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The Importance of Cash Flow

Written by: Wayne Label

Article Overview: What is the cash flow statement and why is it required by GAAP? This article will give you an idea behind the cash flow statement and the basic principals used to create it. It will show the difference between the accrual and the cash methods of accounting for business transactions. Importance of cash flow

The Importance of Cash Flow



According to US GAAP, accounting financial statements are created based on an accrual principal. Even though some small businesses accounting is done using the cash method, accrual is an accepted method of accounting in the US. For non-accountants it might be difficult to understand the difference, but it is pretty simple; under the cash accounting, revenues and expenses are recognized as soon as cash is disbursed or received, while under the accrual method, they are recognized as soon as the revenue is earned and expense is incurred. This concept is a cornerstone of US GAAP and is taught in every basic accounting course.

The Statementof Cash Flowsis a statement of cash transactions during a fiscal period. It consists of three parts; operating, investing and financing. This way, management and other interesting parties learn exactly what types of activities generate cash and what activities cause the cash outflow.

You might ask why we need to know the details; well, because regardless of how high a net income is, if cash flow is week, company will face problems meeting its obligations. Think about it; net income is generated from sales, sales are not all cash sales, some of them are on credit. So if the company fails to collect outstanding balances from the customers, it will not have the sufficient funds to pay salaries and pay its vendors. Even though net income, which is based on an accrual method, might be high, at the end of the day, everything comes to cash flow.

Operating activities are activities that are necessary to generate sales; such as sales, salaries to sales people and advertising. Cash sales will be reported as cash inflows, salaries as cash outflows.

Investing activities are activities that involve purchase or sale of property, plant and equipment. For example, buying a building; it is an investment for the company. If a building is paid for by cash down payment and financing, only cash down payment will be reported as an investment activity.

Financing is an activity that causes cash inflow or outflow to support any aspect of a business activity. For example, if a company bought a building by partial cash down payment and the rest is financed, the financed portion is reported in financing activities.

The idea is to create a detailed report of cash activity. It is a "cash log" for the fiscal period that shows in a great detail what happened in a cash account.

One thing that you have to remember is that, when accountants refer to cash, it is not just cash sitting in a bank account, it also means cash equivalents, instruments that can be easily converted into cash. They include: cash in the bank account, commercial paper (it is a short term loan), investments that mature in less than three months, CDs, money market accounts and US T-bills. They are all listed in a current assets portion on the balance sheet.

As you can see, even though accrual method is accepted as GAAP in US, cash makes a huge difference in the operations of the company.

Websites like the author of this artilce offer number of resources for learning accounting in the form of articles, blogs and other literature. Books like Accounting for Non-Accountants, 2nd edition, by Dr. Wayne Label, CPA present very simple concepts on accounting and give good explanations that help beginners to learn accounting. It is a source that non-accountants can use to get familiar with the profession and the problems it faces as far as accounting fraud and ethics are concerned.

I hope article has inspired you to get involved with an accounting profession. It is a very good tool for every businessman to learn and master. It will open your eyes to a complex world of business analysis that will improve your financial performance.

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Article Tags: accounting, accounting for nonaccountants, Balance sheet, financial statements, fraud and eithics, generally accepted accounting principles GAAP, income statement, statement of cash flows



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