As it happens, there may be situations where owners and investors make payments into the company. It could be that there is a need for extra capital to meet regulatory requirements, need for extra financing to close a certain deal or simply little extra is needed for either keeping the business going or expanding a bit. Either way, the owners may every now and then make the payments into the company.

Those payments are never ever part of the income statement, but as they are inflow of cash (provided the payment wasn’t done in the form of any other type of asset), they are shown on the statement of cash flows obviously.

Now another question is where they are classified under. When you think about the pure purpose of those payments – it’s either extra resources needed for expanding, keeping operations going, buying assets etc. – they key word being “financing” here.
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The statement of cash flows normally starts from the operating income, which in itself includes numerous expenses and income. As it happens though, the income statement is based on accrual based accounting, whilst the statement of cash flows displays the actual cash movements. So you have to either make adjustments or remove certain lines or items from the income statement to move it closer to reflect the actual cash movement.

Now whilst some of those expenses and income are classified within other part of the statement, there are some movements on the income statement, which include no cash movement whatsoever and as a result should be adjusted from the operating income for it to show cash flows from the operating activities.
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On the statement of cash flows under operating activities you have the “changes in receivables”, “changes in inventory” etc. When you see those lines, you know the cash flows are presented using the indirect method. The direct method is always used for investing and financing activities, but can be used for operating as well. However, as the direct method is fairly simple, with this post we are going to explain the logic behind the indirect method.

First and foremost, the “changes in” are disclosed for those areas which are directly connected to operations – receivables, inventory and payables. They are those balances, which are affected by revenue, cost of goods sold, operating expenses etc.
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Interest paid on the statement of cash flows can be disclosed either under operating or financing activities. No doubt you have seen both being used and it would make sense to have them either under one or the other. None of these is wrong actually and we will explain why.

Operating activities and cash flows from operating activities are in essence those that keep the business going and relate to the everyday proceeds and expenses. They are your payables to suppliers, invoices for goods, sales, receivables from customers etc. What operating also means, is keeping the company liquid enough to have enough resources to keep everyday business going. As it happens, every business has taken some sort of operational loan – either overdraft or short term business loan to finance working assets. When you look at the loan like that – it’s taken to keep the operations going – it only makes sense to have those related interest disclosed under the activities the cash flow relates to.
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The word “cash flows” indicates to the key question you should be asking when preparing the statement. “Was cash actually paid?” is the number one question that should always be asked.

For an example in a situation where you have bought PPE items during the period and now are going to disclose the outflows on the cash flow statement. Ask yourself though if there aren’t any invoices still unpaid for those items. This is something we have seen in practice happening quite a lot. If there are invoices still unpaid to suppliers, those are already a part of the changes in accounts payable and should always be excluded from outflows amounts done to purchase the items disclosed on the statement. The reason behind this is obviously a simple fact that the cash didn’t move.
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