The Cash Flow Statement

The Cash Flow statement is one of the three main financial statements, but it is often overshadowed by its companion statements – the Income Statement and Balance Sheet.

  • The Income Statement provides information on Revenue and Profit over a certain period of time
  • The Balance Sheet gives a snapshot of financial health at a certain point in time

But it’s the Cash Flow Statement that allows us to see how effective a business is at managing its cash and what the cash is spend on.

Cash is the lifeblood of every business.

If a business is unable to pay employee salaries, vendor invoices, or taxes then a business will no longer be viable as a business.

In a prior post entitled “Cash vs Accrual Accounting”, we discussed why it’s important to understand the difference between Profit and Cash.

Where Profit is defined as Revenue minus Expenses.  We report Revenue when it is earned and Expenses when they are incurred.

But earning Revenue does not always increase Cash immediately, just as incurring Expenses doesn’t always decrease Cash at the moment the expense is incurred.

To see this important difference in Cash Accounting, let’s use Microsoft’s Form 10-K for Fiscal Year 2018 as an example.

If we want to see how much cash a business has, we can look in the Balance Sheet.  Here, we can see if the cash position has increased or decreased from the previous year.

But this doesn’t give us a complete picture.  We can’t see how the cash came into the business or, more importantly, on what or how it was spent.

To get a complete picture of the business we need to look at its Cash Flow Statement.

Think of the Cash Flow Statement as a report that show you how cash enters and leaves a business.  If you see a positive figure, that indicates cash entering the company.  If we see a negative figure, that indicates cash leaving the company.

The Cash Flow Statement

The Cash Flow Statement has three main components:

  • cash flow from Operations
  • cash flow from Investing activities
  • cash flow from Financing activities

Operations

Operation is the most important part because it shows how much cash is generated from the actual operations of the business, selling the company’s products and/or services.

Investing

As the name implies, this is cash spent on investments or cash received from the sale of investments.  These activities fall outside the normal core business activities of selling goods and/or services.

This section displays investments in machinery or equipment…

… or the acquisition of another business.

Financing

This section displays the cash flow from financing activities, such as the raising, borrowing, and repaying of capital.

We can see if the company issued shares of stock,

if dividends on existing shares were paid to stockholders,

or if a bank load was taken out or a debt repaid.

Reconciliation

The bottom of the Balance Sheet is the Reconciliation section.  It shows the starting point of cash from the last reporting period, and the ending balance from the current balance sheet.

The difference between the two is the net change of cash which must equal the sum of the three previously described sections.

In other words, the beginning balance of cash plus the cash flows from operations, investing, and financing must equal the ending balance from the current balance sheet.

Let’s look at the three main section in greater detail.

Cash Flow from Operations

There are two different methods used to calculate Cash Flow:

Indirect Method

The Indirect Method takes the Net Income from the Income Statement as a starting point.  Because Net Income does not equate to Cash, many adjustments must be made.  This makes it a less than intuitive method to understand.

Direct Method

The Direct Method doesn’t start with the Net Income but rathe lists different types of transactions that produce cash amounts received and paid.  Some of these line items include:

  • Cash received from customers
  • Cash paid to suppliers
  • Cash paid to employees
  • Taxes and interest paid

NOTE: GAPP and IFRS (discussed in the previous post) allow both methods to arrive at the same result.

“Which method should I use?”

While the Direct Method is easier to read and provides better insight, it can be very time-consuming to prepare.

The Indirect Method is plinked to both the P&L and Balance Sheet.  It’s less intuitive but much easier to prepare.  For this reason, it is the method of choice for most companies.

This post will focus on the Indirect Method.

Adjusting Net Income using the Indirect Method

As stated, we begin with Net Income which is taken directly from the Income Statement.  We then adjust Net Income to arrive at the Cash Flow.

Common Adjustments

Depreciation and Amortization are expenses in the Income Statement that don’t have any impact on cash, known as a “non-cash transaction”.
When we account for the “wear and tear” of an asset, no cash leaves the business.  It’s how we allocate the asset’s expense over its useful life.

The only time Cash is affected is when the asset is initially purchased.  But depreciation and amortization reduce net income, and since Net Income is the starting point we need to add this expense back.

The same applies to the gain/loss when disposing of assets.  An example of this would be the company’s sale of a forklift that it initially acquired for $10,000 two years ago.

