The Bridge Part
Some balance sheet accounts are directly related to cash and are part of the day-to-day operations of the business, All current assets (lesson 2) and current liabilities (lesson 3) are examples of balance sheet accounts that are directly related to cash and need to be included in the operating activities section.
Full disclosure: this next part gets a bit technical, because I’m explaining why you would add or subtract the change in some balance sheet accounts to net income to get to cash generated or used from operations. If you’re really not interested, skip down a little bit to the Get to the Point heading.
Let’s look at accounts receivable to illustrate. Accounts receivable represents the amount a company is owed by it’s customers. If most sales are on account (i.e. you rarely receive payment at the time of purchase), accounts receivable will go up and down as sales fluctuate.
If you sold more this year than you did last year, accounts receivable would likely be higher (you have more outstanding invoices because you sold more). If accounts receivable is higher, you haven’t been paid for those additional sales. To get to cash generated or used from operating activities, we need to reduce net income by the amount we haven’t received cash for – this year’s accounts receivable number minus last year’s. We subtract because the additional sales will be recorded in the net income number, but we don’t want them recorded in the cash received number.
Therefore an increase in accounts receivable must be subtracted from net income to get to cash received for sales. If you just remember that last line, it’ll be enough to understand the rest. (I totally get that this is tough to understand, it’s definitely the hardest statement to figure out.)
This same concept can be applied to each piece of the current assets and current liabilities section of the balance sheet. Remember that liabilities are the opposite of assets, they’re an amount owed by the company. When you think about an increase in accounts payable, it’s the opposite of accounts receivable. An increase in accounts payable (expenses on the income statement you haven’t paid cash for yet) needs to be added to net earnings to calculate cash generated or used for operating activities.