Cash Flow From Operations – Understanding Cash Flow (Part II)

There are two fundamental basis of accounting – accrual and cash basis.  In cash basis of accounting, a cash flows statement is unnecessary as the income statement will clearly identify the change in cash.  But there is a significant drawback to cash basis accounting.  In general, it does not convey the true financial performance of the business.  Since bills are often paid after the receipt of goods or service, their cash outlay may not have been included in the cash basis accounting report.

This is counteracts the matching principle in accounting.  To obtain true financial performance, businesses must use accrual basis accounting.  As a matter of best practices, the American Institute of Certified Public Accountants requires accrual accounting for any publicly traded company.

To understand the cash situation, the cash flows statement is an additional report included in financial statements to basically convert the accrual basis balance sheet and income statement into a cash basis report.  This way, management gets the best attributes of both accrual and cash basis accounting.

The cash flows statement has three major sections:

1) Cash flow from operations,
2) Cash flow from investing, AND
3) Cash flow from financing.

Items two and three are explained in other chapters.   This particular chapter is a continuation of Cash Flow from Operations – Basic Formula (Part I).   If you have not read this, please do so prior to continuing.  In this chapter, cash flow from operations is explained in the aggregate so the reader can quickly calculate cash flow from operations.   From this point a more detail calculation is expanded upon for the reader to fully grasp the basic mechanics of cash flow.   Examples are inserted throughout  to assist the reader in comprehending the effects of various types of transactions upon cash flow.

Sources and Uses of Cash

In business there are three major sources of cash. 

Payments from Customers

This is the most important of all sources of cash.   The traditional business model has the customer paying cash at time of purchase or delivery.  In modern day business, customers are allowed to defer payment to a later date; this is known as “on account”.  In a typical growth operation the accountant will see the accounts receivable grow from one period to the next.   In regular operations this is usually the number one source of cash consumption, i.e. deferred payments.   Since profit is calculated on the accrual basis, it must be adjusted lower to reflect any increase (non-payment) in accounts receivable when adjusting to cash basis reporting.

Borrowing Money

The second source of cash is borrowing from third parties, usually vendors and banks.   Loans are either short-term current liabilities or long-term.  Traditional long-term debt is used in purchasing fixed assets which is a cash flow related to financing and investing (acquisition of a fixed asset).  Short term debt is customarily granted by vendors/suppliers, credit card companies and government authorities for taxes due.  Similar to accounts receivable, most growth oriented businesses must borrow more money from vendors and therefore payables expand from one accounting period to the next.   This expansion of debt is a source of cash.

What is fascinating is that with growth comes the expansion of both receivables and payables.   Since the receivable includes the (mark-up and overhead included in the sales price) the cash out aspect usually exceeds the cash in from the increase in current liabilities.  Again growth in current liabilities is a function of the product and/or service sold.   So another source of cash is necessary.


The third and remaining source of cash is from invested capital commonly referred to as equity.   When growth outpaces the ability to secure payments from customers and borrow money it must be funded from either existing working capital or augmented with more invested cash from owners.  In a cash flows statement, this is reported in the cash from financing section.

On the flip side of sources of cash are uses of cash.  Quite honestly, the number of uses far exceed the three major sources of cash.   Uses of cash are better explained in the timing of payments than in groups.  The following describe the typical uses of cash based on the regular accounting cycle (monthly).

Payroll – The shortest cycle group is payroll.   Most small businesses pay every two weeks, some weekly.   Rarely are there less than two payrolls per accounting cycle.  This means cash must exit the company regularly even if no customers pay that month.  In the service driven industry, this single line item is by far the greatest drain on existing working capital.

Materials and Supplies – In a similar pattern as payroll, materials and supplies must be paid regularly or vendors/suppliers will stop providing the goods.   Payments are pretty much weekly and rarely extend to monthly cycles.   Notice that the two most frequent uses of cash (payroll and materials) are also the first two line items in cost of sales on the income statement.

Recurring Expenses – This use of cash occurs monthly and includes items such as rent, utilities,  insurance, taxes, office operations, employee benefits and interest on debt.   The interesting aspect of these expenses is the static nature of them.   They are relatively the same amount each month and do not fluctuate with a change in volume of sales.

Debt Service – This is also a monthly amount and the principal portion is a function of cash flow from financing, i.e. it is a financing outflow.

