Introduction to the Statement of Cash Flows

Our hero, Carl, is really becoming an entrepreneur and he is starting to understand how to talk like a businessman. He now understands what assets, liabilities, and owners’ equity are. He knows what revenue, expenses, and net income mean. He has generated two of the three financial statements: the balance sheet and the income statement. Today Carl sets out to tackle the statement of cash flows.

Many accountants and business people believe that the statement of cash flows is the most important of the financial statements. This is because the statement of cash flows cannot be manipulated like the other financial statements. At this point in your jedi-accounting training we haven’t told you (or Carl) about how easily the balance sheet and the income statement can be manipulated (we will get there in time young Padawan). It’s worth noting right now that the balance sheet and income statement require a lot of estimates from managers and accountants; and where there are estimates there are chances for manipulation. With the statement of cash flows you either have the cash or you don’t—a quick call to the bank is all that is needed to verify the accuracy of the statement of cash flows.

The Need for a Statement of Cash Flows

The purpose of this financial statement is to show how cash is coming into the business and how cash is leaving the business. Investors and creditors care a lot about cash. One of the main reasons that businesses fail is cash-flow issues (or lack of cash). Yes, even successful, growing companies can fail because they don’t manage their cash correctly.

Tina "Tick-Tock" Walton is a big deal in the clock business.

Carl, owner of Carl’s Clockworks is surfing the Internet reading about one of his heroes, Tina “Tick Tock” Walton. Tina is the most successful clock vendor this side of the Atlantic Ocean. While reading about Tina, Carl finds an interesting paragraph or two where Tina discusses how the business almost failed due to cash-flow issues.

Tick Tock is quoted as saying, “In the early days I was selling clocks like crazy. I didn’t make customers pay a dime until six months had passed. This led to a lot of people buying clocks that probably wouldn’t have otherwise. My sales revenue was over $500,000 in those first six months and I opened up three different stores in different locations because I was growing so fast. That being said, I didn’t have a lick of cash and the creditors were asking for their money.”

Carl is a little confused about how it was possible that Tina didn’t have any cash if she was making so many sales. What Carl doesn’t understand is that Tina was making sales on account (the customers didn’t have to pay any cash for six months). This means that even though “Tick Tock” had over $500,000 in revenues she probably had close to $500,000 in accounts receivable as well. Tina wouldn’t be seeing much cash until the six month period when customers started paying off their accounts.

Michael Scott helped Tina with her cash flow problems.

Just before Tina had to close down her shops, a mystery investor (later identified as Michael Scott.) bailed her out by supplying her with the cash that she needed to pay off her debts. The rest is history.

This story about Tina “Tick Tock” Walton really illustrates why creditors and investors want to look at a statement of cash flows. If a company doesn’t have enough cash to pay off its immediate bills, then it will be forced to close its doors.

In the next lesson Carl will learn what goes on the statement of cash flows.

Next Lesson: Lesson 5.1 – What is a Statement of Cash Flows?