The Cash Flow Statement

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The Cash Flow Statement

We all know the importance of Cash in a Business.

After all, Cash is King (or Queen!).

Whatever you prefer.

Simply put, if cash isn't managed carefully, the business can run out of it - which would spell disaster.

Keeping that in mind, managing Cash Flow is TOP PRIORITY for any Business.

But, that's easier said than done.

To help manage and see the movement of Cash within a Business, accountants prepare a 3rd Financial Statement called The Cash Flow Statement.

NOTE: The First two Financial Statements are The Income Statement and The Balance Sheet.

"So, what's the problem? Why is managing Cash with just looking at the Income Statement & Balance Sheet so hard?"

The problem of managing cash using the Income Statement and Balance sheet happens since most Businesses use Accrual accounting to keep track of their Business Functions.

While Accrual accounting is a good measure of the OVERALL HEALTH of a Business, it's shortcoming is that it makes it hard to figure out how much cash really came in and went out of a business.

To solve this problem - In 1987, the accounting profession made it mandatory to include the Cash Flow Statement in Financial Reports.

The addition of the Cash Flow Statement made it easier for readers to know whether the business cash balance increased or decreased during a period as well as to know the main reasons for the increase or decrease.

This was especially helpful to Business Owners to make better strategic decisions and Investors to make better Investing decisions.

How does the Cash Flow Statement work?

To understand the Cash Flow Statement - First, review the Diagram below.

SUPERPOWER INC. 

THE CASH FLOW STATEMENT 

FOR THE YEAR ENDED DEC 31, 20XX

AMOUNT ($)

CASH FLOW FROM OPERATING ACTIVITIES

Net Income 

102,496

Add (Deduct) non cash effects on Net Income

Add: Depreciation applied to Fixed Assets

10,000

(Increase) Decrease in Current Assets:

Accounts Receivable

18,630

Inventory 

(18,113)

Prepaid Expenses

2,699

Increase (Decrease) in Current Liabilities

Accounts Payable 

6,845

Accrued Expenses

(200)

NET CASH FLOW FROM OPERATING ACTIVITIES 

60,472

CASH FLOW FROM INVESTING ACTIVITIES

Purchase of Property, Plant and Equipment

(60,472)

NET CASH FLOW FROM INVESTING ACTIVITIES

(60,472)

CASH FLOW FROM FINANCING ACTIVITIES

Proceeds from Borrowings

0

Repayments of Borrowings

(21,499)

NET CASH FLOW FROM FINANCING ACTIVITIES

(21,499)

NET INCREASE (DECREASE) IN CASH FOR THE PERIOD

27,096

Cash at the beginning of the period

131,203

CASH AT THE END OF THE PERIOD 

158,299

The diagram above illustrates a BIG PICTURE VIEW of the functioning of a Cash Flow Statement.

As you can see - the Cash Flow Statement is GROUPED into 3 Parts

1. The Cash Flow from Operations

2. The Cash Flow from Investing &

3. The Cash Flow from Financing

The Net Cash increase/decrease in each of these activities impacts the overall cash balance of the Business and the Total Increase/decrease in Cash Balances for the period is added (or subtracted) from the companies beginning cash balance to arrive at the Ending Company Cash Balance.

The segregation of activities into Operating activities of a Business, Investing activities and Financing activities is no accident.

The movement of Cash to and from the business in relation to each of these activities tells us a different story about the Business.

Let's explore each of these activities and the Cash Flow Statement a bit further.

THE CASH FLOW FROM OPERATIONS

The Cash Flow from Operations in the Cash Flow Statement represent Cash Receipts and Cash Disbursements into the company from it's core operations.

Arguably, this is the most important of the three types of cash flow and is a prime indicator on how a company is performing.

Caution

A negative Cash Flow from Operations is usually a very bad sign and needs to be investigated further by a reader of the Cash Flow Statement.

The Core operations that are used as inputs to calculate the Cash Flow from Operations can be traced from two places - The Income Statement as well the changes in Current Assets and Current Liabilities in the Balance Sheet.

There are 2 Methods that Accountants use to calculate the Cash Flow from Operations.

They are called the 1. The Direct Method and 2. The Indirect Method.

Though the methods used differ, the results are always the same i.e. both methods lead to the same amount of Inflow (or Outflow) from the Cash Flow from Operations.

The Direct Method

This method is called the direct method because it calculates the net cash flows from operations in a much more straightforward fashion than the indirect method. The direct method uses a simple income statement style approach by adding up the income and subtracting the expenses. This is a pretty common sense way to present this section.