Purchase of Fixed Assets – This includes other assets such as tangible and intangible items.  This is customarily reported as an investing outflow.

Owner Payments – As a business matures, owners want their return on investment paid back.   This is done in the form of dividends or distributions.  This is a cash use reported in the financing section of the cash flows statement.

The cash flow from operations accounts for sources of cash related to customer payments and short team borrowing (increase in current liabilities).  Three uses of cash are also reported: 1) payroll, 2) materials and supplies and 3) monthly recurring expenses.  The other sources and uses of cash are addressed in the other two parts (investing and financing) of the cash flows statement.

For the remainder of this chapter it is assumed in all examples and illustrations that there is:

A) No long-term borrowing of money
B) No investment by owners during the period illustrated
C) No principle payments made
D) No purchase of fixed assets
E) No owner payments

All activity relates to items commonly portrayed in the cash flow from operations.

Operational Cash Flow in the Aggregate

The whole concept of cash flow focuses on the change in cash for the company from one period to the next.   Cash is defined as actual cash and its equivalents.  This includes all the traditional cash accounts:

A) Petty Cash
B) Till Boxes and Registers
C) Checking Accounts
D) Savings Accounts
E) Money Market Accounts

One of the questionable items is cash held in escrow.   A couple of examples include escrow funds held by the company’s attorney and escrow funds held by a mortgagor.  The key is the ability to control these funds.  The funds held by an agent acting for the company like an attorney is considered an equivalent.   Whereas if funds require two parties to release like those with a mortgage holder then they are really no different then prepaid expenses.  In general escrowed money is restricted in nature and thus not a cash equivalent.

To calculate the change in cash, the accountant needs both the beginning and ending balance sheets.  The beginning balances are customarily the ending balances from the prior period.   Here is an example for a small business for successive months:

.                           ACME RETAIL PRODUCTS
.                             Comparative Balance Sheets
.        For the Two Months Ending July 31, 2016 and August 31, 2016
.                                               July 312016      August 31, 2016

Current Assets
.  Cash                                              $31,742              $57,305

.  Money Market                                20,608                18,111
.  Inventory                                         73,471                91,618
.  Accounts Receivable                       21,742                20,019
.  Prepaid Expenses                              4,140                  3,680
.  Sub-Total Current Assets            $151,703            $190,733

Fixed Assets Net of Deprec               92,808                92,808
TOTAL ASSETS                            $244,511            $283,541

Current Liabilities
.  Accounts Payable                          $41,202               $57,396
.  Credit Cards                                    16,416                 13,404
.  Accrued Items                                 23,753                 26,006
.  Sub-Total Current Liab.                   81,371                 96,806

Long-Term Debt                                 46,017                  46,017
TOTAL LIABILITIES                     127,388                142,823

.  Stock                                                25,000                  25,000
.  Retained Earnings                            44,502                  44,502
.  Current Earnings                               47,621                 71,216
TOTAL EQUITY                                117,123               140,718
TOTAL LIABILITIES & EQUITY  $244,511             $283,541

The total change in cash from the last moment in July through August equals:

.                             July        August     Change
Cash                  $31,742     $57,305    $25,563

Money Market    20,608       18,111       (2,497)
.                         $52,350     $75,416    $23,066

So a cash flows statement will account for the $23,066 increase in overall cash position.  Since the cash flows statement is comprised of three sections: 1) cash flow from operations, 2) cash flow from investing and 3) cash flow from financing, this chapter specifically excludes cash flows from investing and financing to focus on cash flow from operations.  In the above example there is no depreciation, no purchase of fixed assets nor any form of change in long-term debt or common stock.  Therefore the entire change in cash is a direct result of cash flow from operations. So in this case, the accountant must account for the increase of $23,066.

Since cash flow from operations focuses on changes in current items (assets and liabilities) let’s find out what changes occurred.

Current Assets

To calculate the changes, take the total current asset balances and determine the change in one month.   The total change is $190,733 (balance on August 31, 2016) less $151,703 (balance on July 31, 2016) or $39,030.  Of this amount, $23,066 is in the form of cash.  Since the accountant is trying to account for cash, he must exclude the cash change from the total change in current assets.   Therefore the net current assets change equals $15,964. Think about this logically.   To obtain assets and cash, the business must either borrow money (since this example is excluding cash flows from investing and financing, only short-term borrowings are considered) or earn the money via sales to customers.

