Companies often make available to investors and the general public financial statements that indicate the firm’s financial position at some point in the past. These historical documents are published monthly, quarterly, or annually. Using these statements, potential investors can see trends from period to period to help determine the profitability of a firm and the risk associated with becoming a part owner of the corporation.
The Statement of Cash Flows
The Statement of Cash Flows shows the flow of cash into and out of the organization. Unlike the balance sheet which lists the values of assets, liabilities, and owners’ equity, the cash flow statement is a measure of actual money, not just value. The income statement also indicates value but it does show some aspects of cash. For example, the retained earnings represent cash kept to reinvest in the organization. However, the income statement is not a schedule of cash flows; it contains non-cash items such as depreciation which can skew the perception of the cash position of a firm.
A cash flow statement is usually broken down into three categories, or sources, of cash flows. The operating section shows cash flows from normal operations of the firm. It includes items such as increases and decreases to net income, accounts receivable, inventory, accounts payable, and accrued expenses. Again, these items all indicate actual cash changes from these items.
The investing section shows cash flows from investments such as when one company buys stock in another and realizes capital gains in the form of cash. Often this section shows negative cash flows, or outflows of cash, for the purchase of land, plant, and equipment. Items in this section point out future directions of the company. For example, purchases of equipment may indicate that the managers’ intention to increase production for subsequent periods.
The financing section shows cash flows from capitalization activities. These items include changes in cash from the payment of notes payable, long-term debt, and cash dividends paid to stock holders. These items are also found on the right-hand side of a balance sheet but on a cash flows statement, the figures represent cash inflow or outflow because of capitalization not just a listing of the book values of these items.
The balance sheet shows only the book values of assets, liabilities, and owners’ equity. It does not show any cash inflows or outflows the company experienced during the period in question. Income statements often show non-cash items so they are not reliable indicators of a company’s cash position. Liquidity in a firm is important to investors because it represents a large part of a company’s profitability. Cash, the most liquid asset, is the least risky asset a company can own because its value can be realized almost immediately without loss of value due to friction or conversion costs. The Statement of Cash Flows is the only document of the three that shows accurate measures of the flow both in and out of a firm of the most liquid asset, cash.