The Six-Step Process for Preparing a Statement of Cash Flows

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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define and discuss the purpose of the cash flow statement. You'll learn how to construct the statement using six easy steps of the indirect method for cash flow. We'll also provide examples of incoming and outgoing cash activities.

The Statement of Cash Flows

Daniel owns a profitable widget business. Even though revenues have doubled since inception, cash volatility occurs frequently, and bills are paid late every month. Daniel calls his new Certified Public Accountant (CPA) and asks him to analyze the company's financials to determine any anomalies. Later the next week, the CPA informs Daniel the former CPA never constructed cash flow statements, so looking into the business's financials would be a little more work than anticipated.

A statement of cash flows provides details on incoming and outgoing cash transactions and explains net increases or decreases in cash. Broadly, it looks at anything which generates cash, including operations, investments, and financing. The CPA shows Daniel an easy, six-step process to prepare a statement of cash flows. Let's take a closer look at these six steps.

Step 1: Calculate the New Cash Balance

A business will start and end the year with a cash surplus or deficit. Subtracting the annual beginning and ending cash in one year provides the beginning balance for the next year. For example, the widget company began the year with $10,000 and ended with $5,000; therefore, net cash is $5,000 ($10,000 - $5,000). The main purpose of the cash flow statement is to explain this reduction in cash. Also, analyzing cash transactions allows for proper planning for the following year.

Step 2: Calculate Operating Activities

The next step is to start with net income and add depreciation back in, since it was a deducted non-cash transaction on the income statement. Now we'll account for incoming and outgoing operating cash activities. Operating activities are the actions the business undertakes as a normal course of doing business. Examples of the widget company's outgoing operational cash activities include: paying suppliers, rent, utilities, and taxes. After this, we can add any incoming operational cash activities, such as customers paying their widget credit accounts.

Step 3: Calculate Investing Activities

The CPA explains the next category is investing. Daniel chuckles and expresses the widget company barely pays its bills, let alone invests in the stock market. The CPA clarifies investing activities include buying and selling securities as well as property, plant, and equipment. For example, let's say you heard behind closed doors the city plans to develop hundreds of acres of land next to the widget business. If you had the money, you could purchase the land at a discount, which constitutes a decrease in cash. If the city purchased your land at a premium six months later, the new profit would be listed in this section as incoming cash due to investment.

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