Statement of Cash Flows

The statement of cash flows is the third major financial statement (in addition to the income statement and balance sheet). This statement shows the flows of cash within the firm and associates these flows with three types of activities: operating (selling goods and services), investing (buying and selling assets), and financing (obtaining monies from investors). The objective of this text is to discuss the need for cash flow information, describe the cash flows from various business activities, illustrate the preparation of a statement of cash flows, and consider noncash transactions.

The Need for Cash Flow Information

The purpose of the statement of cash flows is to provide information about the firm’s cash receipts and disbursements during a period of time. Creditors and owners need predictions of future cash flows from investment decisions. Individuals need to predict future cash receipts from interest, dividends, principal repayment, and return of capital. Future cash flows to the investor depend upon the firm having adequate cash to make payments. Information about current cash flows of the firm is useful for predicting future cash flows to the investor.

The importance of this information was recognized by the FASB when it issued SFAS No. 95 requiring all firms to prepare a financial statement explaining cash receipts and disbursements.[1] As stated by the FASB:

The information provided in a statement of cash flows, if used with related disclosures and information in the other financial statements, should help investors, creditors, and others to (a) assess the enterprise’s ability to generate positive future net cash flows; (b) assess the enterprise’s ability to meet its obligations, its ability to pay dividends, and its need for external financing; (c) assess the reasons for differences between net income and associated cash receipts and payments; and (d) assess the effects on an enterprise’s financial position of both its cash and noncash investing and financing transactions during the period.[2]

The present discussion about the usefulness of cash flow information does not negate the usefulness of net income as a measure of performance (recall, too, that the accrual basis is more useful than the cash basis for predicting the long-run cash-generating ability of the enterprise). Net income measures the change in all the firm’s assets and liabilities that results from the firm’s operations. For example, sales revenue is interpreted as an accomplishment of the period, independent of whether the revenue has resulted in a cash receipt or a receivable from the customer. However, the income statement alone does not give information about changes in the specific types of assets, liabilities, and owners’ equity. Thus exclusive reliance on net income as a long-run indicator of financial success may cause the investor to overlook current shortfalls in the actual flow of cash through the business. And if a business cannot meet its immediate needs for cash, its future viability is in jeopardy.

Comparing the beginning and ending cash balances using the balance sheet reveals the change in cash during the year. However, comparative financial statements indicate only the cumulative effects of all the transactions that affected assets, liabilities, and owners’ equity, not the causes of the changes that took place during a period. Thus only the net change in an account (e.g., cash) can be observed. No information is given regarding the specific transactions which caused the cash account to change. The statement of cash flows explains the exact changes that occurred in the balance sheet accounts and their related cash flow effects—the short-run financial impact of a firm’s activities. This information is used by investors to assess the firm’s ability to meet its obligations, expand its operations, take advantage of new opportunities, and provide a return to its investors.

Cash Flows from Operating, Investing, and Financing Activities

Before describing the procedures underlying the preparation of the statement of cash flows, the types of business activities that impact cash during the year are considered. The firm’s cash balance can be increased by (1) profitable operations; (2) a decrease in noncash assets (e.g., land sold for cash or a note receivable collected); and (3) an increase in liabilities or owners’ equity (e.g., bonds payable issued or common stock sold). Likewise, the firm’s cash balance can be decreased by (1) a loss from operations; (2) an increase in noncash assets (e.g., equipment purchased for cash); and (3) a decrease in liabilities or owners’ equity (e.g., notes payable reduced or dividends paid). The purpose of the statement of cash flows is to explain changes in the cash account according to the managerial activities that cause them. These activities are classified as operating, investing, and financing. As will be seen, this classification becomes the basis of the format used to prepare the statement of cash flows.

Operating activities are those transactions and events directly related to the regular production and delivery of goods and services to customers. Cash flows from operations are the cash effects of the transactions that impact net income. Included are the cash receipts from the sale of goods or services and cash payments for expenses such as merchandise inventory, wages, supplies, interest, taxes, and the like. A company may have cash used by operations, even though net income is positive, if accounts receivable are slow to be collected and inventories are building up instead of being sold.

Investing activities arise from the acquisition and sale of assets such as buildings, equipment, and land. These resources provide the capacity over time to carry out the operations of the business. Cash inflows related to investment activities arise from collections on loans made to others (e.g., notes receivable) and proceeds from selling property, plant, and equipment. Thus the sale of land would be a cash inflow from investing activities equal to the amount paid by the buyer. Cash outflows arise from loans made to other entities, purchase of another firm’s common stock, or acquisition of property, plant, and equipment. For example, lending monies to a third party would be an increase in notes receivable and a cash outflow from investing activities.

