accrual basis on which the income

statement is constructed, you quickly

appreciate the need for a statement that

focuses solely on cash and identifying

the sources and uses of cash during the

period.

Thus the statement of cash flow is the

third statement which is needed to

complete the description of a company's

financial position and performance. As I

said, the purpose of the statement of

cash flows is to show where the firm got

cash during the year and how it was spent. In

so doing it provides an explanation of

the change in the cash balance on the

balance sheet from one year to the next.

The bottom line figure on the statement

of cash flows, the net increase or

decrease in cash, should equal the change

in the cash account as you see here with

Fastenal. Cash flows are classified into

one of three categories ... cash flows

related operating activities, cash flows

related to investing activities, and cash

flow related to financing activities.

Operating activities are those directly

related to your primary sales activities.

Things like cash received from customers,

cash paid to employees, suppliers, and

anyone else that supports your operating

activities, Investing activities capture

money spent on fixed assets and

investments in other companies as well

as cash received when these investments

are sold. Financing activities include

issuing stock, borrowing and repayment of

loans, stock buybacks, and the payment of

dividends to stockholders. One thing that

can be a little tricky when reading a

statement of cash flows is that most

firms use what is called the indirect

format for the statement, as opposed to the

direct format. These terms, direct and

indirect, refer only to how the

operations section is presented. The

investing and financing sections are

always presented using the same format.

Let me show you an example. This

is what a direct format statement of

cash flows looks like. The operations

section is showing line items for the

direct cash inflows and cash outflows

just as happens in the investing and

financing sections. In the indirect format,

the only thing that changes is the

operations section. Now instead of showing

the operating inflows and outflows

separately, the operations section begins

with net income from the income

statement and presents a reconciliation

of net income to the actual net cash

from operations. Note that the investing

and financing sections are identical.

Here are the two operations sections

side-by-side. You should take a minute to

study this to make sure you see that

both formats arrive at the same cash

flow from operations of a hundred

eighty-five thousand dollars. They're

just two different ways to show the net

cash generated or used from operations.

Some people prefer the direct method so

they can more easily see the separate

amounts of cash paid or received. Others

prefer the indirect method because they

like the easy comparison between net

income and cash flow from operations.

I should point out that with the indirect

method though, most people new to

accounting find it hard to understand

why certain items are added back and

others subtracted. Well it's beyond the

scope of this video to go into any sort

of in-depth explanation of each line

item, but suffice it to say they each

represent the difference between the way

something is captured in net income,

based on the accrual method, and its

actual cash flow. For example, take

depreciation expense. Depreciation as we've

seen, is a normal expense on the income

statement that reduces net income,

However it doesn't use any cash. No cash

is paid out when depreciation expense is

recognized. So cash flow from operations

will always be more than that income by

the amount of depreciation expense. In

order to adjust or reconcile net income

to cash flow then we must add back

depreciation expense. That's the sort of

thing that is happening with each line

item.

For our purposes in this segment, your

focus when viewing an indirect cash flow

statement should really be on the

relation between net income and cash

flow from operations.

One would hope that over time the pluses

and minuses would average out and there would

be a pretty strong relationship between

net income and cash flow. If cash flow

from operations starts to decline

without a similar decline in that income,

that could be a red flag that the firm

is having a hard time collecting cash

from its customers, or even worse maybe

manipulating the financial numbers. The

statement of cash flow is really needed

to complete the financial picture of the

firm. The balance sheet lists the

company's resources and the claims on

those resources at a single point in

time. Thus, it becomes important to

compare the end-of-the-year balance

sheet to the beginning-of-the-year

balance sheet to identify changes and to

see if and where the firm is growing. The

income statement is necessary to provide

more detail on the operations of the

firm, how well it did during the year

at selling its products and services.

And the statement of cash flow provides

direct insight into where we got our

cash and how it was spent. The key

takeaway is that you cannot rely on

any one of these statements alone to

fully evaluate a firm's financial

health.

You really have to examine all three and

understand the different insights each

statement can provide.