Statements of Cash Flows

Cash Flow

The statement of cash flow is one of the basic financial statements for a business. It reports a company’s major cash income and outflow for a period. The statement reports cash flows by three types of activities:

Cash flows from operating activities – Cash flows from transactions that affect the net income of the business.

Cash flows from investing activities – Cash flows from transactions that affect the investments in noncurrent assets, such as the purchase and sale of fixed assets.

Cash flows from financing activities – Cash flows from transactions that affect the debt and equity of the company.

The statement of cash flows generally lists the cash flows from operating activities first, followed by the cash flows from investing, and finally the cash flows from financing. The total of the net cash flows from these activities is the net increase (or decrease) in cash for the period. The beginning cash is added to the net in/decrease to get the ending cash balance. This equals the cash reported on the balance sheet.

Cash Flows From Operating Activities

This is the most important of a business’ cash flows. There are two methods for reporting cash flows from operating activities: the direct method, and the indirect method. The direct method is the preferred method per accounting guidelines. However, when doing the direct method, a reconciliation must be done as well. The reconciliation is very similar to the indirect method. Because of this, most companies just do the indirect method, so we’ll be focusing on the indirect method. The indirect method reports the cash flow from operations by taking the net income, and adjusting it for revenue and expenses that do not involve the receipt or payment of cash.

Cash Flows from Investing Activities

This cash flow normally come from selling fixed assets, investments, and intangible assets. The outflows normally include payments to acquire fixed assets, investments and intangible assets. Cash flows from investing activities are reported on the statement first by listing cash inflows. The cash outflows are then listed. If the inflows are greater than the outflows, net cash flow provided by investing activities is reported. If the inflows are less than the outflows, then net cash flow used for investing activities are reported.

Cash Flows From Financing Activities

The inflows for financing activities normally come from issuing debt or equity securities, such as bonds, notes payable, and preferred and common stock. The outflows included paying cash dividends, repaying debt, and acquiring treasury stock. As with investing activities, inflows are listed first, followed by outflows. If inflows are greater, then net cash flow provided by financing activities is reported. If inflows are less, then net cash flow used for financing activities is reported.

Noncash Investing and Financing Activities

A company may have activities that do not directly involve cash. For example, it may issue common stock to retire long-term debt. Although these transactions do not have a direct effect on cash, they do eliminate future cash payments to pay interest and retire the bonds. Since future effect on cash flows is affected, these transactions should be reported. These are reported on a separate schedule at the bottom of the statement of cash flows.

Statement of Cash Flows – Indirect Method

To collect data for the statement of cash flows, the changes in the noncash balance sheet accounts is analyzed. The logic in this is that the change in any balance sheet account can be analyzed in terms of changes in other balance sheet accounts. To illustrate, the accounting equation we learned in the first article can be rewritten below to focus on cash:

Assets = Liabilities + Stockholder Equity
Cash + Noncash Assets = Liabilities + Stockholder Equity
Cash = Liabilities + Stockholder Equity – Noncash Assets

Thus, if the cash account changes, then there must be a change in either liability, stockholder equity or noncash assets.

Additional data are also obtained by analyzing the income statement accounts and supporting records. There is no order in which the noncash balance sheet accounts must be analyzed. It is usually more efficient, however, to analyze the accounts in the reverse order in which they appear on the balance sheet. With this, the retained earnings provides a great starting point for determining the cash flows from operating activities.

Retained Earnings

The retained earnings account must be analyzed carefully because some of the entries may not affect cash. A decrease in retained earnings from issuing a stock dividend does not affect cash and are not reported on the statement of cash flows.

Cash Flows From Operating Activities – The Indirect Method

The net income of a company normally is not equal to the amount of cash generated from operations during the period. This is because net income is determined using the accrual method of accounting. Under this method, revenues and expenses are recorded at different times from when the cash is actually received or paid. Merchandise may be sold on account and the cash received at a later date.

Under the indirect method, these differences are used to reconcile the net income to cash flows from operating activities. In practice, the adjustments often begin with expenses that do not affect cash, such as depreciation of fixed assets and amortization of of intangible assets. These types of activities are added back into the net income.

The next adjustments are for gains and losses from disposal of assets. These activities should be reported in the cash flows from investing activities, not operating activities. Gain from selling land, for example, is deducted from net income in determining cash flows from operating expenses to avoid double counting the cash flow from the gain. Losses from the disposal of fixed assets are added into the net income.

Net Income is also adjusted for changes in noncash current assets and current liabilities that support operations. These are the result of revenue or expense transactions that may or may not affect cash flow. A sale of $10,000 on account increases accounts receivable, but cash is not affected. Thus, the increase to accounts receivables is deducted from net income in arriving at cash flows from operating activities. A decrease in accounts receivable is added to the net income in arriving at cash flows from operating activities.

Dividends payable, although a current liability, is not included in the operating activity section. Dividends payable is omitted because dividends are not an operating activity that affects net income. These are part of financing activities.

In summary, when arriving at Cash Flows from Operations, the following example shows how items are added and subtracted from the Net Income:

Cash Flows Used for Payment of Dividends

Cash dividends that are declared have not yet been paid. These do not affect cash at all. However, cash dividends that are paid due affect cash flows. Payment of a cash dividend is represented as an outflow of cash that is reported in the financing activities section.

Common Stock

When common stock is issued, the common stock account increases. In addition, there is an increase in paid-in capital in excess of par – common stock account. The cash inflow is reported on the financing activities section of the statement of cash flow.

Bonds Payable

If a company retired bonds by paying a cash payment for the face amount of the bond, then the bonds payable account would decrease. This decrease would be recorded in the financing activities section as cash flows from financing activities: cash paid to retire bonds payable.

Buildings

The purchase of a building is reported as outflow of cash in the investing activities section. A credit (increase) in building depreciation would represent depreciation expense for the period. The depreciation expense has already been considered as an addition to the net income in determining cash flows from operating activities, as shown above.

Land

When land is sold, it is reported as an increase to the cash flows from investing activities. When land is bought, it is represented as a decrease, or outflow, of cash in the investing activities section.

Preparing the Statement of Cash Flows

The statement of cash flows is prepared from the data assembled and analyzed above. Below is an example of a statement of cash flow: