The Statement of Cash Flows

Cash Flow from Operations

The operating cash flows refers to all cash flows that have to do with the actual operations of the business, such as selling products.

Learning Objectives

Distinguish events that would affect the operating section of the cash flow statement from all of the business’s other transaction

Key Takeaways

Key Points

  • Operating cash flows refers to the cash a company generates from the revenues it brings in, excluding costs associated with long-term investment on capital items or investment in securities (these are investing or financing activities).
  • GAAP and IFRS vary in their categorization of many cash flows, such as paying dividends. Some activities that are operating cash flows under one system are financing or investing in another.
  • Major operating activities such as manufacturing products or selling a product may appear on the income statement but not on the cash flow statement, because cash has not yet changed hands.

Key Terms

  • IFRS: International Financial Reporting Standards. The major accounting standards system used outside of the United States.
  • GAAP: Generally Accepted Accounting Principles refer to the standard framework of guidelines, conventions, and rules accountants are expected to follow in recording, summarizing, and preparing financial statements in any given jurisdiction.

The operating cash flows component of the cash flow statement refers to all cash flows that have to do with the actual operations of the business. It refers to the amount of cash a company generates from the revenues it brings in, excluding costs associated with long-term investment on capital items or investment in securities (these are investing or financing activities). Essentially, it is the difference between the cash generated from customers and the cash paid to suppliers.

Cash flows from operating activities can be calculated and disclosed on the cash flow statement using the direct or indirect method. The direct method shows the cash inflows and outflows affecting all current asset and liability accounts, which largely make up most of the current operations of the entity. Those preparers that use the direct method must also provide operating cash flows under the indirect method. The indirect method is a reconciliation of the period ‘s net income to arrive at cash flows from operations; changes in current asset and liability accounts are added or subtracted from net income based on whether the change increased or decreased cash. The indirect method must be disclosed in the cash flow statement to comply with U.S. accounting standards, or GAAP.

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US GAAP vs. IFRS Cash Flow Classification: Some transactions may be classified as different types of cash flows under GAAP and IFRS accounting standards.

One major difference between GAAP and IFRS is how interest paid is categorized. Under GAAP, a loan payment would have to be broken down into two parts: the payment on principal (financing) and the payment of interest (operating). Under IFRS, it is possible to categorize both as financing cash flows.

All of the major operating cash flows, however, are classified the same way under GAAP and IFRS. The most noticeable cash inflow is cash paid by customers. Cash from customers is not necessarily the same as revenue, though. For example, if a company makes all of its sales by extending credit to customers, it will have generated revenues but not cash flows from customers. It is only when the company collects cash from customers that it has a cash flow.

Significant cash outflows are salaries paid to employees and purchases of supplies. Just as with sales, salaries, and the purchase of supplies may appear on the income statement before appearing on the cash flow statement. Operating cash flows, like financing and investing cash flows, are only accrued when cash actually changes hands, not when the deal is made.

Cash Flow from Investing

Cash flow from investing results from activities related to the purchase or sale of assets or investments made by the company.

Learning Objectives

Distinguish investing activities that affect a company’s cash flow statement from the business’s other transactions

Key Takeaways

Key Points

  • Assets included in investment activity include land, buildings, and equipment.
  • Receiving dividends from another company’s stock is an investing activity, although paying dividends on a company’s own stock is not.
  • An investing activity only appears on the cash flow statement if there is an immediate exchange of cash.

Key Terms

  • investing activity: An activity that causes changes in non-current assets or involves a return on investment.
  • merger: The legal union of two or more corporations into a single entity, typically assets and liabilities being assumed by the buying party.
  • purchase return: merchandise given back to the seller from the buyer after the sale in return for a refund
  • investing activities: actions where money is put into something with the expectation of gain, usually over a longer term

One of the components of the cash flow statement is the cash flow from investing. An investing activity is anything that has to do with changes in non-current assets — including property and equipment, and investment of cash into shares of stock, foreign currency, or government bonds — and return on investment — including dividends from investment in other entities and gains from sale of non-current assets. These activities are represented in the investing income part of the income statement.

