Overall Statement of Cash Flows – Direct Method
Overall Statement of Cash Flows – Indirect Method
Wrap-Up
This chapter covered our final financial statement. Next week we will move on to actually analyzing the financial statements, as investors would. This next section will involve more calculations than we have seen up to this point, but they are relatively simple calculations.
Section 1.) Overview of Cash Flow Statement
The Statement of Cash Flows is one of the four required financial statements a company must publish. This statement identifies the sources of receipts and uses for cash during the year. In other words, where did the company get their cash from and where did they spend it? The cash flow statement represents activities across a period of time. In other words, it shows how much cash has gone into or out of the company over a period of time? More specifically, it shows the various reasons for those cash receipts or expenditures.
Note that cash flow does not necessarily equal income or loss for the year. The income statement shows the income or loss. A company can technically have a positive cash flow, but still be reporting losses, just by borrowing more money, selling off their assets, or issuing stock. Inversely, a company can have a negative cash flow, but still be very profitable. This may happen when they are paying off debt, buying new equipment to expand, etc.
Cash flow is extremely important for a company. Just because a company has high amounts of income doesn’t necessarily mean it is healthy. They have to have some cash coming in from that income so that they can pay the bills.
One main difference between net income and cash flows is the timing difference. The company may count something as revenue this period, but not receive the cash flows until next period. Similarly, they may count something as an expense this period, but not have to pay until next period. Another example would be when the company purchases equipment. The negative cash flow occurs in year 1 (for the full amount), but the expense is spread out across the life of the asset through depreciation.
Another difference between the net income and cash flows is more permanent. That would be the different transactions that impact cash flows, but do not impact net income at all. For example, if the company borrows money from the bank, that is a positive cash flow, but is not ever going to be reported as revenue. When the company pays the money back to the bank, that is a large negative cash flow, but is not an expense. Yes, there would be interest expense along the way that impacted both cash flow and expenses, but that is separate from the original amount borrowed.
The Cash Flow Statement is broken down into three types of cash flows:
Operating Activities
Investing Activities
Financing Activities
The operating activities section shows the various increases and decreases (aka inflows and outflows or sources and use) in cash that relate to the core operations of the company. Cash collected from selling inventory or providing services to customers. Cash payments for salaries, utilities, inventory and supply purchases, etc. There are also some odd items that are required by US GAAP to be reported in the operating activities section. These include interest paid (for money borrowed by the company), interest received (for money lent by the company) and dividends received (for stock that the company owns from another company.)
Interestingly, dividends paid (to stockholders of the company) are treated as financing activity inflows. Cash inflow from operations (a positive number) are seen as preferred. Cash outflows (a negative number) are indeed seen as a negative thing that should be minimized where possible. The operating section is seen as the one section that should be sustainable into the future. In other words, if the company is operating properly, there is no reason why they can’t continue to have positive inflows year after year.
The investing activities section shows the various increases and decreases in cash that relate to purchases or sales of long-term assets. The more obvious examples would be when the company purchases stocks or bonds of another company as investments. When they buy the investments, it is a cash outflow. When they sell the investments, it is a cash inflow. However, investing activities also arise when long-term equipment, buildings, etc. are purchased in order to expand the company. This is seen as an investment in the company itself.
Cash inflows from investing (a positive number) isn’t always considered to be a positive thing for a company. This is because they are selling off their long-term assets to generate cash. If the company truly no longer needs those assets, that is one thing, but if they are desperately selling off their equipment (and thus capacity) just to get cash to pay the bills, that is not going to be sustainable for very long. It also makes it likely that the company won’t be able to generate as much operating cash flow in the future, since they don’t have as much equipment, etc.
Cash outflows from investing (a negative number) may actually be a good thing, because it may mean that the company is buying more equipment, investing in growth, etc. It could lead to increased operating cash flows in the future.
The financing activities section shows the various increases and decreases in cash that relate to borrowing money (and paying it back) or issuing stock (and potentially buying it back in the future.) Basically, these are the various ways that a company finances its operations.
Cash inflows from financing (a positive number) isn’t always considered to be a positive thing for a company. This is because they may be borrowing more money that they need to pay back in the future. Alternatively, they may be issuing more stock, which could lead to pressure to pay more dividends in the future. Cash outflows from financing (a negative number) may actually be a good thing, because it may mean that the company is paying off their debt or possibly buying back their own stock.
The cash health of a company is not determined by the total amount of cash flows, but rather which sections the cash flows are occurring in.
At the end of the cash flow statement, the totals from all three sections will be added/netted together to arrive at the increase or decrease to cash that period. That will then be added to (if positive) or subtracted from (if negative) the cash balance at the beginning of the period to reconcile to the cash balance at the end of this period. Note that the current year beginning cash balance is most often gathered by pulling the prior year’s ending balance.
Example of Final Reconciliation
Increase in Cash $7,250
Beginning Cash Balance $10,000
Ending Cash Balance $17,250
This below video goes through an overview of the cash flow statement, including all three sections.
Section 2.) Operating Section
The operating section is the most unique of the three in that there are actually two methods that can be used to prepare it. These are the direct method and the indirect method. The direct method directly identifies cash flows that relate to various operating activities. This is often done by scanning the cash account and looking for specific categories of payments or receipts. For example, they would identify cash receipts from customers and count that as an increase. They would identify cash payments to employees, payments to vendors, payments to utility companies, etc. as operating cash outflows. All of these inflows and outflows would be netted together to show the overall cash flows from operating activities.
