Why is the Statement of Cash Flows Required?
Cash is the lifeblood of a company. It’s so important that is it any surprise that there’s a financial statement that just looks at the inflows and outflows of the cash into a business. It’s the statement of cash flows.
To help us understand the statement of cash flows, let’s take a look at a brand new consulting company called Acme Consulting in its first month of business, January.
In January, it had two clients. We did one day’s work for the first client and they paid us $500 in cash. From these two numbers, we can build up a very simple set of financial statements, the income statement and the balance sheet. Let’s do that.
The income statement shows us sales of $500. There are no expenses, so our net income is $500.
The balance sheet shows cash for $500, total assets of $500. And the owner’s equity and retained earnings (equal to the total of all the income and losses for the entire history of the company, which is less than a month). The key point I want to make here is that, in a perfect world, the net income just simply becomes cash.
But we don’t live in a perfect world and the second client proves this. For them, we do two days’ worth of work and we charge them $1,000. Sales go from $500 to $1,500. Net income goes from $500 to $1,500. Owner’s equity and retained earnings goes from $500 to $1,500. But the client doesn’t pay us. They agree, and we agree with them, that they will pay us next month.
Now I have a serious problem because the balance sheet no longer balances.$500 total assets no longer equals $1,500 of retained earnings. This is serious trouble. Tune in to the next video to see how we resolve this.
Next video — cash flow statement to the rescue.