Cash flow statements are the third of the core financial reports produced by companies, following the income statement and balance sheet. Cash flow statements tell investors and managers exactly where and how a company is spending its cash.

The purpose of the cash flow statement is to provide clarity on how a company is managing its cash flow. It does this by reconciling the sources and uses of cash from both the income statement and balance sheet and combining them onto one report.

Accrual accounting can make cash flow hard to see
Public companies report their financial statements using a type of bookkeeping called accrual accounting. An important characteristic of this system is that income and expenses can be recorded, even though no cash actually changes hands.

For example, in many business-to-business transactions a company may not require the customer to pay cash immediately to receive its product. The customer may have 30, 60, or even 90 days to actually pay that bill. On the financial statements, the selling company creates an account receivable on the balance sheet, notating that the actual cash is to be collected later. Simultaneously, it will recognize the sale as income on the day the product changes hands.

The selling company's income statement will show the sale and the associated cost of goods sold. The balance sheet will see inventory reduce and accounts receivable increase. Appropriately, though, cash won't change. That's because no cash has actually changed hands.

When the customer does eventually pay the bill in the future, the selling company's balance sheet will show an increase in cash and a corresponding decrease in accounts receivable. Because the sale was already recognized on the income statement when the product changed hands, there is no impact on the income statement when the cash is collected.

The statement of cash flow sits in between the income statement and the balance sheet
In the preceding example, the interrelationship between the income statement and balance sheet can be seen. The statement of cash flow takes into account all the changes on both and consolidates the impact to cash into one financial statement -- the statement of cash flow.

This is a critical role in the financial reporting process because dangerous cash flow changes have the potential to be hidden in the gap between the income statement and balance sheet.

For example, imagine that a clothing store decides to begin offering charge cards to its customers. The company is effectively using the charge cards to allow customers to buy clothes without paying immediately. The company must collect the payment in 30 days, just like the accounts receivable example above.

The charge card program will likely increase sales and net income immediately because it will make it easier for customers to buy the clothes in the store. No cash, no problem. Investors may see this boom in sales and net income, and think that the store is doing amazing. Sales and profits are up big, after all.

However, if the company gives charge cards to customers with bad credit who don't eventually pay, the entire company could collapse from those bad debts. On the financial statements this danger would be found by monitoring how the company's accounts receivables are changing relative to its sales.

An easier way, however, would be to monitor the company's cash flow statement. The cash flow statement will show the company's cash flow from operations declining in spite of rising sales and profits. The company could offset the drop in cash flow from operations for a little while -- they could borrow money or tighten its spending, for example, but eventually this trend could erase all the company's cash and lead to bankruptcy.

A savvy investor would recognize this problem and spot the spike in sales as a short term success creating a major long term problem.

Investors need all three financial statements to fully see how a company is performing
When a company pays its bills, that's a use of cash. When it pays down a debt, that's also a use of cash. Conversely, when it takes out a loan, collects an account receivable, or makes a cash sale, it generates cash. These are everyday events in the operation of all businesses, but the cash impact is not clearly seen on either the income statement or balance sheet alone.

The income statement is very well designed to show sales, expenses, and profits in a given period of time. The balance sheet is equally adept at describing what a company owns and owes at specific points in time. But it is the statement of cash flow that fills in the gap between them, bringing focus to how a company is managing its true cash flow.

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