5.5 The Statement of Cash Flows

Importance of the Statement of Cash Flows

Remember, most firms use accrual accounting. Revenues and expenses are recorded when they occur, not necessarily when cash moves. This can create timing differences between profits and cash flows. A firm can be profitable and still not have an adequate flow of cash. The opposite is also true: it can experience a net loss and still have cash on hand. Earning a profit is wonderful, but it is not the only goal an organization has. It must also have adequate cash flow to support daily operations. To support cash planning and to provide external financial statement users such as lenders and investors information about the firm’s cash flow, the statement of cash flows is prepared. Cash flow is also a crucial metric for determining the value of a company.

External financial statement users also rely on the statement of cash flows to help them evaluate the quality of the firm’s earnings. Users compare earnings to cash flow to assess the validity of the earnings data. For example, a firm reporting a strong profit but very little cash flow might raise some questions as to what was recorded to drive profits that isn’t also driving cash flows.

The statement of cash flows also helps external users determine the driving forces behind the firm’s cash flows. They can see if cash is generated primarily by daily operations or if cash is being generated or consumed by events outside the firm’s normal course of business.

There are two key methods of preparing the statement: direct and indirect. FASB (Financial Accounting Standards Board) favors the direct method. Despite that, the most common method used by far in general practice is the indirect method. The direct method lists cash flows directly from revenues and expenses, whereas the indirect method reconciles income to cash flows. The indirect method begins with net income and reconciles each account in order to arrive at net cash flow. It essentially reconciles accrual basis accounting to cash basis, or cash flow.

Operating Activities

To provide clear information about what areas of the business generated and used cash, the statement of cash flows is broken down into three key categories: operating, financing, and investing. The operating section reflects cash flows generated by and used by the day-to-day operations of the business. Investing activities include investments in other firms as well as investments in the firm itself (items like machinery, land, or other fixed assets). Finally, financing activities are those used to provide funds to run the business (loans, interest).

As mentioned, operating activities are those that are used or generated by the day-to-day operations of the firm. The operating activities section of the statement of cash flows begins with net income. All lines thereafter, in that section, are then adjustments to reconcile net income to actual cash flows by adding back noncash expenses like depreciation and adjusting for changes in asset and liability accounts. For example, depreciation is a noncash expense. Thus, depreciation is added back to net income.

To prepare the statement of cash flows for Clear Lake Sporting Goods, we need the beginning cash balance from the balance sheet, net income and depreciation expense from the income statement, and a set of comparative balance sheets to see the change in asset and liability accounts (see Figure 5.15).

Figure 5.15 Comparative Income Statements and Balance Sheets

Clear Lake’s statement of cash flows begins with the current year net income of $35,000 from the income statement. Next, noncash expenses are deducted. Clear Lake’s only noncash expense on their current year income statement is depreciation of $3,600. Since deprecation is an expense that reduces income but is not actually paid out in cash in the current period, it must be added back to net income to reconcile net income to cash flow.

Next, changes in operational assets and liabilities are used to continue reconciling net income to actual cash flow. For example, Clear Lake’s accounts receivable increased from the prior period to the current period. This means that there were more sales recorded but not yet received in cash in this period than there were in the prior period, making an increase in accounts receivable a reduction on the statement. Inventory increased, which means additional cash was spent to acquire it, making it a use of cash or reduction to net income to move closer to cash. Accounts payable and unearned revenue, both liability accounts, increased. Since these are liabilities, an increase would indicate that the liability was incurred but not as quickly paid out; thus it is an increase to the statement.

Tallying all these adjustments to net income shows Clear Lake’s net cash flows provided by operating activities of $53,600 (see Figure 5.16).

Figure 5.16 Operating Activities Section of the Statement of Cash Flows

Investing Activities

As mentioned, investing activities include investments in other firms as well as investments in the firm itself (items like machinery, land, or other fixed assets). These are items that are capitalized (placed on the balance sheet and depreciated over time) and thus did not reduce net income. They did, however, cause an impact to cash flow (see Figure 5.17).

During the current year, Clear Lake purchased an additional $5,000 in short-term investments (see the comparative balances sheets; the balance in that account increased by $5,000 since the prior year). They also purchased additional plant assets in the amount of $13,600. This amount can be figured by comparing the difference in the current and prior plant assets accounts and including the impact of current year depreciation ($50,000 current year balance less $40,000 prior year balance and $3,600 of depreciation = $13,600 of new assets purchased).

Figure 5.17 Investing Activities Section of the Statement of Cash Flows

Financing Activities

Recall that financing activities are those used to provide funds to run the business. Common items in this section of the statement include the payment of dividends, issuance of common or preferred stock, and issuance or payment of notes payable (see Figure 5.18).

In the current year, Clear Lake took out additional notes payable (a cash inflow). We can see this by the increase in their notes payable account from the prior year to current year ($40,000 to $50,000). This is an inflow of cash and thus an increase on the statement. Dividends of $30,000 were paid to shareholders (found on the statement of retained earnings and the statement of owner’s equity). Finally, we see that Clear Lake must have issued additional common stock, as their common stock balance increased from $75,000 to $80,000.

Figure 5.18 Financing Activities Section of the Statement of Cash Flows

The final task to wrap up the statement of cash flows is to tally net cash generated or used by summing all three sections. This amount is then used to adjust the beginning cash balance from the balance sheet. Assuming the statement was prepared correctly, the sum should equal the ending cash balance on the balance sheet.

In the full statement, we can see that Clear Lake has net cash flow of $20,000. The beginning cash balance was $90,000, making the ending cash balance $110,000 (see Figure 5.19).

Figure 5.19 Full Statement of Cash Flows

Analyzing Performance

The statement of cash flows can be used in a number of ways to assess firm performance by both internal and external financial statement users. Internal users can assess sources of and uses of cash in order to aid in adapting, as necessary, to ensure adequate future cash flows. External users also use the statement. Recall that comparing net income to operational cash flows can help assess the quality of earnings. In the next section you’ll explore operating cash flow and free cash flow to the firm, two key points of analysis in assessing cash flows.