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Cash Flow Statement: Example of cash flow statement (indirect method)

It is important to note that investing activity does not concern cash from outside investors, such as bondholders or shareholders. For example, a company may decide to pay out a dividend. A dividend is often thought of as a payment to those who invested in the company by buying its stock. However, this cash flow is not representative of an investing activity on the part of the company. The investing activity was undertaken by the shareholder. Therefore, paying out a dividend is a financing activity.

Some examples of investment activity from the company’s perspective would include:

  • Cash outflow from the purchase of an asset (land, building, equipment, etc.).
  • Cash inflow from the sale of an asset.
  • Cash outflow from the acquisition of another company.
  • Cash inflow resulting from a merger.
  • Cash inflow resulting dividends paid on stock owned in another company.

It is important to remember that, as with all cash flows, an investing activity only appears on the cash flow statement if there is an immediate exchange of cash. Therefore, extending credit to a customer (accounts receivable) is an investing activity, but it only appears on the cash flow statement when the customer pays off their debt.

Cash Flow from Financing

Cash flows from financing activities arise from the borrowing, repaying, or raising of money.

Learning Objectives

Distinguish financing activities that affect a company’s cash flow statement from all of the business’s other transactions

Key Takeaways

Key Points

  • Financing activities can be seen in changes in non-current liabilities and in changes in equity in the change-in-equity statement.
  • A positive financing cash flow could be really great for a company (it just went issued stock at a great price) or could be due to the company having to take out loans to stay out of bankruptcy.
  • Issuing credit is not a financing activity though taking on credit is. Like all cash flows, such activities only appear on the cash flow statement when the exchange of money actually takes place.

Key Terms

  • financing: A transaction that provides funds for a business.
  • financing activities: actions where money is flowing between the company and investors in the company, such as banks and shareholders

Financing Activities

One of the three main components of the cash flow statement is cash flow from financing. In this context, financing concerns the borrowing, repaying, or raising of money. This could be from the issuance of shares, buying back shares, paying dividends, or borrowing cash. Financing activities can be seen in changes in non-current liabilities and in changes in equity in the change-in-equity statement.

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NYSE: The cash from issuing stocks in a market such as the New York Stock Exchange is positive financing cash flow.

On the liability side, a company may take out a loan. Everything concerning the loan is a financing activity. Receiving the money is a positive cash flow because cash is flowing into the company, while each individual payment is a negative cash flow.

However, when a company makes a loan (by extending credit to a customer, for example), it is not partaking in a financing activity. Extending credit is an investing activity, so all cash flows related to that loan fall under cash flows from investing activities, not financing activities.

As is the case with operating and investing activities, not all financing activities impact the cash flow statement — only those that involve the exchange of cash do. For example, a company may issue a discount which is a financing expense. However, because no cash changes hands, the discount does not appear on the cash flow statement.

Overall, positive cash flow could mean a company has just raised cash via a stock issuance or the company borrowed money to pay its obligations, therefore avoiding late payments or even bankruptcy. Regardless, the cash flow statement is an important part of analyzing a company’s financial health, but is not the whole story.

Interpreting Overall Cash Flow

Having positive and large cash flow is a good sign for any business, though does not by itself mean the business will be successful.

Learning Objectives

Explain the significance of each component of the Cash Flow Statement

Key Takeaways

Key Points

  • The three types of cash flow are cash from from operations, investing, and financing.
  • Having positive cash flows is important because it means that the company has at least some liquidity and may be solvent.
  • A positive cash flow does not guarantee that the company can pay all of its bills, just as a negative cash flow does not mean that it will miss its payments.
  • When preparing the statement of cash flows, analysts must focus on changes in account balances on the balance sheet.
  • Cash flows from operating activities are essential to helping analysts assess the company’s ability to meet ongoing funding requirements, contribute to long-term projects and pay a dividend.
  • Analysis of cash flow from investing activities focuses on ratios when assessing a company’s ability to meet future expansion requirements.
  • The free cash flow is useful when analysts want to see how much cash can be extracted from a company without causing issues to its day to day operations.

