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Because we are interested in the combined effects of investment, operating, and financing decisions, analyzing both the income statement for the period and the balance sheets at the beginning and the end of the period together provides more basic insights than either statement alone. Management decisions not only affect the profit for the period, but cause accompanying changes in most assets and liabilities, particularly in the accounts making up working capital, such as cash, receivables, inventories, and current payables. The statement that captures both the current operating results and the accompanying changes in the balance sheet is the cash flow statement, statement of cash flows, or funds flow statement. It gives us a dynamic picture of the ultimate changes in cash resulting from the combined decisions made during a given period.
The statement is prepared by comparing beginning and ending balance sheets and using key items of the income statement for the period, all interpreted in terms of uses and sources of cash:
•    Cash generated by profitable operations or drained by unprofitable results.
•    Cash impact of changes in working capital requirements.
•    Commitments of cash to invest in assets or to repay liabilities.
•    Raising of cash through additional borrowing or by reducing asset investments.
•    Cash impact of issuance of new shares or repurchase of shares.
•    Cash impact of dividends paid.
•    Adjustments for accounting allocations, write-offs, and other noncash elements in the income statement and the balance sheets.
•    Net impact of the period’s cash movements on the company’s cash balance.
The cash flow statement thus offers a ready overview of the combined cash impact of all management decisions during the period. The user can judge both the magnitude and the relationships of these cash movements, such as the company’s ability to fund investment needs from operational results, the magnitude and appropriateness of financing changes, and disproportional movements in working capital needs. Observing the cash flow patterns can stimulate questions about the effectiveness of management strategies as well as the quality of operational decisions. The amount of detail can vary widely, depending on the nature of the business and the different types of movements emphasized.
In the past, basic formats for these statements differed widely as well. In more recent times, the FASB and SEC required that all published cash flow statements follow a common format, listing uses and sources by the familiar three decision areas: investments, operations, and financing. This rule recognized the usefulness of this arrangement in understanding the dynamics of the business system, as described earlier.
One aspect of the cash flow statement that requires some explanation is the treatment of accounting write-offs. From a cash flow standpoint, write-offs such as depreciation and amortization merely represent bookkeeping entries that have no effect on cash. The reason is simply that the assets being amortized by these entries represent cash that was committed in past periods. Consequently, the write-off categories, insofar as they had reduced net profit, must be added back here as a positive cash flow, thus restoring the cash generated by operations to the original level before the write-off was made. The reader will recall that we recognized the cash flow implications of the depreciation effect in the earlier discussion of the business system.
The cash flow statement has the same inherent limitations as the balance sheet and the income statement, because it’s derived from the accounting data contained in these statements. However, because it focuses on the changes incurred during the period, the limitations due to historical valuation are usually not significant. However, we must remember that by displaying the net change from the beginning to the end of the chosen period in each asset, liability, and owner- ship account reported, the statement might “bury” major individual transactions that occurred during the period and perhaps offset each other. Normally, however, material transactions of this kind (such as major investments, acquisitions, or divestitures) are noted specifically in the company’s cash flow statement. The statement therefore affords the user the most detailed picture of the impact of major events of the period.

To apply the insights gained from the conceptual overview of the business system, we must now look for available information that will:
•    Allow the manager or analyst to track the financial condition and operating results of the business.
•    Assist in understanding the cash flow patterns in more specific terms.
In the process of financial/economic analysis, a variety of formal or informal data are normally reviewed and tested for their relevance to the specific purpose of the analysis. The most common form in which basic financial information is available publicly, unless a company is privately held, is the set of financial statements issued under guidelines of the Financial Accounting Standards Board (FASB) of the public accounting profession and governed by the U.S. Securities and Exchange Commission (SEC). Such a set of statements, prepared according to generally accepted accounting principles (GAAP), usually contains balance sheets as of given dates, income statements for given periods, and cash flow statements for the same periods. A special statement highlighting changes in owners’ equity on the balance sheet is commonly provided as well.
Since financial statements are the source for a good portion of analytical efforts, we must first understand their nature, coverage, and limitations before we can use the data and observations derived from these statements for our analytical judgments. Financial statements reflect the cumulative effects of all of management’s past decisions. However, they involve considerable ambiguity. Financial statements are governed by rules that attempt to consistently and fairly account for every business transaction using the following conservative principles:
•    Transactions are recorded at values prevailing at the time.
•    Adjustments to recorded values are made only if values decline.
•    Revenues and costs are recognized when committed to, not when cash actually changes hands.
•    Periodic matching of revenues and costs is achieved via accruals, deferrals, and accounting allocations.
•    Allowances for negative contingencies are required in the form of estimates that reduce both profits and recorded value, usually affecting shareholders’ equity or special set-asides.
These rules leave reported financial accounting results open to considerable interpretation, especially if the analyst seeks to understand a company’s economic performance and to establish the basis for shareholder value results. It’s common practice among professional analysts to adjust the data reflected on financial statements for known accounting transactions which do not affect cash flows, and to make assumptions about the economic values underlying recorded asset values.