Cash Flow Fundamentals

Business accounting systems prescribed by the Financial Accounting Standards Board (FASB), the regulatory body for the discipline of financial information, require that accounting information be promulgated on an accrual basis, which essentially means that sales made and bills incurred are assumed to be paid in a given accounting period, even though in fact lags in payment do occur and are carried from one accounting period to another. As a result, it is necessary to identify actual cash flows, since payrolls and bills have to be honored on time, and while accounting data will show such things as "profitability", expenses such as depreciation require no cash outlay.

In addition, the economic viability of a business is its ability to covert products and/or services to profitable cash, which can be used to reduce outstanding obligations and invest in new assets. Cash flow is therefore the life blood of a business enterprise. Corporate stakeholders of all kinds -- stockholders, creditors, employees, and trade creditors -- are vitally concerned about the company's ability to convert it business activities to cash, and also in the sources from where such cash came and which purposes it is used.

In order to prepare a statement of cash flows in the prescribed form it is first necessary to look at the income statement and balance sheet for the last two accounting periods and identify (1) those assets which have been increased from one period to another, called uses of funds, and (2) those asset investments which have been reduced, called sources of funds. As well, one must look at the liability side of these statements and identify those increases, called sources, and reductions of liability, called uses. The point of this exercise is to be sure all increases in funds equal all uses and that the amount of cash on hand is verified.

When this essential process is complete then the preparation of a cash flow statement is possible. This statement identifies the actual flow of cash from the main business activity: sales, rents, and so on. This statement identifies as well the flow of cash into and out of the permanent asset structure of the business, such as building and equipment bought or sold. The third element of this statement is the identification of the amount of money received from financing activities such as borrowing and selling stock as well as any pay downs of those obligations. The goal is to see where the actual money goes and how it was received. This information is not readily found on income statements.

The amount of cash a business has resides in a verifiable bank statement. Any process that resolves financial data into a verifiable amount of cash in a bank has to be of interest to any person concerned about that company. In addition, the cash flow statement serves as the the first document that indicates the decision making acumen of the management of a company in how it acquires and uses the asset structure of the business.

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