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

There are two fundamental basis of accounting – accrual and cash basis. With 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 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,

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