The statement of cash flows provides insight into the impact that operating, investing and financing activities have on a company’s cash position during a reporting period. The first section of the statement of cash flows reconciles net income to the cash flow from operations. This subtotal is the difference between the cash generated from customers and payments made to suppliers. A company with a strong cash flow from operations has the ability to make new investments, service debt and distribute earnings to shareholders.
Compute the difference between the current year’s balance sheet and the previous year’s balance sheet. The operating section of the statement of cash flows adjusts net income to reflect the impact of non-cash items. For instance, if inventory was $500 last year and $1,000 this year, subtracting this year from last year will yield -$500. This represents the amount of cash that was used to fund the increase in inventory, and a reduction in cash that must be subtracted from net income.
Add depreciation and amortization expenses to net income. Depreciation and amortization are non-cash expenses that are subtracted from revenue. Depreciation and amortization must be added back to net income to isolate the impact operations had on cash flow.
Add or subtract the changes in assets and liabilities. This can included accounts such as inventory, accounts receivable and accounts payable, as well as accounting estimates and adjustments, such as accrued interest and deferred revenue. Increases in assets will consume cash while decreases will add to cash. On the other hand, increases in liabilities will increase cash while decreases will consume cash. For example, assume accrued payroll expense was $800 at the beginning of the year and $1,200 at the end of the year. This is an increase in a liability account and results in a $400 addition to cash.
Compute the operating cash flow. Sum net income and the items identified in Step 2 and Step 3 to arrive at net cash flow from operating activities.
Verify your work. To double check your work in the operating activities section, the investing and financing sections of the statement of cash flows must be completed. The sum of the cash flows from operating, investing and financing activities represents the total change in cash. The statement of cash flows can be verified by adding the total change in cash to the beginning cash to arrive at the ending cash balance. Ending cash can be verified against the balance sheet.
Increases in assets consume cash and appear as a negative item. Decreases in assets provide cash and appear as a positive item. Increases in liabilities provide cash and appear as a postive item. Decreases in liabilities consume cash and appear as a negative item.