The Cash Movement of Operating Activity.(Brief Article)

Question: What is the significance of the "cash flow from operating activity" on my customer's Statement of Cash Flow?

Answer: Cash flow from operating activity attempts to reconcile net income into a cash basis. Unlike the Income Statement, it is not as subjective to accounting accrual distortions and will give you a better indication of the true "cash" generated from the day-to-day business activity.

The purpose of the Income Statement is to show a company's profitability by starting with the current period revenue and deducting the expenses that helped generate that revenue. As such, the Income Statement tries to match the expenses that were incurred to generate those sales, and disregards the timing of the cash payment of those expenses.

A company buys a piece of equipment and pays $30,000 for it. On the Income Statement, the company tries to match the cost of the equipment as an expense over the period of time that it estimates the equipment will generate sales. The Income Statement would not want to recognize the entire $30,000 as an expense in the year that it was purchased, as it would incorrectly reduce net income for that year when, in fact, using the equipment would generate sales over a period of years. The Income Statement uses depreciation to divide that expense over a period of time to correctly match that expense with the years the equipment will be used to generate revenue.

On the other hand, the Statement of Cash Flow attempts to show you the "cash movement" for the year. It is trying to show you how the cash was generated (through operations, stock sales or bank loans) and how it was used (through operations, fixed asset purchases, dividends or paying down bank loans).

On the Statement of Cash Flow, the depreciation expense for the year is added back to the net income figure as, after the initial purchase, no more cash is being spent for the purchase of the equipment. The Statement of Cash Flow shows the initial purchase of the equipment as a use in the cash flow from "investing activity," not from operations. If there were a loan for the equipment, the loan payments would be included as a use of cash in the cash flow from "financing" activities.

Revenue on the Income Statement is recognized generally at the point of sale. However, if the company extends terms to its customers, they will have accounts receivable balances outstanding at the start of the year. The cash from beginning accounts receivable will be received from customers during the year. A company will also have accounts receivable balances at the end of the year from the customers whose sales have been recorded on the Income Statement, but whose money they have not yet collected. The Statement of Cash Flow attempts to recognize the "cash movement" of revenue, so the ...