THE STATEMENT OF CASH FLOWS: A FINANCIAL FOCUS FOR SMALL BUSINESS

THE STATEMENT OF CASH FLOWS:
A FINANCIAL FOCUS FOR SMALL BUSINESS

Lowell E. Stockstill, Wittenberg University
Sharon L. Dietz, Wittenberg University
Wayne O. Maurer, Wittenberg University

ABSTRACT
The Statement of Cash Flows (SCF) replaces the Statement of Changes in Financial
Position as part of a full set of financial statements for all business enterprises. Small
business historically has underutilized funds flow statements because of their
cumbersome format, working capital emphasis, and cost of preparation. The SCF's
checkbook approach to cash flows streamlines its preparation and enhances its relevance
to small business. The long ignored statement may prove to be small business' most
important source of financial information. Consequently, the SCF should be an integral
part of SBI financial analysis.

INTRODUCTION
The use of funds statements is not a recent phenomena. They first appeared in the United
States in the 1890's. By the turn of the century such statements had evolved three
definitions of funds (cash, current assets, and working capital). In the 1920's H. A. Finney
spearheaded a drive to focus on the working capital definition as the best means of
providing liquidity information. The statement's format remained virtually unchanged for
the next 50 years [1, p. 20].

The utilization of a funds statement dramatically increased in the 1950's. Its inclusion
was recommended in 1963 [2] and mandated in 1971 [3]. As recent as the 1980's, the vast
majority of firms still defined funds as working capital [4, p. 74]

A rash of bankruptcies in the late 1970's by ostensibly sound companies led to
reexamination of the working capital definition [5]. Although this represented a positive
step for financial analysts, more specific guidelines were desirable for the long term [6,
pp. 22, 23]. Accounting and financial professionals, with the exception of local
accounting firms, have agreed that a cash definition of funds better facilitates user
understanding and cash flow analysis [1, pp. 23, 24].

Although not required by the Financial Accounting Standards Board, the clear trend was
towards a cash definition of funds. Accounting Trends and Techniques reported that of
600 companies surveyed by the American Institute of Certified Public Accountants, the
number of companies defining funds as cash or near cash increased from 10% to 52%
from 1980-1983 [7, p. 27]. Big business' response was even more dramatic. By 1985
approximately 70% of the Fortune 500 firms had changed their focus to a cash format [8,
p. 3]. This trend continued through the new Exposure Draft [9], and has culminated with
the Statement of Cash Flows [10].

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REPORTING GUIDELINES
The Statement of Financial Accounting Standards No. 95 (SFAS 95) promulgated
standards of financial reporting for the Statement of Cash Flows (SCF). The SCF
replaced the Statement of Changes in Financial Position which was mandated by APB
Opinion No. 19 [3]. Because APB No. 19 lacked a clear definition of the denominator for
the preparation of the SCFP (Funds = working capital or cash plus or cash); a definitive
classification format (sources and uses or activity); and a clear objective for the
statement, it was necessary to issue a statement which dealt with these stortcomings.

SFAS 95 eliminated the ambiguities in APB 19 related to the purpose, the denominator,
and the format as evidenced by the following quotes:

"The primary purpose of the Statement of Cash Flows is to provide relevant
information about the cash receipts and cash payments of an enterprise during a
period...

To achieve its purpose of providing information to help investors, creditors, and
others in making those assessments, a Statement of Cash Flows should report the
cash effects during a period of an enterprise's operations, its investing
transactions, and its financing transactions." [10, paras 4, 6 (emphasis added)]

The denominator was precisely defined as cash and cash equivalents. Cash includes cash
on hand, demand deposits, and other deposit accounts where withdrawals can be made
without prior notice or a penalty [10, para 7]. Cash equivalents were defined by the
following:

"Cash equivalents are short term, highly liquid investments that are both: a.
readily convertible to known amounts of cash; b. so near their maturity that they
present insignificant risk of changes in value because of changes in interest rates.

Generally, only investments with original maturities of three months or less
qualify under that definition" [10, para 8] (Examples are Treasury Bills,
commercial paper, money market funds).

