Cashflow

What's the difference between Cashflow and an Income Statement?

Recently, a close friend asked: What is cashflow? I don’t get it. How is it different from my Income Statement?

This post will be geared towards a total beginner, a blank slate, and will offer links to a deeper understanding of cashflow.

First, let’s quickly review the context of finance.

In finance, there are 3 primary statements, which track our income, wealth, and cash:

  1. Income Statement

  2. The Balance Sheet

  3. Cashflow Statement

The income statement shows income - expenses = net income.

The balance sheet shows assets - liabilities = net equity/worth

The cashflow statement shows the fluctuations in your cash based on the influences from your income, expenses, assets, and liabilities.

As you can see the cashflow statement is the bridge linking between the income statement and the balance sheet.

You have some assets (currencies/cash, commodities, equities, and/or bonds), you also have some liabilities (student loans, credit cards, personal loans, etc.). This information is tracked in your balance sheet. Notice cash sits here as an asset.

You also have a salary you earn every month from work you preform, or alternative income sources from various work preformed, or maybe you own an asset which pays you regularly, then you spend some of that income, or all of it on your life’s needs and wants. This information is tracked in your income statement.

However, the pile of cash you posses changes and fluctuates over time based on two separate set of activities which are not accounted for in the same statement. So, how do we account for the changes in cash from expenses as well as debt repayments, or purchasing of assets/ income from assets as well as income from an employer? The answer is the Cashflow Statement.

The Cashflow Statement shows you how your cash is changing over time, based on the use cases: Income, Expenses, Assets, Liabilities.

There are 3 components to a cashflow statement:

  1. Cashflow from Operating Activities = Income Statement

  2. Cashflow from Investing Activities = Linked to Assets

  3. Cashflow from Financing Activities = Linked to Liabilities

If you have no Assets and no Liabilities, then your Income Statement is your Cashflow Statement. However, if you’ve taken out and are repaying any loans, if you’ve been investing in assets/ receiving payments from assets; then the cashflow statement is critical for your understanding of how your cash position is fluctuating and for what specific reasons.

In order not to overwhelm, and keep this simple, we’ll end here.

For further understanding, cashflow formula, cashflow patterns follow these links:

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Making Sense of Cashflow for an Individual

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Thinking of cashflow for an individuals differs from the traditional logic for corporate cashflow in the following ways:

  1. 99% of individuals do not/should not use accrual accounting.

  2. Thus, only the direct cashflow calculation method applies to individuals.

i.e. Accrual accounting, and the indirect cashflow calculation method should be avoided when applied to individuals.

What does this mean?

First, this means that an individual’s accounting system should operate on a cash basis, meaning records should be made when transaction take place (i.e. not when they are scheduled). Second, when calculating cashflow in the direct method, one should simply replace/equate the Income Statement to the first section of the cashflow statement, which is cashflow from operating activities.

The 3 components of a cashflow statement are:

  • Cashflow form Operating Activities = Income Statement

  • Cashflow form Investing Activities = Linked to Assets

  • Cashflow from Financing Activities = Linked to Liabilities

The changes in the cash position based on these 3 components, i.e. the delta between the starting balance and the ending balance is the individual’s cashflow.

Moreover, an individual can have one of 3 cashflow patterns:

  1. Employment -> Taxes Deducted -> Payout/Deposit -> Expenses -> Repeat. (no material balance sheet interaction)

  2. Employment > Taxes Deducted -> Payout/Deposit -> Expenses -> Liabilities and possibly some Asset purchases. Repeat. (balance sheet interactions are centered around liabilities, maybe assets)

  3. Assets -> Income -> Investing -> Liabilities -> Expenses - Taxes on remaining balance. Repeat. (emphasis on assets and income).

For an overview on personal cashflow go here: https://www.fullpowerfinance.com/cashflow

For an example of how to calculate your cashflow statement, linked to the other two financial statements: https://www.fullpowerfinance.com/statements

If you don’t understand any of this, start here:

https://www.fullpowerfinance.com/new-blog/what-is-cashflow