On the other hand, an increase in inventory signals that a company has spent more money to purchase more raw materials. If the inventory was paid with cash, then the increase in the value of inventory is deducted from net earnings.
A decrease in inventory would be added to net earnings. If inventory was purchased on credit, then an increase in accounts payable would occur on the balance sheet, and the amount of the increase from one year to the next would be added to net earnings.
The same logic holds true for taxes payable, salaries payable, and prepaid insurance. If something has been paid off, then the difference in the value owed from one year to the next has to be subtracted from net income. If there is an amount that is still owed, then any differences will have to be added to net earnings.
Example of a Cash Flow Statement
From this CFS, we can see that the net cash flow for the 2017 fiscal year was $1,522,000. The bulk of the positive cash flow stems from cash earned from operations, which is a good sign for investors. It means that core operations are generating business and that there is enough money to buy new inventory.
The purchasing of new equipment shows that the company has the cash to invest in itself. Finally, the amount of cash available to the company should ease investors’ minds regarding the notes payable, as cash is plentiful to cover that future loan expense.
Limitations of the Cash Flow Statement
Of course, not all cash flow statements look as healthy as our example or exhibit a positive cash flow. However, negative cash flow should not automatically raise a red flag without further analysis. Poor cash flow is sometimes the result of a company’s decision to expand its business at a certain point in time, which would be a good thing for the future.
Therefore, analyzing changes in cash flow from one period to the next gives the investor a better idea of how the company is performing, and whether a company may be on the brink of bankruptcy or success. The CFS should also be considered in unison with the other two financial statements.
As we have already discussed, the CFS is derived from the income statement and the balance sheet. Net earnings from the income statement are the figure from which the information on the CFS is deduced.
As for the balance sheet, the net cash flow in the CFS from one year to the next should equal the increase or decrease of cash between the two consecutive balance sheets. For example, if you are calculating cash flow for the year 2019, then the balance sheets from the years 2018 and 2019 should be used.
What Is the Difference Between Direct and Indirect Cash Flow Statements?
Using the direct method, actual cash inflows and outflows are known amounts. The cash flow statement is reported in a straightforward manner, using cash payments and receipts.
Using the indirect method, actual cash inflows and outflows do not have to be known. The indirect method begins with net income or loss from the income statement, then modifies the figure using balance sheet account increases and decreases, to compute implicit cash inflows and outflows.
Is the Indirect Method of the Cash Flow Statement Better Than the Direct Method?
Neither is necessarily better or worse. However, the indirect method also provides a means of reconciling items on the balance sheet to the net income on the income statement. As an accountant prepares the CFS using the indirect method, they can identify increases and decreases in the balance sheet that are the result of non-cash transactions.