Getting from Net Income to Cost from Operations

As mentioned earlier, the first line of the cash flow statement of most companies is net income from the income statement, which, as we know, is prepared in accordance with the accrual method of accounting. The subsequent lines should be thought of as adjustments to this accrual net income, in order to arrive at the amount of cash generated from operations during the same period.

For example, since depreciation expense reduces net income on the income statement, but does not reduce cash, an adjustment must be made on the cash flow statement to exclude this noncash expense from net income since the ultimate goal of the cash flow statement is to determine how much cash was generated (vs. accounting profit).

In addition to depreciation, there are several other common adjustments you will encounter on a company’s cash flow statement (Exhibit 7.2):

• Changes in working capital

  • Changes in accounts receivable

  • Changes in inventories

  • Changes in all other current assets (except cash)

  • Changes in accounts payable

  • Changes in other current operating liabilities (nondebt)

• Increases/decreases in deferred tax assets and liabilities