A small service company starts the month with $5,000 in cash. It earns a profit of $2,000 during the month and ends with $4,500 in the bank. Follow its accounts to see where the apparent mismatch comes from. All the figures are fictional. Assume accrual accounting, no interest or income tax expense in the example period and no transactions beyond the ones described.
Start with work performed
The company completes $10,000 worth of services. It records $10,000 of revenue. Customers pay $6,000 during the month, leaving $4,000 owed. In accrual accounting, recording revenue and collecting the money can happen on different dates.
The company incurs $7,500 in operating costs and pays them all. It also records $500 of depreciation for the use of equipment. Deduct both expenses from revenue and you get $2,000 in profit. The income statement counts the depreciation charge as an expense for this period.
Follow the money from operations
Customers pay $6,000. The business pays $7,500 to operate. Operating cash falls by $1,500. The SEC’s cash-flow guide describes a second way to reach this result. Start with the $2,000 profit, add back the $500 depreciation charge, then subtract the $4,000 increase in unpaid customer invoices. The result is the same $1,500 outflow.
The adjustment makes the timing visible. The invoices count in profit because the company did the work. They add cash when customers pay. Depreciation records an expense against the use of an asset during the month, while an equipment purchase has its own cash payment date.
Add equipment and financing
The company separately pays $3,000 for equipment and receives $4,000 from a new loan. The equipment purchase is an investing cash outflow. The borrowing adds cash under financing and creates a repayment obligation. Combine the $1,500 operating outflow, $3,000 investing outflow and $4,000 financing inflow. Cash falls by $500, from $5,000 to $4,500.
When reading a real statement, use the same reporting period across the documents. Look at operating cash, then see whether investment and borrowing explain the rest of the change. Check the balance sheet for amounts customers owe and the notes for the company’s accounting policies. Together the statements tell you how it earned its profit and how it funded its cash needs.
Sources & further reading
- SEC beginner’s guide to financial statements
Explains how the major financial statements describe different parts of a company’s finances.
- SEC income statement guide
Shows revenue, costs of sales and subsequent expenses in a worked statement.
- SEC statement of cash flows guide
Describes direct and indirect methods, the three categories of cash flows and the opening-to-closing reconciliation.