The direct method is the preferred method under FASB 95 and presents cash flows from activities through a summary of cash outflows and inflows.

The Direct Method Encompasses these 6 factors to come up with the Net Cash Flow from Operations.

1. Cash Receipts from Sales = Sales + Decrease (or - Increase) in Accounts Receivable.

2. Cash Payments for Purchases = COGS + Ending Inventory - Beginning Inventory + Beginning Accounts Payable - Ending Accounts Payable. 

3. Cash Payments Made to Employees = Beginning Salaries Payable - Ending Salaries Payable + Salaries Expense

4. Cash Payments for Prepaid Assets = + Ending Prepaid Rent, Prepaid Insurance etc. - Expired Rent, Expired Insurance etc - Beginning Prepaid Rent, Prepaid Insurance etc. 

5. Interest Payments = Beginning Interest Payable - Ending Interest Payable + Interest Expense. 

6. Income Tax Payments = Beginning Income Tax Payable - Ending Income Tax Payable + Income Tax Expense 

While being easier to read, this is not the method preferred by most firms as it requires more time and information to prepare.

For a more in depth analysis of the Direct Method, you can check out our article here.

The Indirect Method

The indirect method on the other hand, starts with the net income from the income statement and adds back all of the non-cash activities to arrive at the ending net cash from operating activities.

The Indirect Method is a more of a round about way of calculating the same number.

Please find below the factors that encompass the calculation of the Indirect Method.

Cash Flow from Operating Activities

Net Income

Add Back: Non Cash Expenses (Depreciation, Depletion and Amorization Expense)

Add Back: Non Operating Losses (Loss on Sale of Fixed Assets)

Deduct: Non Operating Gains (Gains made on Sale of Fixed Assets)

Add Back: Decrease in Current Assets (Accounts Receivable, Inventory, Prepaid Expenses etc.)

Deduct: Increase in Current Assets (Accounts Receivable, Inventory, Prepaid Expenses etc.)

Add Back: An Increase in Current Liabilities (Accounts Payable, Accrued Expenses, Taxes Payable Etc.)

Deduct: Decrease in Current Liabilities (Accounts Payable, Accrued Expenses, Taxes Payable Etc.)

= Net Cash Flow from Operating Activities

For a more in depth analysis of the Indirect Method, you can check out our article here.

THE CASH FLOW FROM INVESTING

As the name implies, the Cash Flow from Investing is the Cash Flow that a company generates from it's investments.

There are two kinds of Investments that a company makes -

The first is an investment in Fixed Assets.

A company considers expenditure on Fixed Assets an investment since they believe that an Investment in Fixed Assets will give them a positive return in the long run and boost their sales in some way.

The Second is Investments in bonds and shares of other companies.

Together, these comprise the Cash Flow from Investing for a company.

THE CASH FLOW FROM FINANCING

Companies can't always meet their cash requirements from day to day operations.

In many cases, a business needs more money which it raises through Borrowing (Debt) or through the company owners (Equity) or a combination of the two.

The Cash Flow from Financing summarizes the

  • Cash movements from Debt related or Equity related activities such as borrowing and paying debts (bonds). 
  • Owners Investing Capital in the Business and the return of Capital to them. 

Interesting Fact

Many Businesses records 1000's of transactions in a year - amongst which the large majority are operating transactions and only a small minority will be related to the Cash Flow from Investing or the cash flow from financing. Though few in number, these investing and financing transactions are very important and usually involve big chunks of money.

The Cumulative net Cash increase/decrease from Operating, Investing and Financing Activities is added to the beginning cash balance of the company to arrive at the ending cash balance.

Under special circumstances, you may see additional line items on the cash flow statement that are specific to the company. For example, if a company discontinues a part of its operations, a separate line item may be added on the cash flow statement to highlight the same and show the impact this discontinuation has had on Cash.

For companies which have a global presence, you may also see a line called - Effect of foreign currency exchange rate changes- which would add/subtract the gain/loss experienced to the company cash position due to the fluctuation of currencies.

Summary

The Cash Flow Statement seems pretty straightforward but can get quite complex in large businesses.

Cash Flow in a Cash Flow Statement is categorized into Cash Flow from Operations, Cash Flow from Investing and Cash Flow from Financing.

The Direct Method and the Indirect Method are two ways in which Accountants choose to Calculate Cash Flow from Operations.

Final Thoughts

If you are new to accounting the next thing I would read about would be one of the two other Financial Statements - The Income Statement or The Balance Sheet.

If you want to learn accounting with a dash of humor and fun, check out our video course.

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