When discussing financial statements, most people think about the two most common ones: the Income Statement (or Profit and Loss Statement) and the Balance Sheet. These two are fundamental in evaluating a company’s financial health. The Income Statement shows how much revenue the company has generated and what expenses have been incurred, providing insight into profitability. The Balance Sheet details a company’s assets, liabilities, and equity at a given point in time—essentially showing what a company owns versus what it owes.
However, there is a third crucial financial report often overlooked: the Statement of Cash Flows. This statement provides insight into a company’s liquidity, which is vital for assessing the ability to meet short-term obligations and invest in growth. While the Income Statement and Balance Sheet offer important data, the Statement of Cash Flows brings the bigger picture together, showing the actual movement of cash in and out of the business.
Why is the Statement of Cash Flows Important?
The need for a Statement of Cash Flows arises from the requirement to report financials using accrual accounting. This method recognizes income and expenses when they are incurred, not necessarily when cash exchanges hands. For instance, under accrual accounting, if you sign a five-year lease with the first six months rent-free, you don’t simply report zero lease expenses for the first six months. Instead, you spread that expense evenly over the entire lease term, even if no cash changes hands initially.
While this method of accounting provides a more accurate picture of the company’s financial obligations and profitability, it doesn’t reveal how much cash the company has on hand. Investors, lenders, and other stakeholders need to understand a company’s cash position because, in the end, liquidity—the ability to meet short-term obligations—matters the most. That’s where the Statement of Cash Flows comes in.
The Three Categories of Cash Flows
The Statement of Cash Flows is divided into three main categories:- Cash Flows from Operating Activities: This section includes the day-to-day cash transactions related to the core operations of the business. For example, it shows cash outflows from purchasing raw materials or paying wages and inflows from selling goods or services.
- Cash Flows from Investing Activities: These cash flows stem from purchasing or selling long-term assets, such as property, equipment, or securities. If a company buys machinery to produce its products, that would fall under investing activities.
- Cash Flows from Financing Activities: This includes cash inflows and outflows related to equity and debt. Examples are taking out a loan (an inflow) or paying off the principal on that loan (an outflow). This section is particularly important for startups or companies with fluctuating cash flows that may rely on external financing to fund operations.
The Importance of Differentiating Cash Flows
A key aspect of the Statement of Cash Flows is not just reporting cash inflows and outflows but differentiating between operational, investing, and financing activities. For example, you may have plenty of cash, but if most of it comes from financing activities (debt), that’s not necessarily sustainable in the long run. While taking on some debt can be healthy, the company needs a balance of cash inflows from regular operations to be sustainable.
Investors care deeply about liquidity, the ability to convert assets into cash to pay bills. A strong Statement of Cash Flows that shows healthy operating cash flows can reassure investors about a company’s long-term viability.
Handling Leases in the Statement of Cash Flows
Lease payments—whether from finance leases or operating leases—also show up in the Statement of Cash Flows. The classification of these payments varies based on the type of lease:
- Finance Leases: These are treated similarly to debt. The principal portion of lease payments is considered a financing activity, while the interest portion is considered interest paid, which might be recorded as an operating or financing activity depending on the company’s accounting policy.
- Operating Leases: These are simpler, and lease payments are treated as cash outflows from operations. There’s no ownership transfer at the end of an operating lease, so the payments are considered a standard operational expense.
For companies using complex lease agreements, understanding how to categorize cash flows correctly is crucial. Some companies may want to differentiate the interest and principal components of their lease payments even for operating leases. This is where specialized accounting software can simplify the process, helping companies manage the nuances of lease accounting under standards like Topic 230 of the accounting code, which governs the treatment of interest in the Statement of Cash Flows.
Short-Term Leases and Cash Flows
Short-term leases—those lasting 12 months or less—are handled differently. Most companies opt for the practical expedient, excluding these leases from recognition as assets and liabilities. In the Statement of Cash Flows, short-term leases are reported as operational cash outflows, and there is typically no need for straight-lining or other complex accounting treatments.
However, even though they are lumped together under operating activities, companies are required to distinguish cash flows from short-term leases from those of other operating leases in their reporting.
Disclosure Requirements for Cash Flows
Disclosure is another key aspect of lease accounting and cash flow reporting. Alongside cash flows from leases, companies must disclose their future cash obligations for the next five years and beyond. This gives stakeholders insight into future financial commitments and how they might affect cash flow down the road.
In particular, businesses must demonstrate their ability to meet non-current (longer-term) cash obligations with their available cash and operational cash inflows. If they can’t, it could be a red flag for investors and lenders.
The Role of Software in Managing Cash Flows
With the complexities involved in properly accounting for leases and cash flows, software solutions like Visual Lease become invaluable. Visual Lease, for instance, helps businesses comply with lease accounting standards, accurately segregating operating and financing activities, and automating the calculation of interest and principal components for leases. It simplifies the process of preparing financial statements and ensures accuracy and transparency for stakeholders.
In summary, the Statement of Cash Flows is critical for providing a complete picture of a company’s financial health. While accrual accounting is necessary to match expenses with the periods in which they are incurred, it can obscure the company’s actual cash position. Cash is ultimately what keeps a business running, and the Statement of Cash Flows offers a clear view of where that cash is coming from and where it’s going.
By using tools like Visual Lease, companies can navigate the complexities of lease accounting, ensure compliance, and provide investors with the transparency they need to make informed decisions. In an increasingly complex financial world, understanding and managing cash flow has never been more important.