Over the two years of use, the forklift’s value has depreciated by 50% to a value of $5,000.

At the end of a heated auction on “e-buy_my_unwanted_stuff-Bay”, the company sold the forklift for $8,000.

The Income Statement will reflect a gain of $3,000 on the disposal of the forklift.

However, the Cash Flow Statement needs to reflect the full cash impact, not the profit of the disposal.

We need to deduct the $3,000 gain as Net Income in the Cash Flow Operating section and show the full $8,000 cash in.  But selling unneeded equipment is not an ongoing core operation of this business, so we record the $8,000 as a Sale of Asset in the Cash Flow Investing section.

Changes in Working Capital mainly consist of inventory, receivable, and payables.

To understand why we need to adjust for these Balance Sheet items we need to understand how these positions influence the amount of money the company has in the bank.

  • Inventory – Suppose that your inventory for last year was 100 and this year the inventory is 150. Your inventory increased by 50 which means you are keeping more inventory in stock.  This increase in inventory had to be paid for, so more cash has left the business.
    It would be easy to think that the cash spent would be reflected in the Net Income of the Operating section, but Net Income only includes the expenses for Cost of Goods of sold products, not for additional inventory.
    The increase in Inventory needs to be reflected on the “(Increase)/Reduction of Inventory” line of the Operating section.

  • Receivables – These work similarly to Inventory. Suppose you sell a customer a product for 100 but you sell it to them on credit.  The cash is yet to be received.
    In the Income Statement we show the earned revenue which increases our Net Income, so our starting point includes the 100.
    Because cash wasn’t received, if Accounts Receivable increases we adjust with a negative number.  If they are lower, we adjust with a positive figure.

  • Payables – Payables work the opposite way because they are liabilities.  If we had 120 in Payables last year but have 140 in Payables this year, we payed out less to our suppliers.  We’re working with their money, which is good for our cash balance.
    A higher figure for Payables is a positive cash increase in change.  If they decrease, it’s negative for our cash balance because we used more of our cash to pay the suppliers.

Putting it All Together

All that’s left to do is sum up all the adjustments with Net Income on top to derive the Cash Flow from Operations.

Regardless of weather you are a huge company like Microsoft, or a small business selling decorative plates on a beach, you want to see a positive value for “Net cash from operations” in the Operations section of the Cash Flow Statement.

The Role of Capital

If you maintain large quantities of inventory, grant long terms for repayment with your customers, or have a large amount in overdue receivables, you are using a LOT of cash to finance those positions.

Cash that is no longer available to do things like add capacity, expand your business to new markets, or invest in marketing or development.

Cash Flow from Investing Activities

Remember when we adjusted our Net Income due to Depreciation and Amortization as well as Gains and Losses due to the disposal of equipment?  The reason we did this is because these are non-cash transactions that don’t affect the cash balance.

What is affected is the cash in or out flow when the business is buying or selling these assets.  And that’s exactly what we see here in the Investing section of the Cash Flow Statement.

When a company purchases new property or equipment, we see it noted here in this section.

Likewise, if the company acquires another company or other investments we will see those actions reflected here as well.

Cash Flow from Financing Activities

This section summarizes the cash transactions from:

  • Raising capital
  • Borrowing capital
  • Repaying capital

When a company borrows money form a bank or issues bonds or shares, it receives cash.

This cash will be reported as a positive amount in the cash flow from Financing Activities.  A positive amount informs the reader that cash was received which increased the company’s cash balance.

On the other hand, when a company repays the principle portion of its loans, purchases its own shares, or pays dividends to its stockholders/owners, the amount of cash used will be reported as a negative amount. The negative amount informs the reader that cash was used which reduced the company’s cash balance.

The Cash Flow Statement

When we see all these elements together…

  • Cash Flow Operating
  • Cash Flow Investing
  • Cash Flow Financing

…we see a more complete picture of the company’s financial health.

It’s important to be able to distinguish between these three elements as it will give you a good idea of where the company makes and spends its money.

As we have seen in this lecture, the sum of these three types of cash flow gives us the company’s change in net cash for the period.

The Net Cash Flow is the difference between the amount of cash the company had at the beginning of the period versus the amount of cash it has at the end of the period.

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