SFAS 95 addresses the format issue in paragraphs 26 and 27. Cash flows are to be
reported for operating, investing, and financing activities in a fashion so that the sum of
these flows when added to the beginning cash and equivalents balance will equal the
ending cash and equivalents balance. Also, SFAS 95 encourages the use of the direct
method wherein major classes of gross cash receipts and gross cash payments are
disclosed for net cash from operations. The gross cash receipts and payments at a
minimum should include: "a. cash collected from customers, including lessees, licensees
and the like; b. interest and dividends received; c. other operating cash receipts, if any; d.
cash paid to employees and other suppliers of goods or services, including suppliers of
insurance, advertising, and the like; e. interest paid; f. income taxes paid; g. other
operating cash payments, if any" [10, para 27]

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Further detail of items a. and d. is encouraged if this would increase the usefulness of the
statement. As an alternative, the indirect (reconciliation) method can be used wherein net
income is adjusted for changes in balance sheet accounts and noncash charges and credits
to income.

The disclosure of the cash flows from financing activities and the cash flows from
financing activities and the cash flows from investing activities will be the same
regardless of whether the direct method or the indirect method is used. Also, disclosure
must be made about noncash investing and financing activities either in schedule form or
in a narrative [10, para 32]. The end result of either method is to report net cash provided
or used by each of the activities and the aggregate effect of those flows on cash during
the period. In addition, if the direct method is used, the reconciliation of net income to
cash flow from operation must be shown in a separate schedule.

DIRECT VERSUS INDIRECT
There are two methods of preparing the SCF: the direct method and the indirect method.
The direct method illustrates the composition of all operating cash receipts and payments,
whereas the indirect method only shows net income adjusted for deferrals and accruals.
Regardless of method used, net cash flow from operations is the same.

The direct method is more informative and consistent with the primary purpose of the
SCF. It eliminates much of the confusion that now exists regarding the relationship
between business activities (income) and cash receipts and payments (cash flow) [12,
p. 57]. Also it provides the direct transition necessary to maximize Statement use for
planning, monitoring, and evaluating cash flows. The direct method emphasizes cash
received and paid from business operations. Finally, this method is simple and practical
for the small business. All data is readily available in the cash receipts and payments
journals. The task becomes merely one of organizing the information into a form usable
by management.

The indirect method focuses on the difference between net income and net cash flow
from operating activity [10, para 108]. Although this information is important to investors
and creditors when there are material accruals, deferrals, and noncash items depreciation,
amortization, depletion, etc.), they are seldom significant in a small business enterprise.
(The direct method requires supplemental disclosure of these items.)

The indirect method's major weakness stems from the fact that it does not disclose
operating cash receipts and payments. These items are particularly important in assessing
a business external borrowing needs and its ability to repay principal [10, para 111].
The complexity of reconciling net income and cash flows also diminshes the indirect
method's usefulness to small business.

A SCF using the direct method appears in Exhibit Ia. It shows all cash flows from
operating, investing, and financing activities. Exhibit Ib reports the reconciliation and the
supplemental disclosures required by SFAS 95. This information is required as part of the
SCF for all companies that desire statements prepared in accordance with generally

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accepted accounting principles. Exhibit II illustrates the indirect method. Although not
encouraged for small business, it was included for comparison purposes.

ADVANTAGES FOR SMALL BUSINESS
Cash is the small business entrepreneur's basic frame of reference. It is viewed as the true
discretionary resource available to business and it serves as the standard measure by
which its financial wealth and progress are measured [12, p. 22]. The direct method of
preparing the SCF highlights specific operating sources of cash and specific operating
uses of cash. This information provides the focus of four critical small business analyses:
(1) forecasting cash flows; (2) monitoring cash flows; (3) evaluating the quality of cash
flows; and (4) valuing the business.

Although the exact prediction of future cash flows is not possible, the analysis of
historical cash receipts and payments which affect the firm over time is fundamental if
users of financial information are to make predictions [1, p. 20]. The forecasting of cash
requirements can be easily acheived from the accululated data used to prepare the SCF
[13, p. 31]. Using the historical relationship regarding operating receipts and sales and
operating disbursements and sales, provides the basis for a major component of cash
flows from operations. In addition, passive cash receipts and disbursements and
nonrecurring cash receipts and disbursements can be projected. The data provided in
these steps can be summarized into a cash operating budget for the upcoming period.
This same procedure can be repeated for various levels of anticipa ed sales, thus
providing a sound basis for forecasting a flexible operating cash budget.

Monitoring of cash flows is important for a small firm. It is not unusual for a small
company to have increasing revenues and decreasing cash. The SCF can be instrumental
in monitoring cash receipts and payments during the period by preparing an interim
statement. Since cash receipts and payments are visualized as checkbook entries, they are
easily organized in a recordkeeping format that facilitates the preparation of an interim
report [12, p. 22]. This interim statement should be compared to the flexible operating
cash budget whose sales level corresponds with the sales level for the period. The
comparison provides management with the information necessary to either go ahead as
planned in the cash budget, or delay certain expenditures as necessary. This process
should be repeated as often as deemed necessary by management.