Financing activities relate to transactions with creditors and owners. Cash receipts from financing activities arise from bonds, mortgages, notes, and other long-term borrowing as well as the sale of common stock. For example, borrowing funds from a bank increases notes payable and is a cash inflow from financing activities. Cash outflows relate to repayments of amounts borrowed as well as reacquisition of the firm’s common stock and payments of dividends or withdrawals by the owners. Thus repayment of a note payable would be a cash outflow for financing in that period.

Operating, investing, and financing activities occur during the management of the business over its natural operating cycle. Operating plans determine the amount of various assets which will be needed—investing activities. Cash to acquire the desired assets must be obtained from creditors or owners—financing activities. Such funds are then available for investing in the assets necessary to support operations. Actual operations, in turn, produce cash flows from sales (collections of accounts receivable) to replace resources used, to provide products and services, and to make payments to creditors and owners. In this manner, the three types of management activities are interrelated.

When the statement of cash flows is prepared, the cash effects of operating, financing, and investing activities are shown separately to facilitate an evaluation of the three types of management functions. This enables the investor to separately analyze the various sources and uses of cash and assess trends in the firm’s activities.

Preparing the Statement of Cash Flows

The firm’s beginning-of-period and end-of-period balance sheets (comparative balance sheets) are used along with the income statement and other relevant information to prepare the statement of cash flows. The previous period’s ending balance sheet is used for the beginning-of-period account balances, as they are one and the same. Preparation of the statement of cash flows involves two basic steps: (1) analyzing changes in the balance sheet accounts to determine their effect on cash (using any other relevant information) and (2) using this analysis to calculate cash flows from operating, investing, and financing activities. These steps provide the information needed to prepare the statement of cash flows.

Step 1: Analyze Changes in the Balance Sheet Accounts

Calculate the change in cash. The first step is to determine the change in cash during the period. This is done by using comparative balance sheets (beginning-of-period and end-of-period) and calculating the increase or decrease in cash.

Calculate the change in each noncash account. The second step is to analyze the change in each noncash account together with any additional information available to further explain the cause of each change. These changes are categorized as arising from three activities: (1) operations, as in sales (accounts receivable) and expenses (prepaid expenses, inventories, depreciation, accounts payable, accrued liabilities); (2) investing, as in long-term assets (land, equipment, buildings); and (3) financing, as in long-term liabilities (notes payable) and owners’ equity (paid-in capital and retained earnings). All these changes are interpreted for their impact on cash during the period.

Step 2a: Calculate Cash Flows From Operating Activities

Having analyzed and categorized the changes in the noncash accounts, the next step is to calculate cash from operations. The analysis of the changes in the balance sheet accounts related to sales and expenses is used to adjust the income statement to the cash basis. Two approaches are used in practice to determine cash flows from operations: the direct approach (each income statement account is adjusted to the cash basis) and the indirect approach (the effects of accruals and deferrals are removed from net income). Both approaches yield the same cash flows from operating activities. The difference lies only in how the information is shown in the statement. The choice of which method to use is left to the firm.

Direct Method
Using the direct method, the objective is to calculate net operating cash flow as the difference between operating cash receipts (cash collections from customers) and cash disbursements (cash payments for purchases and operating expenses). Each individual income statement component of revenue and expense is adjusted to remove the noncash portion.

Cash Receipts from Customers. Revenues are first adjusted for noncash sales and collections of accounts from previous periods. The balance sheet account which causes revenues to be on the accrual basis is accounts receivable. Suppose we observe from the comparative balance sheets that the accounts receivable balance has decreased from the beginning of the period to the end of the period. We would conclude that not only were the current period’s sales collected in cash, but also some from the previous period. Then cash receipts from customers are equal to the revenue plus the decrease in accounts receivable during the year. On the other hand, suppose the accounts receivable balance had increased from the beginning of the period to the end of the period. We would then conclude that not all of the current period’s sales were collected in cash. Some of the sales are represented by the increase in accounts receivable. To determine cash receipts from customers, we would subtract from revenue the net increase in accounts receivable.

These adjustments are summarized below.