So let’s first look at short-term borrowing of money.

Current Liabilities

Here is a snapshot of current liabilities:

.                                      July 31, 2016          August 31, 2016     Change
Accounts Payable               $41,202                    $57,396            $16,194

Credit Cards                         16,416                      13,404               (3,012)
Accrued Items                      23,753                      26,006                 2,253
.                                           $81,371                    $96,806             

In the above, the aggregate change is an increase of $15,435.  This means ACME borrowed money from vendors, suppliers and from either employees or the government for accrued items.   So of the $39,030 of increase in current assets, $15,435 was funded by short-term borrowings of money.   This leaves a net change of $23,595 that has to come from sales.   Remember, cash flow from operations has to come from net profit and short-term borrowing of money.   So is the net profit $23,595?   Let’s find out.

Current Earnings

In accounting, the current net profit is reported as current earnings on the balance sheet.   Retained earnings is the lifetime to date profit less distributions/dividends paid out lifetime to date.  This is as of the last day of the recently completed accounting year (fiscal or calendar).   ACME’s current earnings reflects year to date information.   On July 31, 2016 ACME’s net profit year to date equals $47,621.  On August 31, 2016 it increased to $71,216.  So during the month of August, the net profit earned is equal to the difference or $23,595.

So indeed the company earned $23,595 of profit to fund some of the increase in current assets.   So current assets increased in the aggregate $39,030 funded by borrowing money and earning money per the following schedule: 

Sources of Cash
Borrowing Money (increase in current liabilities)               $15,435

Earning Money (current earnings – August)                          23,595
Sub-Total Sources of Cash                                                     39,030

Uses of Cash
Purchase of More Assets (current assets)                             (15,964)
Unused Cash Added to Cash and Cash Equivalents             $23,066

Cash Balance on July 31, 2016                                             $52,350
Cash Balance on August 31, 2016                                          75,416
Cash Increase During the Period                                           $23,066

Notice that both the ending cash balance change and the net effect of sources and uses match.  To help you understand with greater clarity, let’s look at some insights to the above.


There are several insights to the above example.

1) Although calculated in the aggregate, the above method can be applied to any cash flow analysis.   The key is understanding the relationship of sources and uses of cash.  The absolute best source of cash is earnings.  After all, this is why business exists – to make a profit.

2) Think of the logic of the above business operation.  During the month of August inventory increased from $73,471 to $91,618.  This means that ACME bought more inventory from suppliers, most likely for some kind of fall sale.   Anyway, when a business increases inventory, more purchase orders are issued and filled by vendors.  Therefore expect accounts payable to increase too.   In ACME’s case, accounts payable increased $16,194.  Inventory increased $18,147 and was mostly funded by a corresponding increase in accounts payable.  In most cases there is a very high correlation between inventory and accounts payable.  The two are pretty much married on the books.

3) Notice with accounts receivable customers paid cash of $1,723 to decrease the overall balance.   This is good news.  First it means that the net profit generated didn’t fund an increase in receivables.   Secondly it also means that most likely ACME is managing accounts receivable appropriately.           

4) In a typical cash flow from operations calculation the accountant would need the income statement as the third document.   This is because the income statement would include some non-cash items such as depreciation, amortization and allocation (warranties) as a deduction in deriving net profit.  These non-cash deductions are added back to end up with the cash profit generated.   With the above example there are no non-cash adjustments because:

A) Net fixed assets did not change which means no depreciation was taken during August of 2016.

B) There are no other assets on the balance sheet whereby amortization and allocations are sourced.  Other assets include tangible and intangible assets.


Understanding cash flow from operations is easier when the accountant or owner can relate cash flow to sources and uses of cash.  Sources of cash in operations come from profit and short-term borrowing of money.  Uses include payroll, cost of sales and regular monthly recurring charges.  To calculate the cash flow from operations simply add the profit to any change in current liabilities.  From this value subtract any increase in current assets (or add any decrease in current assets) to account for uses of cash.

Cash flow from operations is a simple two step formula if done in the aggregate.   Just as with learning any skill or technique some practice is necessary.   The next lesson zooms into the detail of cash flow from operations.   Please continue reading this series to fully grasp the skill of preparing cash flow statements.   Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol)  I would love to hear from you.  If interested in my services as an accountant/consultant; click on My Services‘ in the footer of this article.

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About David J Hoare 427 Articles
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns