Financial Statements 101 - the Cash Flow Statement

There are two chief things I want you to understand about the cash flow statement:

1) How the cash flow statement is really an interaction between your balance sheet and your income statement and

2) The difference between your income statement and your cash flow statement.

First things first ... the picture of the interaction between your balance sheet and your income statement:

The bottom two columns represent your balance sheet. The left is your assets, the right your liabilities. The top portion of this picture is your income statement. The very top row is your income the very bottom row is your expenses. Income minus expenses equals what is left over correct? On the balance sheet, for our purposes an asset is something you own that puts money into your pocket every month while a liability is something that takes money out. Note, these are not the accounting definitions, they are financial independence definitions.

Now, the ellipse that travels up from our asset column and into our income column is our cash flow. This cash flow is generated by our assets and once we have attained a level sufficient enough to meet our expenses, then we are financially independent. This is the first dimension of cash flow you need to understand.

Second, the cash flow statement and how it differs from the income statement.

To understand the cash flow statement, first think of the income statement - income minus expenses equals what is left over ... simple enough correct? Now I want you to understand the difference between accrual and cash accounting. The income statement is generally reported on an accrual basis. This means that if you have a sale in July, even if you don't receive the payment for 60 days in September, the sale is recorded in July on the income statement. The cash flow statement says no way Jose, the cash isn't collected until September so I will not show the cash income until September. This is known as cash accounting and it applies to payables (bills we owe) as well as receivables (the sale example we just ran through.) On the payables end the income statement would say "I had an expense of $200 in February for supplies" and if it was on 90 days credit the cash flow statement would say "yeah but I didn't pay it until May so I will show it in May."

The second thing to understand about the cash flow statement is that it shows the beginning and ending cash balance of your company. So, think of it like this: how much cash are you starting out with at the beginning of the month ... let's say $1,000. Now how much income did you take in? Let's say we made $3,000 cash in the month. Now, what were the expenses, including interest and principle payment on debt. (this is an important difference to note as well. The income statement is an operating profit statement so it will only report interest on a loan payment. In theory, a principle payment is applied towards an asset buying you equity, technically a balance sheet item but the cash flow statement wants to know about all cash transactions which includes both interest and principle payments.) Let's say we had $2,000 in expenses so ... what is your cash position:

Starting Cash - $1,000

Income - $3,000

Expenses- $2,000

Ending Cash- $2,000

See how the math works in that example? Also, the cash flow statement wants to know the sources and uses of cash from three major sources: operations, financing and investing. Cash flow from operations comes from the making and selling of product and can be thought of as the cash that comes from the income statement. Financing activities can be the retirement of debt or initiation of debt and investing activities can include the purchase of building and/or equipment and the raising of capital from investors.

Below is an example income and cash flow statement. The top portion, the "Profit Plan" is the income statement portion. The center section, the "Cash Budget" is the cash flow plan. The bottom section is titled "Loans" and keeps track of what financing has been used (it keeps running tallies of both long and short term loans) and indicates payback (the balances are reduced as payaback occurs.)