The cash flow statement is designed to convert the accrual basis of accounting used to prepare the income statement and balance sheet back to a cash basis. This may sound redundant, but it is necessary. The accrual basis of accounting generally is preferred for the income statement and balance sheet because it more accurately matches revenue sources to the expenses incurred generating those specific sources.

However, it also is important to analyze the actual level of cash flowing into and out of the business. Like the income statement, the statement of cash flow measures financial activity over a period of time. And the cash flow statement also tracks the effects of changes in balance sheet accounts. The cash flow statement is one of the most useful financial management tools you will have to run your business. The cash flow statement is divided into four categories:

  • Net cash flow from operating activities: Operating activities are the daily internal activities of a business that either require cash or generate it. They include cash collections from customers; cash paid to suppliers and employees; cash paid for operating expenses, interest and taxes; and cash revenue from interest dividends.
  • Net cash flow from investing activities: Investing activities are discretionary investments made by management. These primarily consist of the purchases (or sale) of equipment.
  • Net cash flow from financing activities: Financing activities are those external sources and uses of cash that affect cash flow. These include sales of common stock, changes in short- or long-term loans, and dividends paid.
  • Net change in cash and marketable securities: The results of the first three calculations are used to determine the total increase or decrease in cash and marketable securities caused by fluctuations in operating, investing and financing cash flow. This number is then checked against the change in cash reflected on the balance sheet from period to period to verify that the calculation has been done correctly.

Excerpted from Start Your Own Business: The Only Start-Up Book You'll Ever Need, by Rieva Lesonsky and the Staff of Entrepreneur Magazine, � 1998 Entrepreneur Press