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  • As you become more familiar with the

  • accrual basis on which the income

  • statement is constructed, you quickly

  • appreciate the need for a statement that

  • focuses solely on cash and identifying

  • the sources and uses of cash during the

  • period.

  • Thus the statement of cash flow is the

  • third statement which is needed to

  • complete the description of a company's

  • financial position and performance. As I

  • said, the purpose of the statement of

  • cash flows is to show where the firm got

  • cash during the year and how it was spent. In

  • so doing it provides an explanation of

  • the change in the cash balance on the

  • balance sheet from one year to the next.

  • The bottom line figure on the statement

  • of cash flows, the net increase or

  • decrease in cash, should equal the change

  • in the cash account as you see here with

  • Fastenal. Cash flows are classified into

  • one of three categories ... cash flows

  • related operating activities, cash flows

  • related to investing activities, and cash

  • flow related to financing activities.

  • Operating activities are those directly

  • related to your primary sales activities.

  • Things like cash received from customers,

  • cash paid to employees, suppliers, and

  • anyone else that supports your operating

  • activities, Investing activities capture

  • money spent on fixed assets and

  • investments in other companies as well

  • as cash received when these investments

  • are sold. Financing activities include

  • issuing stock, borrowing and repayment of

  • loans, stock buybacks, and the payment of

  • dividends to stockholders. One thing that

  • can be a little tricky when reading a

  • statement of cash flows is that most

  • firms use what is called the indirect

  • format for the statement, as opposed to the

  • direct format. These terms, direct and

  • indirect, refer only to how the

  • operations section is presented. The

  • investing and financing sections are

  • always presented using the same format.

  • Let me show you an example. This

  • is what a direct format statement of

  • cash flows looks like. The operations

  • section is showing line items for the

  • direct cash inflows and cash outflows

  • just as happens in the investing and

  • financing sections. In the indirect format,

  • the only thing that changes is the

  • operations section. Now instead of showing

  • the operating inflows and outflows

  • separately, the operations section begins

  • with net income from the income

  • statement and presents a reconciliation

  • of net income to the actual net cash

  • from operations. Note that the investing

  • and financing sections are identical.

  • Here are the two operations sections

  • side-by-side. You should take a minute to

  • study this to make sure you see that

  • both formats arrive at the same cash

  • flow from operations of a hundred

  • eighty-five thousand dollars. They're

  • just two different ways to show the net

  • cash generated or used from operations.

  • Some people prefer the direct method so

  • they can more easily see the separate

  • amounts of cash paid or received. Others

  • prefer the indirect method because they

  • like the easy comparison between net

  • income and cash flow from operations.

  • I should point out that with the indirect

  • method though, most people new to

  • accounting find it hard to understand

  • why certain items are added back and

  • others subtracted. Well it's beyond the

  • scope of this video to go into any sort

  • of in-depth explanation of each line

  • item, but suffice it to say they each

  • represent the difference between the way

  • something is captured in net income,

  • based on the accrual method, and its

  • actual cash flow. For example, take

  • depreciation expense. Depreciation as we've

  • seen, is a normal expense on the income

  • statement that reduces net income,

  • However it doesn't use any cash. No cash

  • is paid out when depreciation expense is

  • recognized. So cash flow from operations

  • will always be more than that income by

  • the amount of depreciation expense. In

  • order to adjust or reconcile net income

  • to cash flow then we must add back

  • depreciation expense. That's the sort of

  • thing that is happening with each line

  • item.

  • For our purposes in this segment, your

  • focus when viewing an indirect cash flow

  • statement should really be on the

  • relation between net income and cash

  • flow from operations.

  • One would hope that over time the pluses

  • and minuses would average out and there would

  • be a pretty strong relationship between

  • net income and cash flow. If cash flow

  • from operations starts to decline

  • without a similar decline in that income,

  • that could be a red flag that the firm

  • is having a hard time collecting cash

  • from its customers, or even worse maybe

  • manipulating the financial numbers. The

  • statement of cash flow is really needed

  • to complete the financial picture of the

  • firm. The balance sheet lists the

  • company's resources and the claims on

  • those resources at a single point in

  • time. Thus, it becomes important to

  • compare the end-of-the-year balance

  • sheet to the beginning-of-the-year

  • balance sheet to identify changes and to

  • see if and where the firm is growing. The

  • income statement is necessary to provide

  • more detail on the operations of the

  • firm, how well it did during the year

  • at selling its products and services.

  • And the statement of cash flow provides

  • direct insight into where we got our

  • cash and how it was spent. The key

  • takeaway is that you cannot rely on

  • any one of these statements alone to

  • fully evaluate a firm's financial

  • health.

  • You really have to examine all three and

  • understand the different insights each

  • statement can provide.

As you become more familiar with the

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