negative cash flow might not be a red flag (as GenZ would call it, a “beige flag”)? It happens more often than you may think! A company might have made an investment with money from previous operations or paid of a large liability. If all other ratios are looking good and the company’s financial health appears to be well, it is generally safe to say that a negative cash flow is just a part of operations!
Practice makes Perfect
Cash flow statements can be hard to understand, and I encourage you to continue to practice! Hand onto the fact that there has to be a debit and a credit, I promise it’s going to be helpful. Get out there, you got this!