REVENUE + DECREASE IN ACCOUNTS RECEIVABLE
 OR
REVENUE – INCREASE IN ACCOUNTS RECEIVABLE
= CASH RECEIPTS FROM CUSTOMERS

At this point it may be helpful to consider what happens to accounts receivable during a specific period. The beginning balance in accounts receivable is collected in its entirety during the period. This provides a cash inflow equal to the beginning amount. However, the ending balance is created entirely during the period, representing current sales that are not collected in cash. Thus an alternative, but equivalent, way of determining cash receipts from customers is from the following equation (where cash receipts is the unknown):

BEGINNING ACCOUNTS RECEIVABLE + SALES – CASH RECEIPTS FROM CUSTOMERS = ENDING ACCOUNTS RECEIVABLE

Cash Payments for Merchandise. Next we need to adjust cost of sales to cash payments for merchandise. Here we recognize that the firm not only acquires the goods sold during the period, it also purchases merchandise for inventory. If the inventory balance increases from the beginning of the period to the end of the period, the firm purchased merchandise both for sale during the current period and to build up its stock of inventory. The increase in inventory must be added to cost of sales to determine merchandise purchased during the period. On the other hand, the inventory balance could fall from the beginning of the period to the end of the period. This indicates that not all of the merchandise sold came from purchases made this period; some came from the stock of goods on hand at the beginning of the period. The decrease in inventory is subtracted from cost of sales to get purchases during the period. As for the accounts receivable balance, inventory will either experience a net increase or decrease during a given year. These adjustments are shown below:

COST OF SALES + INCREASE IN INVENTORY
 OR
COST OF SALES – DECREASE IN INVENTORY
= PURCHASES

An alternative, but equivalent way of determining purchases during the period is to consider the flow of merchandise into and out of inventory during the year. The beginning balance in inventory is sold to customers as a part of cost of sales during the period, while the ending balance remains on hand for sales in a subsequent period. Thus purchases can be determined from the following equation (where purchases is the unknown):

BEGINNING INVENTORY + PURCHASES – COST OF SALES = ENDING INVENTORY

Continuing the analysis to determine cash payments for purchases, it must be recognized that not all the merchandise purchased during the current period is necessarily paid for in cash. Instead the firm may use short-term credit in the form of accounts payable. If accounts payable increase from the beginning of the period to the end of the period, not all of the purchases represent a cash outflow; some are financed with accounts payable. The increase in accounts payable is subtracted from purchases to obtain cash payments for purchases. Alternatively, the accounts payable balance could fall from the beginning of the period to the end of the period. This implies not only were the current period’s purchases paid for in cash, but also some from the previous period. The net decrease in accounts payable would be added to purchases to obtain cash payments for purchases. These adjustments are summarized below:

PURCHASES + DECREASE IN ACCOUNTS PAYABLE
 OR
PURCHASES – INCREASE IN ACCOUNTS PAYABLE
= CASH PAYMENTS FOR PURCHASES

An alternative, but equivalent, way of determining cash payments for purchases (the unknown) is from the following equation:

BEGINNING ACCOUNTS PAYABLE + PURCHASES – CASH PAYMENTS = ENDING ACCOUNTS PAYABLE

Cash Payments for Operating Expenses. Operating expenses also must be restated to the cash basis. Prepaid expenses may have been recorded that relate to cash expenditures to be used for operations in later periods. Examples include prepaid rent, insurance, and the like. An increase in prepaid expenses from the beginning of the period to the end of the period indicates that not only were the current period’s expenses paid for in cash, but also the amount represented by the increase in prepayments. The net addition to prepaid expenses must be added to operating expenses to get current period expenditures. On the other hand, a decrease in prepaid expenses indicates that not all of the current period’s operating expenses were paid for in cash. Some have come from the expenses prepaid in previous periods. The net decrease in prepaid expenses must be subtracted from operating expenses to get current period expenditures. These adjustments yield current expenditures for operating items during the year as follows:

OPERATING EXPENSES + INCREASE IN PREPAID EXPENSES
 OR
OPERATING EXPENSES – DECREASE IN PREPAID EXPENSES
= CURRENT EXPENDITURES

Once again, an alternative approach to solve for current expenditures (the unknown) is as follows:

BEGINNING PREPAID EXPENSES + CURRENT EXPENDITURES – OPERATING EXPENSES = ENDING PREPAID EXPENSES

Not all of the operating expenses recognized during the current period are necessarily paid for in cash. Some may be liabilities such as accrued wages or interest payable. If the accrued liabilities increase from the beginning of the period to the end of the period, not all of the operating expenses resulted in a cash outflow. Some are represented by the net increase in accrued liabilities. This net increase must be subtracted from current expenditures to obtain cash payments for operating expenses. On the other hand, accrued liabilities may decrease from the beginning of the period to the end of the period. In this case not only were the current period’s expenses paid for in cash, but also some that were payable from a previous period. The net decrease in accrued liabilities must be added to current expenditures to get cash payments for operating expenses.

