Statement of Cash Flows

The statement of cash flows can be developed using either the direct or indirect method. The two methods use different approaches to determine the company's cash flow from operating activities. If done correctly, both should yield the same value for the cash flow from operating activities. The company's cash flow from investment activities and cash flow from financing activities are calculated the same way regardless of whether the direct or indirect method is used.

The direct method adds together all of the different types of cash outflows and inflows to yield the cash flow from operating activities figure. Any cash flows related to business activities are included in the calculation. These include cash outflow to vendors, cash outflow to employee salaries, cash outflow for payments of interest on loans, and cash inflow from customers. The values for these cash accounts are determined by taking the difference between the start of the period's balance and the end of the period's balance. The direct method delivers a greater level of detail regarding the company's sources and uses of cash. The Financial Accounting Standards Board (FASB) is an advocate of the direct method because of the transparency of the cash flows and thus advises all companies to prepare their statement of cash flow in this manner.

The indirect method employs accrued accounting records to yield the cash flow from operating activities. The indirect method adds noncash expenses to or subtracts noncash revenues from the company's net profit. The company's net profit can be found on the income statement. Accountants generally favor the indirect method because of its simplicity, while stakeholders, such as potential investors and management, may have an aversion to the indirect method because of the reduction of transparency in cash flows.

The statement of cash flows, income statement, and balance sheet are interconnected. Together, a company's financial statements present a more complete illustration of the company's financial health than they do separately. For example, changes in a company's assets and liabilities trigger changes to the income statement in the form of depreciation expense or interest expense. The net income figure from the income statement may flow through to the balance sheet as retained earnings (net of dividends) and also serves as the basis to calculate cash flows from operating activities on the statement of cash flows. Further, a company's statement of cash flows provides more detailed information about cash assets included on the balance sheet and is related to net income shown on a company's income statement.

Each financial statement provides a different piece of financial information. The balance sheet examines a company's assets, liabilities, and shareholders' equity; the income statement examines where the company is putting those assets and liabilities to use; and the statement of cash flows reveals how well the company uses its assets to produce cash to meet its liabilities and continue funding operations.

Shareholders and other stakeholders use the ratios, which are calculated using data from the financial statements, to pinpoint a company's strengths and limitations. These ratios can provide information, such as cash flow and asset turnover. In contrast, investors use the ratios to ascertain if the company is a suitable investment, and creditors use the ratios to determine the company's risk of default. Some examples of ratios are the operating cash flow ratio, the asset turnover ratio, and the operating cash flow to sales ratio.

The operating cash flow ratio is the company's cash flow from operating activities divided by its current liabilities. This ratio is a measure of the company's liquidity for the near term. The asset turnover ratio is the company's sales revenue divided by the company's average total assets. Jake's Home Decor Shop calculates its average assets by taking the average of its total assets for two consecutive years. The asset turnover ratio is a valuable tool for determining the company's efficiency in using its assets to produce revenue. The operating cash flow to sales ratio is the company's cash flow from operating activities divided by sales revenue. This ratio is useful for determining the company's ability to transform sales revenue into cash.

Additionally, Jake's Home Decor Shop can calculate its free cash flow by using its financial statements. Free cash flow is discretionary money available for purchasing additional investments, repaying debt, purchasing treasury stock, or increasing company liquidity. Free cash flow is the cash flow from operating activities minus the increase in fixed assets during the period. Calculating the free cash flow can provide valuable insight to Jake's Home Decor Shop. For example, the company's free cash flow is an indicator of the company's capability of growing operations, paying its liabilities, and offering shareholders dividends.