Cash flow statement

Using the cash flow statement

The cash flow statement explains the change in cash by three activities: operating, investing and financing activities.

Cash flow from operating activities is the change in cash as a result of the daily operations. It is the balance of money received from customers and cash paid to suppliers, personnel, etc. It also includes interest paid and interest and dividend received on securities that the firm holds.

There are two common ways to compute the operating cash flow: the direct method and the indirect method. With the direct method, the different cash flows (cash received from customers, cash paid to suppliers, etc.) are shown separately. With the indirect method net income is used as a starting point. Adjustments are made in order to undo accrual accounting. Both methods result in the same cash flow from operating activities. I will focus on the indirect method, because it is most widely used.

Cash flow from investing activities is the change in cash as a result of investments and disinvestments, including transactions involving financial long term assets such as notes receivable.

Cash flow from financing activities is the change in cash as a result of obtaining and repaying loans, issuing shares, buying back shares and paying dividend.

Key points:
- the cash flow statement explains the change in cash by three types of activities: operating, investing and financing activities
- cash flow from operating activities is the cash generated (or used) by the ‘daily’ transactions
- there are two methods to compute the operating cash flow: the direct method (showing separate cash flows) and the indirect method (starting with net income and making adjustments)
- cash flow from investing activities is the cash invested /disinvested by buying/selling long term assets
- cash flow from financing activities is the cash that has been raised/repaid by issuing/repaying loans, or selling/repurchasing shares, and paying a dividend

Creating the cash flow statement

To create the cash flow statement, it is helpful to keep the business equation in mind. The business equation states that total assets equal total liabilities plus equity. This is true for all transactions together as well as a single transaction, or the transactions over a period. Therefore, the change in assets (∆assets) must also be equal to the change in liabilities (∆liabilities) plus the change in equity (∆equity).

∆assets = ∆liabilities + ∆equity

Since we are interested in the change in cash (∆cash), we split the change in assets in the change in cash and the change in the other (non-cash) assets:

∆cash + ∆non-cash assets = ∆liabilities + ∆equity

Then, taking ‘∆non-cash assets’ to the right-hand side:

∆cash = ∆liabilities + ∆equity - ∆non-cash assets

Thus, the change in cash can always be explained by changes in all other T-accounts. The use of this formula is best illustrated using an example.

Example


Consider the end of year condensed balance sheet of Google for 2007 and 2008 (Google's annual report).
Condensed balance sheet Google 2007 and 2008
Naturally, total assets equal total liabilities plus total equity. Also, the business equation holds for the changes.
Change in condensed balance sheet Google 2008

In this example the balance sheet is condensed. The same principle holds when the T-accounts are used.

Adding/subtracting the changes in all the non-cash T-accounts adds up to the change in cash. However, this is not yet an informative cash flow statement. However, it is a starting point for creating the cash flow statement. What we need is to allocate all these changes to the three categories: operating, investing and financing activities.

With the indirect method, net income is taken as the starting point to compute operating cash flow. All cash flows which are also an expense/revenue are included in net income. Hence, items that require an adjustment are (1) items that are included in the calculation of net income, but which are not a cash flow, or (2) items that are a cash flow, but are not included in net income.

Depreciation is an example of an item that affects net income, but does not affect cash flows. At the time of investment, cash is spent on a long term asset. The depreciation during the economic lifetime is an expense (but not a cash flow). Hence, depreciation is added back to net income in the operating cash flow section.

Examples of items where the cash flow does not have to match the expense/revenue include the following: cash received from customers does not have to be the same as revenue; cash paid to suppliers does not have equal cost of goods sold; interest paid does not have to equal interest expense, etc.

Current assets and liabilities (with the exception of interest-bearing debt) are operations related. That means that the change in all current assets and current liabilities will be included in the operating section of the cash flow statement. This makes sense, because these T-accounts are used because of accrual accounting. With the indirect method net income (accrual accounting) is being corrected to result in operating cash flow (cash accounting). Hence, the corrections basically ‘undo’ the accrual accounting.

Example


The balance of Accounts receivable at the beginning of the year and end of the year is 50 and 60, respectively. Thus, accounts receivable has increased by 10.

Net income increases when the sale is recognized (and not when the customers pay). As a result, the increase in accounts receivable (customers have delayed payment) must be subtracted from net income in the operating cash flow section. This is also in line with the formula used: ∆cash = ∆liabilities + ∆equity - ∆non-cash assets. As accounts receivable is a non-cash asset, the increase must be subtracted (note that the change in assets is subtracted).

The operating section starts with net income as the starting point. For the investing and financing section the ‘real’ cash flow is shown. For example, if a new machine is purchased for 50, then an entry like ‘investments in new machines -50’ is included in the investing activities.

Depending on the country’s GAAP, there could be flexibility in the classification of items. For example, under IFRS interest paid can be classified as an operating cash flow as well as a financing cash flow, whereas under US GAAP interest paid has to be classified as an operating cash flow.


Example


The following information is available for CTU Inc. for the year 20x8:

Net income 500  
Accounts payable at beginning of year 110  
Accounts payable at end of year 120  
Inventory at beginning of year 80  
Inventory at end of year 65  
Depreciation expense 30  

Furthermore, during the year a machine with a historic cost of 80, and a book value of 30 is sold for 32 in cash.

The operating cash flow section for the year 20x8 (Assuming no other information would be relevant):

Net income 500  
Change in accounts payable 10  
Change in inventory 15  
Depreciation expense 30  
Gain on sale machine -2  
  ____  
Operating cash flow 553  

gain or loss on sale of long term asset

When the firm sells a long term asset at a gain or a loss the cash flow of the disinvestment is an investing cash flow. At the same time, the gain or loss affects net income, which is the starting point for computing operating cash flow. As a result, the gain or loss needs to be adjusted for in the operating cash flow section.

Example


The firm sells a machine for 45 cash, which is an investing cash flow. The book value of the machine was 40. Assume this is the only transaction during the period, so net income is 5 and operating cash flows are 0.

The cash flow statement using the indirect method:

Operating cash flows    
  Net income 5  
  Gain on sale machine -5  
  ___  
  0  
     
Investing cash flows    
  Sale machine 45  
     
Financing cash flows -  
     
  ___  
Change in cash 45  

The correction ‘gain on sale machine -5’ is needed to undo the gain on sale of +5 which has increased net income.

Key points:
- The change in cash always equals the changes in liabilities and equity minus the change in non-cash assets: ∆cash = ∆liabilities + ∆equity - ∆non-cash assets
- With the indirect method, net income is taken as the starting point to compute operating cash flow, with corrections for (1) items that are included in the calculation of net income, but which are not a cash flow, and (2) items that are a cash flow, but are not included in net income.
- some countries’ GAAP can allow flexibility with respect to classification of cash flows. For example, under IFRS interest paid can be classified as an operating cash flow as well as a financing cash flow.



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