You might be thinking, why do we need a cash flow statement when we have an income statement? Aren't they effectively doing the same thing? The answer is no.

Firstly, the income statement shows income and expenses only, whereas the cash flow statement shows all cash inflows and outflows.

For example, buying a machine is not an expense.

It is an asset, and so the purchase of the machine won't appear in the income statement, but the cash paid for the machine will be shown as a cash outflow in the cashflow statement.

Secondly, the income statement is prepared on what is called the accrual basis, not the cash basis.

The accrual principle is that things should be recognized in the income statement when the event happens, and not when the cash is received or paid.

Let's explain this with a couple of examples.

Imagine a company pays two years head office rent in advance, so two years worth of rent say that amounts to $240,000 comes out of the bank account in one go.

If the cash basis of accounting were used, this $240,000 would go into the income statement as an expense as soon as it is paid.

However, that does not reflect the reality of this expense.

The reality is that the amount paid relates to an expense that covers a two year period.

Under accrual accounting, the expense is recognized as it is incurred every month.

As the company uses the building, one month of rent expense is incurred and only that part is recognized in the income statement as an expense.

So if we were to look at the income statement for the first six months of the year, only $60,000 would appear as a rent expense.

That is the monthly rent of $10,000.

So the 240,000 divided by 24 months times 6.

If we contrast this to what happens in the cashflow statement, the full amount of $240,000 will be a cash outflow and incorporated into the cashflow statement as soon as it is paid, and that's because the cashflow statement works on a cash basis.

This works the other way around too.

Take electricity as an example.

A company does not pay their electricity bill As it uses electricity.

It'll only get an electricity bill at the end of a period that it'll then pay within a certain number of days.

The reality is that the company has been using electricity and incurring the expense, so it needs to be recognized as an expense in the income statement.

The company can't wait until it receives the bill or later still pays the bill.

Instead, the company needs to recognize what is called an accrual, which is an estimate of what the electricity they have been using is worth.

This accrual will appear in the income statement as an expense every month and on the balance sheet as a liability.

Then when the bill is actually received from the electricity provider, the amount of the expense and liability will be corrected if necessary.

The electricity expense will only make its way into the cashflow statement when the bill is actually settled and cash leaves the bank account.

The accrual principle does not just apply to expenses, it applies to income too.

If a company makes sales to customers on credit, the sale will appear in the income statement as soon as the sale is made.

For example, when the goods are given to the customer, it does not matter that the cash has not yet been received.

That is a separate issue.

The reality is that the company has fulfilled its obligations to the customer and the has been made.

So the income statement will show the sale, but the cashflow statement will show nothing until the cash is actually received from the customer.