The Reverse Flip

Everything on the cash flow statement comes from either the income statement or the balance sheet. But, searching through each kind of statement to try to figure out how they are linked can be rather confusing. To make the explanation of where each number comes from easier, try looking at the cash flow statement in another way. Figure 6-2 displays the cash flow statement as you would normally see it on the left. On the right-hand side of the figure, the numbers are listed first.

Figure 6-2: Normal (left) and reversed cash flow (right) statements.

As you can see, all the information is the same on these two views of the cash flow statement. The only difference is their format. Now, use the reverse format to compare the cash flow statement to the other two financial imperative statements: the income statement and the balance sheet.

What Comes From the Income Statement?

The first line on the cash flow statement is net profit. The number on this line came from the bottom line of the income statement. In figure 6-3, you can see exactly where an accountant would get the first line of the cash flow statement.

Figure 6-3: Income statement and cash flow statement connection.

What Comes From Assets on the Balance Sheet?

All other items on the cash flow statement come from the column of changes between last year ‚ s figures on the balance sheet and this year ‚ s figures on the balance sheet. The impact on cash flow from assets is different than the impact from cash flow from liabilities and owner ‚ s equity.

The rules for cash flow from assets will be discussed first. Figure 6-4 shows the movement of cash relative to assets.

Figure 6-4: Movement of cash and assets.

The rule for the changes in cash caused by non-cash assets is that cash flow moves opposite to changes in non-cash assets. If a non-cash asset such as AR increases , that is a use of cash. In other words, this means that the organization is not getting paid for its goods or services by its customers. Therefore, the amount of the increase is subtracted from the cash flow statement. If a non-cash asset, such as inventory, decreases, that is a source of cash. Therefore, the amount of the decrease is added to the cash flow.

Depreciation is a different type of expense in that it does not take any actual cash from the organization. Depreciation is added back as a source of cash in the operating section of the cash flow statement.

ABC MediCompany ‚ s cash flow statement demonstrates this reciprocal relationship between non-cash assets and cash, as shown in figure 6-5.

Figure 6-5: Balance sheet assets and cash flow connection.

You can see how each change in an asset corresponds to a line on the cash flow statement. In this case, the changes in ABC ‚ s current assets (AR, inventory, and prepaid expenses) and long- term assets (property, PPE, and accumulated depreciation) are highlighted on the left-hand side in the order in which they were displayed on the balance sheet. These same items are highlighted on the right-hand side in the order in which they are displayed on the cash flow statement. There is no one correct order to list the same assets on the balance sheet in relation to the cash flow statement.

You can see that cash moves in the opposite direction as non-cash assets from the way that the same numbers are displayed as either positive or negative on the balance sheet and cash flow statement. For example, on the changes in the balance sheet, the increased investment in PPE is shown as a positive number of $485,000. But, to get that increase in PPE shown on the balance sheet, ABC MediCompany had to pay out some cash. That ‚ s why the same number for Purchases/Additions to Property, Plant and Equipment is shown as a negative number, or ($485,000), on the cash flow statement. Cash had to go down by that much for the asset to go up.

 

What Comes From Liabilities and Owner ‚ s Equity on the Balance Sheet?

Liability or owner ‚ s equity has an effect opposite to that of an asset on the cash flow statement. In this case, a positive change on the balance sheet carries over to a positive change on the cash flow statement (figure 6-6).

Figure 6-6: Movement of cash, liabilities, and owner ‚ s equity.

Why would this be? If an organization is delaying payment of a liability, such as accounts payable or accrued expenses, then they are conserving their cash by doing so. Of course, an organization cannot refuse to pay their bills forever without making their suppliers very angry . Delays in payment might help the organization negotiate some immediate cash flow problems, but this situation negatively affects the organization ‚ s future credit and ability to purchase additional goods or services to keep the organization running. Therefore, any rise in cash flow due to delays in payments is a serious trend that must be quickly caught by Senior management.

Likewise, if new liabilities or equity are created by adding long-term debt or by issuing additional stock in a company, these changes to liabilities or owner ‚ s equity are also additions to an organization ‚ s cash flow. On the other hand, if the organization pays its bills, it reduces its cash. The liability goes down, and the cash goes down.

In figure 6-7, you can see how cash moves in the same direction as liabilities and owner ‚ s equity for ABC MediCompany.

Figure 6-7: Balance sheet liabilities, owner ‚ s equity, and cash flow connection.

The current liabilities, accounts payable, and accrued expenses are shown as positive numbers on the balance sheet and again as positive numbers on the cash flow statement. Both these liabilities have increased over the last year. Because ABC ‚ s sales have gone up, there should be proportionate increases in some expenses because ABC should have had to buy more materials to create more products to sell. Still, this increase must be closely watched.

The long-term liabilities on the balance sheet are shown as the sum of the cash flow from financing activities on the cash flow statement. On the cash flow statement, you can see a little more detail about the financing activities. Debt borrowings and debt repayments are broken out so you can see how much cash came in or went out as a result of these activities.

ABC MediCompany had a total of $500,000 in borrowings for this last year. They repaid $50,000 of their borrowings during this last year. The final number ‚ $450,000 ‚ of cash flow from financing activities is the same as the $450,000 on the balance sheet for long-term liabilities.

There is one other item to note between the liabilities and owner ‚ s equity on the balance sheet and the cash flow statement. That is how owner ‚ s equity is shown on the cash flow statement. In this case, ABC MediCompany retained all net profit. It did not pay out any distributions to shareholders. For this reason, owner ‚ s equity and net profit are the same on ABC ‚ s cash flow statement.