The cash flow equation is based on actual cash increases and decreases of a firm during an accounting period. Cash flow is calculated by removing the noncash items from a firm's income statement and changes in balance sheet items. Cash flow is a useful measure of a company's financial health.
Income Statement Adjustments
Noncash expenses on a company's income statement must be added back to the cash flow statement. These expenses include depreciation and amortization. These are expenses that are not actual cash outlays but accounting expenses. They are designed to reflect the value of an asset like machinery or a patent that loses value over time. For example, if a company bought a delivery truck for $20,000, some of the value of the truck is lost to wear each year. The amount the truck depreciates during that year is an expense item on the income statement.
Balance Sheet Adjustments
A firm must adjust cash by changes in balance sheet items. If a firm increases the amount of spending or paying bills, cash must be reduced. Conversely, if a firm increases the amount of money borrowed, cash is increased. If a firm increases liabilities by taking a loan from a bank, cash should be increased. Finally, if other investors purchase stock or bonds from the company, cash will increase.
Tips and Tricks
Cash flow statement adjustments from the balance sheet can be counterintuitive. A good rule to follow is to remember that what increases a liability increases cash. For example, if a firm's accounts payable balance increased from one accounting period to the next, the cash adjustment would be to increase cash by the change. A company's accounting team should practice creating cash flow statements to learn the correct adjustments through repetition.
Companies that ignore cash flow do so at their peril. Cash is the lifeblood of a company. Accounting profits from the income statement are not always timed with actual expenses and income. Current liabilities must be paid in order for most companies to remain in business. Many companies go out of business because cash flow does not come in fast enough to pay real cash expenses for items like raw materials or salaries. Companies that cannot meet working capital requirements will eventually fail.