Tuesday, August 28, 2007

Statement of Cash Flows

Hello everyone.
In my Aug. 19th post, entitled The Basics: Financial Statements and Accounting Terms, I wrote about the three major financial statements that are crucial to understand if you are to invest successfully. To recap (although I suggest you read that post too), there are three major statements and they are the balance sheet, the income statement, and the statement of cash flows.

Balance sheet: an accounting statement that summarizes a company's assets, liabilities, and shareholder's equity at a specific point in time. It basically gives a snapshot of how financially healthy a company is at a discrete instance. It must follow the rule of Assets = Liabilities + Owner's Equity. Read the Aug. 19th post to find out about owner's equity.

Income statement: an accounting statement that summarizes how much a company earns, and what its expenses are. The money that a company earns can be from selling goods, capital gains on stock investments, appreciation in real estate, and interest on bonds it holds.

Expenses can be from the materials it takes to make the goods a company sells, research and development, labor costs, pension costs, and rent/mortgages.

Now, onto the statement of cash flows. In order to understand the statement of cash flows, you must realize that there are two types of accounting used. One is called accrual basis accounting and the other is called cash basis accounting. To promote transparency, the FASB (Financial Accounting Standards Board) mandates that companies use accrual basis accounting.

Here's an example. Let's say you sell paper to a law firm. The law firm can either pay you immediately or in a more typical time frame for large intercompany transcations, a month. Let's go further and say that you sell the paper to the law firm on Jan.1 and they pay you on Jan. 31. On Jan. 1, a sale has taken place - it's just that no physical or electronic money has been transferred from the buyer to the seller. So companies record it in their balance sheets as an asset and on the income statement as revenue.

Unfortunately, this does not tell one a whole lot about how much physical cash comes into the company. This is where the statement of cash flows comes in. The cash flow statement takes the net income from the income statement - the very last line - and adds to it things that do not involve the transfer or cash, like depreciation and amortization and other non-cash expense. I'll discuss these at a later time.

Finally, the cash flow statement has three sections: the operating activities section, the financing section, and the investing sections. I'll be brief.

Operating activities: This portion involves the revenue from cash transactions that arise because of the sale of a company's products or services. It also involves the cash from expenses for the company to make its products or deliver its services.

Financing activities: This portion involves the revenue from cash transactions tha arise through the company raising money. This can be through raising money or issuing stock.

Investing activities: This portion involves the revenue from cash transactions that arise through the company buying or selling an investment, i,e, stock or real estate. These cash transactions also can arise from things like "capital improvements", i.e. renovations to a building.

Thanks for reading and in one of my upcoming posts, I will go more into depth about accounting. However, I won't scrimp on my squshy, less quantitative side.

5 comments:

Seenath Kumar said...

What a great information investors will really love your blog.
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