The indirect method instead starts with net income and adjusts for certain revenues or expenses (and other items) that didn’t really relate to a cash inflow or outflow that period. This will be discussed in more detail in a bit.
The Financial Accounting Standards Board (FASB) recommends (but doesn’t require) the use of the direct method, due to the fact that it provides a very transparent view of exactly what categories of receipts or payments they have related to the operating activities. However, they do require that if the company uses the direct method that they also include a reconciliation between net income and operating cash flows. This reconciliation is what the indirect method is all about. As such, companies essentially choose between doing both the indirect and direct methods OR just doing the indirect method. For this reason, a very large percentage of companies choose to do just the indirect method.
Example of the Direct Method of the Operating Activities Section
Indirect Method Reconciliations
Under this method, there are three categories of adjustments that must be made:
1.) Adjustments for non-cash expenses such as depreciation and amortization, etc.
2.) Adjustments to reverse gains or losses on sales of assets
3.) Adjustments due to changes in current assets and liabilities on the balance sheet.
Adjustments for non-cash expenses (depreciation, amortization, etc.)
This is an expense that is related to the purchase of an asset in one year, and the use of the asset across multiple years. The actual full cash flow occurred in year 1. However, the expense related to the asset is recorded in every year of the asset’s life. This expense reduces net income in each of those years, but it really doesn’t relate to a cash outflow. As such, we need to reverse the effect of that expense. Since the expense reduced net income, we need to add it back in to increase net income.
Adjustments to reverse gains/losses on sales of assets
When a company sells a long-term asset and records either a gain or loss, this increases (gain) or decreases (loss) net income. However, the gain or loss on the sale of the asset is not actually the cash flow. It is generally a small portion of the overall sales price. It is the sales price itself that is the cash flow. Furthermore, the sale of an asset is an investing cash flow (not an operating cash flow.) As such, we should be reversing the effect of that gain or loss to get closer to the true operating cash flow.
A gain would increase net income, so we need to make a reversing adjustment to decrease the amount out of net income during our reconciliation.
A loss would decrease net income, so we need to make a reversing adjustment to increase the amount into net income during our reconciliation.
Adjustments for changes in the current assets or liabilities of the company (current year minus prior year.)
In this section we have to analyze how each current asset or liability (other than cash) has changed from the prior year to the current year. Doing this analysis requires the balance sheets from both years.
The rules for the reconciliation are as follows:
Increase in Current Assets = Subtract out of Net Income
Decrease in Current Assets = Add to Net Income
Increase in Current Liabilities = Add to Net Income
Decrease in Current Liabilities = Subtract out of Net Income
A simple way of thinking about this is that for liabilities, you adjust in the same direction of the change. An increase in current liabilities leads to an increase in net income. For assets, it is the opposite direction. An increase in current liabilities leads to a decrease in net income.
However, we can take a look at some of the individual assets and liabilities to help show the logic behind the reconciliation.
- Increase in Accounts Receivable (AR)- This means that there were sales that increased net income in a period, however they were not yet collected in cash. As such, we need to reduce net income by the amount of the increase in AR.
- Decrease in Accounts Receivable (AR)- This means that we not only collected the amount of the sales for this period, but apparently, we also collected more, since the AR balance decreased from the prior year. As such, we need to increase net income by the amount of the decrease in AR.
- Increase in merchandise inventory- This resulted in a decrease in cash spent buying the merchandise inventory. However, since it is still in the asset account, this means that we haven’t sold it yet and thus haven’t counted it as an expense to reduce net income. Since the cash flow has occurred, we do need to count it as a reduction to net income now (for the purpose of the cash flow statement only.)
Note that we are making an assumption that all merchandise was paid for in cash. If merchandise inventory was instead purchased “on account” (with an accounts payable) instead of cash, the next entry will serve to adjust for that difference. The two adjustments together will net together for the proper adjustment amount.
- Increase in current liabilities (e.g., Salaries Payable, Utilities, Payable, Accounts Payable, etc.) Increases in these payables would have been counted as an expense against net income, however since we have not yet paid it in cash, we need to reverse the effects and add the amount back into net income.
Example of the Indirect Method of the Operating Activities Section
The cash flow statement is all about timing. If there is an increase in an asset in one year, there may very well be a decrease in the next year. In one period we may have an increase in merchandise inventory which results in a deduction from net income and in the next period we may actually sell that merchandise, thus reducing merchandise inventory, thus causing us to have an increase to net income. The required reconciliations for the cash flow statement allow us to arrive at the actual operating cash flows.
Think of the cash flow statement as a conversion from the accrual method of accounting to the cash method of accounting.
Section 3.) Investing Section
As discussed in the overview, the investing activities include the purchases or sales of long-term assets. Some of these are what you would normally think of as an investment (e.g., stocks or bonds of another company.) Others are investments by the company in themselves. The company “invests” in these long-term assets to help them grow production, etc. We simply need to determine how much cash was actually spent on these types of assets or obtained from their sale. Note that any gain or loss on the eventual sale of an asset does not matter. That is not the full cash flow.
Example of the Investing Activities Section
Section 4:) Financing Section
As discussed in the overview, the financing activities include cash flows from the issuance of long-term debt and stock, as well as eventual payment of that debt, repurchase of treasury stock, and dividends. Note that the receipt of dividends from investments in other companies is considered an operating activity, rather than a financing activity. The payment of interest is also considered an operating activity.
Example of the Financing Activities Section
Once all three sections are brought together, they complete the overall cash flow statement as shown in the below examples.
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