The Statement also enables small business management to analyze the quality of cash
flows. The SCF delineates each type of cash flow, highlighting what flows are not usual
in operations such as nonrecurring items and passive cash flows.

The impact of each type of inflow or outflow on total cash generated from operations is
also displayed. Stability and sustainability are two important characteristics that enter into
the determination of future projections [14, p. 291]. This assessment of funds provided by
operations is also a key component of long-run strategic planning. This data is important
to management because adequate funds must be generated from operations for an
enterprise to maintain its operating capabilities and provide for future growth [15, p.
1096].

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Income has become a standardized measuring device for the success or failure of
business. It is often ignored or forgotten that income involves a high degree of estimation.
Income is not a specific amount, but can vary depending on the assumptions, estimates,
and valuations used. A more appropriate measure of potential success is the normal,
recurring cash flow from operations. Except in special cases, this type of earning power is
predominantly recognized as the single most important factor in the valuation of the
company [14, p. 301].

Investors and lenders look ultimately to future cash flows for returns and safety [14, p.
301]. The cash flow generated from operations may be a crucial factor in a firm's ability
to receive financing from outside sources. This data is also used extensively by
commercial bankers to evaluate credit risks since there is uniformity of definition in
conjunction with completeness of the information presented [11, p. 52]. The SCF
provides the necessary data for both management and creditors to quickly confirm their
perceptions of the quality of the cash flows [16, p. 55]. The relationships among the
individual types of operational receipts and payments necessary to evaluate the ultimate
risk are displayed in the direct format of the Statement.

CONCLUSION
Cash flow provides an incisive financial benchmark for small business performance. It
gauges short-term solvency, and it predicts long-term potential.

The Statement of Cash Flows (SCF) focuses on the firm's operating receipts and
payments. Rather than a cumbersome, costly mandate, the SCF provides immediate
utility to the small business. The Statement affords the opportunity to manage cash. The
small business owner can not only forecast and monitor cash flows, but s/he can evaluate
the quality of cash flows. Also, the SCF allows managers and creditors to accurately
assess the value of the firm for future financing decisions.

The Statement of Cash Flows provides valuable information to the small business. Its
ease of calculation makes it a natural consequence for comprehensive financial analysis.
All SBI teams should be encouraged to include this valuable tool in their projects.

REFERENCES
[1] Gibson, C. H., Klammer, T. P., and Reed, S. A., "The Cash Flow Statement," The
CPA Journal, November 1986, pp. 18-38.

[2] Accounting Principles Board Opinion No. 3, The Statement of Source and
Application of Funds, New York: American Institute of Certified Public Accountants,
1963.

[3] Accounting Principles Board Opinion No. 19, Reporting Changes in Financial
Position, New York: American Institute of Certified Public Accountants, 1971.

[4] Ketz, J. Edward, "The New Look of the Funds Statement," Financial Executive,
January - February 1985, pp. 74-76.

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[5] Proposed Statement of Financial Accounting Standards, Exposure Draft, Reporting
Income, Cash Flows, and Financial Position of Business Enterprises, Stamford, CT:
Financial Accounting Standards Board, November 1981.

[6] Norby, W. C., "FASB Exposure Draft: Reporting Income, Cash Flows, and Financial
Position of Business Enterprises," Financial Analysts Journal, March-April 1982, pp. 22-
23.

[7] Kochanek, Richard, and Norgaard, Corine T., "Funds Statement: Why the Focus has
Changed from Working Capital to Cash Flow," FE: The Magazine for Financial
Executives, January 1987, pp. 27-30.

[8] Financial Reporting Developments, Statement of Cash Flows, Ernst & Whinney,
October 1986.

[9] Proposed Statement of Financial Accounting Standards, Exposure Draft, Statement of
Cash Flows, Stamford, CT: Financial Accounting Standards Board, July 1986.

[10] Statement of Financial Accounting Standards, Statement of Cash Flows, Stamford,
CT: Financial Accounting Standards Board, November 1987.

[11] Heath, Lloyd C., "Cash Flow Reporting: Bankers Need a Direct Approach," The
Journal of Commercial Bank Lending, February 1987, pp. 50-59.

