The numbers in the statement of cash flows are derived from the changes in a business’s balance sheet accounts during the year. Changes in the balance sheet accounts drive the amounts reported in the statement of cash flows.
The three primary financial statements of a business — the balance sheet, the income statement, and the statement of cash flows — are intertwined and interdependent.
The lines of connection between changes in the business’s balance sheet accounts during the year and the information reported in the statement of cash flows are shown in the following figure. Note that the $155,000 net increase in retained earnings is separated between the $405,000 net income for the year and the $250,000 cash dividends for the year:
$405,000 net income – $250,000 dividends = $155,000 net increase in retained earnings
Balance sheet account changes are the basic building blocks for preparing a statement of cash flows. These changes in assets, liabilities, and owners’ equity accounts are the amounts reported in the statement of cash flows, or the changes are used to determine the cash flow amounts (as in the case of the change in retained earnings, which is separated into its net income component and its dividends component).
Note in the cash flow from operating activities section in the figure that net income is listed first, then several adjustments are made to net income to determine the amount of cash flow from operating activities. The assets and liabilities included in this section are those that are part and parcel of the profit-making activity of a business.
For example, the accounts receivable asset is increased (debited) when sales are made on credit. The inventory asset account is decreased (credited) when recording cost of goods sold expense. The accounts payable account is increased (credited) when recording expenses that haven’t been paid.
The rules for cash flow adjustments to net income are:
An asset increase during the period decreases cash flow from profit
A liability decrease during the period decreases cash flow from profit
An asset decrease during the period increases cash flow from profit
A liability increase during the period increases cash flow from profit
Following the third listed rule, the $191,000 depreciation expense for the year is a positive adjustment, or add-back to net income. Recording depreciation expense reduces the book value of the fixed assets being depreciated.
To be more precise, recording depreciation increases the balance of the accumulated depreciation contra account that is deducted from the original cost of fixed assets. Recording depreciation does not involve a cash outlay. The cash outlay occurred when the business bought the assets being depreciated, which could be years ago.