Why the Statement of Cash Flows Matters

If you would look at the Polo Ralph Lauren income statement , then you would notice that it generated gross profits of $2.336 billion and operating income of $652.6 million during the same period. After subtracting nonoperational expenses such as interest expense and taxes, Polo Ralph Lauren earned net income of $400.9 million.

2. Adjustments for operating activities. In this part of the statement of cash flows, we either add or subtract the impact of two types of activities: noncash income statement items and changes in operating assets and liabilities.

Non-cash income statement items are those P&L (profit and loss) items that are GAAP (generally accepted accounting practices) accounting in nature but are not accompanied by a cash receipt or disbursement. Examples of these non-cash items are depreciation, amortization, bad-debt expense, stock- based compensation and foreign-currency gains/losses.

Changes in operating assets and liabilities are also adjusted for, because they represent the conversion of assets or liabilities to cash flows derived from income items in a prior reporting period.

For example, Polo Ralph Lauren incurred $144.7 million in depreciation expense during the period. Because depreciation expense is a noncash charge to net income, it must be added back to net income in determining cash flows.

Furthermore, Polo Ralph Lauren turned $26.4 million of accounts receivables into cash during the period. Because these receivables were for net income earned in a prior period, we need to add that to our cash-flow statement.

3. Investments. Investments are when a company purchases or takes a strategic stake in another product, business or company. Operational cash flows are generated from the daily activities of selling goods and services, which are included in net income.

Because investment activity is not an operational transaction, we must adjust for cash flows related to investments. Investments made and capital expenditures ("capex") are accounted for as reductions to cash flows. Sales of investments will be reflected as positive cash flows.