When I was studying Accounting at Pace University I remember how much I dreaded the Statement Of Cash Flows. The first time sitting for the CPA exam I simply skipped over the question in which we had to prepare a statement of cash flows. I just didn’t get it and I walked out of Pace University with a degree in Accounting and a specialization in “Public Accounting” with no clue about how the Statement of Cash Flows worked. I hoped I never would have to see this statement again, and I didn’t for a long time. It wasn’t until I was doing a projection for a company while working through a CPA firm that I not only needed to prepare one, I had to write the formulas to project a monthly statement of Cash Flows which meant that I needed to learn this very fast. Luckily by this time I had the experience so I was able to work it out pretty much within a day. Now I understand it very deeply and I also now understand why investors regard it as possibly the most important when they are evaluating a company and deciding whether or not to invest in it.
2 Important Facts About The Statement Of Cash Flows
- The Statement Of Cash Flows Reconciles Net Income To Cash.
- The Statement Of Cash Flows breaks your cash flows up between Operating, Financing, and Investing activities. This tells you where your cash flows are coming from.
So which came first? The Balance Sheet?
The balance sheet shows our assets, liabilities and equity. It represents a snapshot. A moment in time image of what the company is worth. This shows us how much we have in the bank , how much we owe people, and ultimately what the book value of our company is. Assets – Liabilities = Equity.
Is this the most important financial statement?
Did the Profit and Loss Come First?
This is the statement that tells us how much money we made. After all isn’t that what it’s all about in the end? Making money? We go into a “For Profit” business to make a profit. To make money.
So the Profit and Loss MUST have come first!
But wait! Let’s think about this for a minute. In order to start a business I need capital. I either invest my own money, or someone else invests their money and I deposit that money into a bank account. Which statement reflects this? On both sides of this transaction it’s the balance sheet. Cash in the bank, and equity or capital contributed. So the Balance Sheet comes first? But I know people, like myself who started a business with no capital and the first transaction was a sale, made in exchange for their time and when they were paid the income earned was deposited into their account and this was the first transaction in their business. Which financial statements were affected? The Balance Sheet and the P&L. The money was earned (P&L) and it was due (A/R on the balance sheet). Then the money was received and deposited (both balance sheet events).
The truth is they are all important. The point I want to highlight here is that a great deal of emphasis is placed on the Balance Sheet and P&L while not enough emphasis is placed on the Statement of Cash Flows. Which one is the most important? It depends who you ask and what their vantage point is. The savvy investor wants to make sure that substantially all of the cash flows are coming from operations. They also want to make sure that the equity section of the balance sheet shows an increasing trend. They also want to know that the company shows good liquidity, and good returns on Assets, Equity, and any long term debt. So far every financial statement was just referenced.
What do you think? Which of the financial statements is the most important and why do you think so?
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