[12] DeThomas, Arthur R., and Fredenberger, Wm. B., "Accounting Needs of Very
Small Business," The CPA Journal, October 1985, pp. 14-24.

[13] Bryd, David B., and Byrd, Sandra D., "Using the Statement of Change in Financial
Position," Journal of Small Business Management, April 1986, pp. 31-38.

[14] Bernstein Leopold A., Analysis of Financial Statements, Homewood, IL: Dow
Jones-Irwin, 1984.

[15] Keiso, Donald E. and Weygandt, Jerry J., Intermediate Accounting, edition, John
Wiley & Sons, Inc., 1986.

[16] Seed, Allen H. III, "The Funds Statement: How Can It Be Improved?", Financial
Executive, October 1984, pp. 52-55.

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EXHIBIT Ia

Illustrative Company
Statement of Cash Flows
For Year Ended xx/xx/xx

Cash Flows from Operating Activities




Amount
Cash received from customers



+
Cash paid to suppliers and employees


-
Dividends
received

+
Interest
received

+
Income
taxes
paid

-
Interest paid





-
Other
receipts
or
payments

+/-
---------
Net Cash from Operating Activities



Sum

Cash Flows from Investing Activities
Proceeds from sale of plant assets


+
Proceeds from sale of long term investments

+
Principal payments on long-term receivables

+
Purchase of long-term investments


-
Issuing
long-term
notes
receivable

-
Down payment or advance payments


-
---------
Net
Cash
from
Investing
Activities

Sum

Cash Flows from Financing Activities
Proceeds from issuing equity instruments

+
Proceeds from long- or short-term borrowings

+
Payment
of
dividends

-
Acquisition
of
treasury
stock

-
Repayment of principal on borrowings


-
---------
Net Cash from Financing Activities



Sum
---------
Net Increase in Cash







Sum
+
Cash
at
Beginning
of
Year

---------
Sum
Cash
at
End
of
Year

---------











---------

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EXHIBIT Ib

Reconciliation of Net Income to Net Cash Provided by Operating Activities:

Net Income







$

Adjustments to Reconcile
Depreciation and amortization


+
Changes in deferred liabilities


+/-
Changes
in
deferred
assets

+/-
Changes in accrued liabilities


+/-
Changes in accrued assets


+/-
Changes
in
receivables
+/-
Changes
in
payables

+/-
Changes
in
inventories
+/-
Gain or loss on sale of plant assets

+/-
Gain or loss on discontinued operations

+/-
Gain or loss early extinguishment of debt
+/-
Advance provision for uncollectible accounts
+
---------
Total
Adjustments

Sum
---------
Net
Cash
from
Operating
Activities

Sum
---------
Supplemental Schedule of Noncash Investing and Financing Activities:
Conversion of debt to equity
Acquiring of assets by assuming directly related liabilities
Acquiring assets by entering into a capital lease
Exchanging noncash asset of liability for noncash asset or liability

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EXHIBIT II

Illustrative Company
Statement of Cash Flows
For Year Ended xx/xx/xx

Cash Flows from Operating Activities




Amount
Net Income








$

Adjustments to Reconcile
Depreciation
and
amortization
+
Changes
in
deferred
liabilities
+/-
Changes
in
deferred
assets

+/-
Changes
in
accrued
liabilities
+/-
Changes
in
accrued
assets
+/-
Changes
in
receivables
+/-
Changes
in
payables

+/-
Changes
in
inventories
+/-
Gain or loss on sale of plant assets



+/-
Gain or loss on discontinued
operations

+/-
Gain or loss on early extinguishment of debt


+/-
Advance provision for uncollectible accounts


+
---------
Total Adjustments







Sum
---------
Net
Cash
from
Operating
Activities

Sum

Cash Flows from Investing Activities
Proceeds from sale of plant assets



+
Proceeds from sale of long term investments


+
Principal payments on long-term receivables


+
Purchase of long-term investments



-
Issuing
long-term
notes
receivable

-
Down payment or advance payments



-
---------
Net
Cash
from
Investing
Activities

Sum
---------
Net Increase in Cash







Sum
+
Cash
at
Beginning
of
Year

---------
Sum
Cash
at
End
of
Year

---------

Supplemental Schedule of Noncash Investing and Financing Activities:

Conversion of debt to equity

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Acquiring of assets by assuming directly related liabilities

Acquiring assets by entering into a capital lease

Exchanging noncash asset or liability for noncash asset or liability

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