The Statement of Cash Flows

The Imperative of Liquidity

Organizations must carefully manage their cash flow statements to ensure appropriate liquidity to avoid missing investment opportunities.

Learning Objectives

Consider the concept of liquidity as it pertains to an organization’s available cash flow and overall ability to capture opportunities in the market

Key Takeaways

Key Points

  • Understanding a cash flow statement requires an understanding of the time value of money, the risk and return of certain investments, and the liquidity of existing capital.
  • Differentiating between different investment opportunities based on liquidity can help ensure that cash flow will be available exactly when it is needed.
  • When looking at overall cash flow, liquidity risk should be avoided through diversification.

Key Terms

  • liquidity: The degree to which something is in demand and easily recovered, making it easily convertible to cash.
  • liquidity risk: The risk that an asset, security, or commodity is not easily converted in cash without impacting the price of sale.

Why Liquidity Matters

To accurately frame the discussion of cash flows, an understanding of liquidity is integral. Having cash on hand is a seemingly simple concept. If I have capital, I can spend it. For businesses, however, it is quite a bit more complex. Cash flows must take into account not only amounts of capital, but the time value and availability of said capital.

When an organization has an opportunity to fund, or a debt to pay, they need capital on hand (i.e. capital available now) to provide funding. While an organization may have a great deal of value, this does not mean that said value equates to usable capital.

Let’s take an example. Company A ¬†and Company C want to purchase a new manufacturing machine from Company B. However, Company B will sell at their determined price to the first company with the capital to pay. Capital A has the majority of their money wrapped up in inventory (i.e. holding products for sale) which they expect to sell within 4 weeks, while Company C has their capital in a savings account. Company C will capture the opportunity, as the capital they are using is more liquid.

This chart shows some estimations of various types of capital investments, alongside their respective risk, return and liquidity.

Liquidity: This chart shows some estimations of various types of capital investments, alongside their respective risk, return, and liquidity.

Liquidity Risk

When considering cash flow, it is important to understand liquidity risk. The difficulty in taking a certain asset to market, and recovering capital without incurring a loss of value, is called liquidity risk. When looking at overall cash flow, it’s important to consider how easily the available assets and investments are converted into capital to capture external opportunities.

All investments of capital can be framed with three key attributes: average expected return, degree of risk, and overall liquidity. Business managers and accountants, when considering their investment options, should keep liquidity in mind at all times. Conversely, having cash sitting without investment also incurs an opportunity cost. Inflation generally devalues any cash asset, and investing capital into money markets can generate interest. The decision of how much cash to invest, and where to invest it, is therefore a key consideration when balancing accounts for an organization.

Direct and Indirect Measurement

Cash flow statements can be measured via the direct method and the indirect method to determine overall liquidity.

Learning Objectives

Differentiate between the direct and indirect methods of cash flow accounting, with a particular focus on the more popular indirect method

Key Takeaways

Key Points

  • Statements of cash flow allow internal and external stakeholders to understand an organization’s overall liquidity, and what is presently available for utilization.
  • Understanding cash flows is critical to capturing short-term opportunities and investments, while also acting as a health check for overall operational output over a given period.
  • Using the direct method is simpler but less common, as the direct method does not include the valuation of non-cash items. However, most organizations using the direct method will be required to value these non-cash items in another way.
  • Using the indirect method is more complex, but also more useful in truly understanding overall valuation. It is differentiated by taking into account non-cash changes in valuation. A good example is depreciation.

Key Terms

  • liquidity: The availability of cash in the short-term.
  • indirect method: A method of cash flow accounting that takes into account everything the direct method measures, with the addition of non-cash item valuation.
  • direct method: A method of cash flow accounting that records all cash inflows and outflows. It does not take non-cash item valuations into account.

Why Measure Cash Flows?

When it comes to financial reporting activities, the statement of cash flows is a useful tool when it comes to understanding a business’s liquidity and available short-term cash and cash equivalent assets. In layman’s terms, the statement of cash flows identifies what resources a business can use relatively quickly. Understanding cash flows is useful because it

  • provides accurate information regarding an organization’s liquidity,
  • projects future cash flow expectations in terms of quantity and timing,
  • acts as a point of operating performance comparison between organizations,
  • and highlights key changes in asset and operational valuations.

How to Determine Cash Flows

When understanding how an organization creates a statement of cash flows, it’s important to know there are two established methods: the direct method and the indirect method.

The Direct Method

As the name implies, the direct method of reporting cash flows identifies clear circumstances of cash inflow or outflow. It is a simpler, more straight forward approach to cash flows, where each line item is a tangible form of cash credit or debit. Some common items on a direct cash flow report include:

  • Cash flows from operating activities, such as payments received from customers, payments paid to suppliers and taxes.
  • Cash flows from financing activities, such as dividends paid.
  • Cash flows from investing activities, such as the purchase of new equipment and the sale of assets.

It’s important to note that the direct method requires additional documents to take into account indirect cash flow implications for an organization. As a result, the direct method is less often used simply because the additional requirements limit the advantage of simplicity when filing using this format.

This is a simple monthly cash flow statement from a small business. It's worth noting that there are no investing activities in this example.

Simple Direct Cash Flow Statement: This is a simple direct monthly cash flow statement from a small business. It’s worth noting that there are no investing activities in this example.

The Indirect Method

The indirect method is quite a bit more involved than the direct method, as it incorporates valuation changes in non-cash assets as well. The structure of the indirect method is also somewhat different, as it starts with the overall net income amount for the reporting period, where operational, investing, and financial changes in valuations are then applied to this amount. The resulting balance is considered the net increase or decrease in overall cash and cash equivalents.

Let’s take a look at some examples of indirect cash flow line items for context:

  • Operating items in the indirect method include depreciation and amortization, accounts receivable, inventory, and operating gains and losses.
  • Investment items in the indirect method include capital expenditures and investments (i.e. in securities, other businesses, tangible and intangible assets).
  • Financial items in the indirect method include dividends, stock repurchases, and changes in overall debt.

When you apply each of these items to the net income of a given period, you will derive a net increase or decrease in overall cash flow as a result of investments, financing, and operations for an organization.