Link between the Cash Flow Statement and the Balance Sheet
Cash is an asset and is reported on the balance sheet. The cash flow statement explains the change in cash during an accounting period. This can be illustrated through a simple scenario. Assume that beginning cash is 1,100. This is reported on the balance sheet. The cash flow statement will show the cash receipts and cash payments. For the scenario presented below, the cash receipts equal 3,200 and the cash payments equal 3,300 which means that the net change in cash is -100. This explains how the cash balance went from 1,100 at the start of the period to 1,000 at the end of the period.
|Beginning Balance Sheet 1 Jan 2015||Statement of Cash Flows for Year Ended 31 December 2015||Ending Balance Sheet at 31 Dec 2015|
|Beginning Cash||Plus: Cash Receipts||Less: Cash Payments||Ending Cash|
Link between Cash Flow Statement, Balance Sheet and Income Statement
Let’s consider an example of how items on the balance sheet are related to the income statement and the cash flow statement. Suppose the beginning accounts receivable is 200, the revenue during the year is 5,000 and the cash collected from customers is 4,800. What is the ending accounts receivables? The table below makes it easy to compute the missing amount. We see that the ending accounts receivables will be 400.
|Balance Sheet at 1 Jan 2015||Income Statement||Statement of Cash Flows||Balance Sheet at 31 Dec 2015|
|Beginning A/R||Plus: Revenue||Less: Cash Collected from Customers||Ending A/R|
This example clearly shows that receivables (balance sheet item), revenue (income statement item) and cash collected from customers (cash flow item) are related as follows:
Ending receivables = Beginning receivables + Revenue – Cash collected from customers
Only cash flow from operating activities is presented differently under the two methods. Presentation of cash flow from investing activities and cash flow from financing activities is the same under both methods.
Operating Cash Flow
In the direct method, we take each item from the income statement and convert it to its cash equivalent by removing the impact of accrual accounting.
The rules to adjust are:
Cash collected from customers: Adjust sales for changes in accounts receivable and unearned revenue.
Cash for inputs: Adjust COGS for changes in inventory and accounts payable.
Cash operating expenses: Adjust SG&A for changes in related accrued liabilities or prepaid expenses.
Cash interest paid: Adjust interest expense for changes in interest payable.
Cash taxes paid: Adjust tax expense for changes in tax payable and changes in deferred tax assets and liabilities.
Consider a company that reported sales of $10 million. Accounts receivable for the year went up from $2 million to $4 million. Unearned revenue went up from $1 million to $2 million. Calculate cash collected from customers.
Δ Accounts receivable = $2 million. This is an asset and increase in asset is use of cash so –ve adjustment.
Δ Unearned revenue = $1million. This is a liability and increase in liability is source of cash so +ve adjustment.
Cash collected from customers = + $10 million – $2million + $1million = $9 million.
Consider a company with COGS of $20 million for a particular period. During this period inventory increased by $4 million and accounts payable went up by $2 million. Calculate the cash paid for inputs.
Δ Inventory = $4 million. This is an asset and increase in asset is use of cash so –ve adjustment.
Δ Accounts payable = $2 million. This is a liability and increase in liability is source of cash so +ve adjustment.
Cash paid for inputs = – $20 million – $4 million + $2 million = – $22 million
Indirect method shows how cash flow from operations can be obtained from reported net income as a result of a series of adjustments.
The steps are:
Consider a company with net income of $100 million in 2001. Depreciation expense is $10 million. Gain on sale of equipment is $4 million. Increase in A/R is $8 million. Increase in A/P is $4 million. Increase in inventory is $10 million. Calculate CFO using the indirect method.
|Add non-cash charges (depreciation)||+ 10|
|Less gain on sale of equipment||– 4|
|Less increase in A/R||-8|
|Add increase in A/P||+4|
|Less increase in inventory||-10|
|CFO = $ 92 million|