Why the Statement of Cash Flows Matters

So far, we have looked at an overview of a company's financial statements and focused on how to read an income statement and how to separate a strong balance sheet from a weak one. Now, let's take a look at the statement of cash flows.

In this installment of The Finance Professor, we will examine how the statement of cash flows is constructed, what can be derived from reading and analyzing it and how it relates to the way a company manages its liquidity and cash needs.

First, What Is the Statement of Cash Flows?

A company's statement of cash flows creates a bridge -- or reconciliation -- between a company's cash balances from one accounting period to another. The statement of cash flows is important to investors because it provides insight into how a company generates and expends cash, and ultimately, its ability to return value to shareholders .

Presented below is a summarized version of Polo Ralph Lauren's RL statement of cash flows for its year ended March 31, 2007. (You can obtain a more detailed version from the company's annual report , Web site or SEC filings.)

Polo Ralph Lauren (RL) Statement of Cash Flows

Click here for larger image.

Source: Yahoo! Finance

The statement of cash flows is designed to explain the changes in cash balances from one period to the next. It is constructed as follows:

1. Net income. This is the best place to start, because theoretically, if all that you did was run a cash business without having to capitalize certain assets or utilize liabilities, then net income would be your cash flow. Because net income is not the sole driver of cash flows, we have to make some adjustments (see 2, 3 and 4).