Cash Flow Statement

The statement of cash flows reports the net cash flows relating to operating, investing and financing activities for a period of time (the same period as the income statement). 

Due to accrual accounting, the income statement does not measure cash inflows and outflows. However, since cash is so important (“cash is king”), the cash flow statement is a very important tool for understanding the operations of the company. 

The basic equation of the cash flow statement is: 

cash at the beginning period + cash from operations + cash from investing + cash from financing = cash at the end of the period

The cash flow statement is divided into three categories: 

• Cash from operations equals cash received from selling goods and services less cash paid for providing goods and services 
• Cash from investing equals cash received from sales of investments and PP&E less cash paid for the acquisition of investments and PP&E 
• Cash from financing equals cash received from the issue of debt or equity less cash paid for dividends and the reacquisition of debt or equity

In theory, firms could prepare their cash flow statements by accounting for every cash inflow and outflow, however, this would be burdensome. 

The simpler way to prepare a cash flow statement is to examine the balance sheet for changes in assets, liabilities and shareholders’ equity from the beginning of the period to the end of the period. That is, the change to the value of any item on the balance sheet must have a corresponding cash impact (and must be accounted for somewhere in the cash flow statement). 

• An increase in assets on the balance sheet MUST correspond to a decrease in cash on the cash flow statement. For example, other things equal, an increase in PP&E (asset) on the balance sheet results in a decrease in cash as cash is used to purchase the new equipment. 
• An increase in liabilities and shareholders’ equity on the balance sheet MUST correspond to an increase in cash on the cash flow statement. For example, other things equal, an increase in debt (liability) on the balance sheet (i.e. a new bank loan) increases cash.

Most firms report cash flow from operations using the “indirect method”. Cash flow from operations is the result of adjusting net income for non-cash items. 

An alternative, but less frequently used method is the “direct method” whereby cash flow from operations lists the cash received from customers and the cash expenditures to suppliers. 

This difference between the two methods is purely presentation – numerically they will give the same result.

Under the indirect method, the first line in this section is net income. Typically, the next line is depreciation and amortization (D&A). While D&A does not provide cash, it must be added back in the cash flow statement since it was included in net income (as an expense). D&A will have a positive sign on the cash flow statement.

Then next step would be to adjust for changes in operating assets (i.e. working capital). For example: 

• Change in accounts receivable (asset) 
• Change in inventories (asset) 
• Change in other current assets (asset) 
• Change in accounts payable (liability) 
• Change in accrued expenses (liability) 
• Change in other current liabilities (liability) 

It is important to remember that an increase in assets is a negative cash impact or “use of cash” while an increase in liabilities is a positive cash impact or “source of cash”. Be mindful of the signs (positive/negative) such as an increase in assets will have a negative sign and an increase in liabilities will have a positive sign (and vice versa for decreases).

To summarize, changes in working capital and changes in other operating items results in Cash Flow from Operations.

Cash flow from Investing takes into account acquisitions and sales of investments and property, and plant and equipment (PP&E). The first line item in this section is usually additions to PP&E (commonly referred to as capital expenditures or “CAPEX”) which is a use of cash and will have a negative sign.

The next line item(s) typically proceeds from any sales of PP&E which is a source of cash and will have a positive sign.

Finally, the acquisition of or proceeds from the sale of any other investments is listed. 

The sum of CAPEX (negative), proceeds from the sale of PP&E (positive) and net investment activity (negative) results in Cash Flow from Investing.

Cash flow from Financing takes into account changes to a firm’s debt and equity positions. Line items in this section include: 

• Increase/decrease in short-term borrowings or short-term debt 
• Increase/decrease in long-term borrowings or long-term debt 
• Payments of dividends 
• Issue of capital stock (i.e. common stock, preferred stock) 
• Purchase of treasury stock (decrease of capital stock) 
• Other financing transactions 

Again, increases in liabilities and shareholders’ equity (e.g. increase in borrowings) will have a positive sign and decreases will have a negative sign (e.g. purchase of treasury stock). 

The sum of all of the above line items results in Cash Flow from Financing. 

The sum of Cash Flow from Operations, Cash Flow from Investing and Cash Flow from Financing equal net cash flow for the period and the sum of net cash flow + the beginning cash balance equals the ending cash balance.