Key Terms

  • free cash flow: net income plus depreciation and amortization, less changes in working capital, less capital expenditure
  • cash flow: The sum of cash revenues and expenditures over a period of time.

What is a Cash Flow Statement?

In financial accounting, a cash flow statement (also known as statement of cash flows or funds flow statement) is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents. The cash flow statement, as the name suggests, provides a picture of how much cash is flowing in and out of the business during the fiscal year.

The cash flow is widely believed to be the most important of the three financial statements because it is useful in determining whether a company will be able to pay its bills and make the necessary investments. A company may look really great based on the balance sheet and income statement, but if it doesn’t have enough cash to pay its suppliers, creditors, and employees, it will go out of business. A positive cash flow means that more cash is coming into the company than going out, and a negative cash flow means the opposite.

Relationship to Other Financial Statements

When preparing the cash flow statement, one must analyze the balance sheet and income statement for the coinciding period. If the accrual basis of accounting is being utilized, accounts must be examined for their cash components. Analysts must focus on changes in account balances on the balance sheet. General rules for this process are as follows.

  • Transactions that result in an increase in assets will always result in a decrease in cash flow.
  • Transactions that result in a decrease in assets will always result in an increase in cash flow.
  • Transactions that result in an increase in liabilities will always result in an increase in cash flow.
  • Transactions that result in a decrease in liabilities will always result in a decrease in cash flow

Interpretation

An analyst looking at the cash flow statement will first care about whether the company has a net positive cash flow. Having a positive cash flow is important because it means that the company has at least some liquidity and may be solvent.

Regardless of whether the net cash flow is positive or negative, an analyst will want to know where the cash is coming from or going to. The three types of cash flows (operating, investing, and financing) will all be broken down into their various components and then summed. The company may have a positive cash flow from operations, but a negative cash flow from investing and financing. This sheds important insight into how the company is making or losing money.

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Cash Flow Comparison: Company B has a higher yearly cash flow. However, Company A is actually earning more cash by its core activities and has already spent 45 million dollars in long-term investments, of which revenues will show up after three years.

The analyst will continue breaking down the cash flow statement in this manner, diving deeper and deeper into the specific factors that affect the cash flow. For example, cash flows from operating activities provide feedback on a company’s ability to generate income from internal sources. Thus, these cash flows are essential to helping analysts assess the company’s ability to meet ongoing funding requirements, contribute to long-term projects and pay a dividend.

Analysis of cash flow from investing activities focuses on ratios when assessing a company’s ability to meet future expansion requirements. One such ratio is that for capital acquisitions:

Capital Acquisitions Ratio = cash flow from operating activities / cash paid for property, plant and equipment

This sphere of cash flows also can be used to assess how much cash is available after meeting direct shareholder obligations and capital expenditures necessary to maintain existing capacity.

Free Cash Flows

Free cash flow is a way of looking at a business’s cash flow to see what is available for distribution among all the securities holders of a corporate entity. This may be useful when analysts want to see how much cash can be extracted from a company without causing issues to its day to day operations.

The free cash flow can be calculated in a number of different ways depending on audience and what accounting information is available. A common definition is to take the earnings before interest and taxes, add any depreciation and amortization, then subtract any changes in working capital and capital expenditure.

The free cash flow takes into account the consumption of capital goods and the increases required in working capital. For example in a growing company with a 30 day collection period for receivables, a 30 day payment period for purchases, and a weekly payroll, it will require more and more working capital to finance its operations because of the time lag for receivables even though the total profits has increased.

Free cash flow measures the ease with which businesses can grow and pay dividends to shareholders. Even profitable businesses may have negative cash flows. Their requirement for increased financing will result in increased financing cost reducing future income.