CURRENT EXP + DECREASE IN ACCRUED LIABILITIES = CASH PAYMENTS FOR OPERATING EXPENES
 OR
CURRENT EXP – INCREASE IN ACCRUED LIABILITIES

Alternatively, we can solve for cash payments for operating expenses from the following equation:

BEGINNING ACCRUED LIABILITIES + CURRENT EXPENDITURES – CASH PAYMENTS = ENDING ACCRUED LIABILITIES

Depreciation. Depreciation expense may be included in cost of sales and/or as a part of operating expenses. Depreciation expense must be removed from the expenses on the income statement since it is an item that did not require the use of cash during the period. The cash outflow related to long-lived assets occurs when the asset is paid for. Depreciation allocates the cost of the asset to operations over its useful life. This is unrelated to the cash outflow to pay for the asset. Payment for the asset is shown in the cash flows from investing activities section of the statement of cash flows when the asset is purchased.

This direct method of analyzing cash flows from operating activities provides important information regarding the specific sources and uses of cash. Major sources of operating cash receipts and disbursements are clearly depicted. Knowing specifically the transactions related to operations responsible for the change in cash during the period may help investors predict future cash flows from operations.

Indirect Method
The indirect method is commonly used by firms to calculate cash flows from operations. While it results in the same cash flows as the direct method, the method of disclosing the information is quite different. The indirect method begins with net income and makes adjustments to remove the noncash revenues and expenses. This is in contrast to the direct method, which makes the noncash adjustments directly to the revenue and expense accounts.

The balance sheet accounts used in the direct method to obtain cash from operations are also used in the indirect method. If the adjustment to obtain cash collections from customers is an increase (decrease) to revenue, the corresponding adjustment to net income to obtain cash flows from operating activities is an increase (decrease). Net income is adjusted in this manner for the effect on revenue of the change in accounts receivable. These adjustments are summarized below.

Net Income
+ Decrease in Accounts Receivable OR – Increase in Accounts Receivable
– Increase in Inventory OR + Decrease in Inventory
– Decrease in Accounts Payable OR + Increase in Accounts Payable
– Increase in Prepaid Expenses OR + Decrease in Prepaid Expenses
– Decrease in Accrued Liabilities OR + Increase in Accrued Liabilities
+ Depreciation Expense
= Cash Flow from Operating Activities

Unlike the adjustments for noncash revenues, the directional adjustments for noncash expenses in the indirect method are opposite to those in the direct method. In the indirect approach, an increase (decrease) to an expense is a decrease (increase) to net income.

For example, in the direct method we increased cost of sales for an increase in inventory to determine cash payments for purchases. This increase to an expense is a decrease to net income in the indirect method. Likewise, cost of sales (an expense) is increased when there is a decrease in accounts payable, thus reducing net income. An increase in accounts payable would be a reduction to cost of sales, or an increase to net income.

Similar logic is used for the adjustments to net income necessary for operating expenses to get cash flows from operations. An increase in prepaid expenses is an addition to operating expenses to obtain the cash outflow, and thus a reduction to net income in the indirect method. A decrease in prepaid expenses is a reduction to operating expenses and therefore an increase to net income.

Finally, net income must be increased by the period’s depreciation expense since there was no cash outflow related to this item in the current period.

Step 2b: Calculate Cash Flows From Investing Activities

We now turn our focus on determining the cash flows from investing activities by referring to the analysis of the changes in the noncash accounts. We are interested in asset accounts which do not relate to operations. In general, special attention must be given to the sale of a fixed asset. To measure net income for the period, we calculate a gain or loss based on the difference between the proceeds from sale and the unexpired cost (book value) of the asset. In preparing the statement of cash flows, the effect on cash arises from the proceeds of the sale. Thus the statement of cash flows shows a source of cash equal to the total proceeds received from the sale of an asset, and net income would be adjusted to exclude the effect of any gain or loss from the sale.

Step 2c: Calculate Cash Flows From Financing Activities

To determine the cash flows from financing activities, we focus on changes in liabilities and owners’ equity that are not related to operations. If common stock has been sold or purchased, the transaction would have been a cash inflow leading to a change in the paid-in capital account. The net change in the firm’s retained earnings for the period must be divided into (1) the increase (decrease) due to net income (loss) and (2) the decrease from dividends. We can observe the change in owners’ equity from the comparative balance sheets and net income (loss) from the income statement. It is then necessary to check that the net income (loss) explains the change in owners’ equity. Often, the reconciling item is dividends. The following equation helps with the analysis:

BEGINNING RETAINED EARNINGS +(-) NET INCOME (LOSS) – DIVIDENDS = ENDING RETAINED EARNINGS

Step 3: Prepare the Statement of Cash Flows

The last step is to arrange the information obtained from the analyses in step two into a formal statement of cash flows. As with the income statement and balance sheet, a standard format is used. The statement is captioned to identify the entity, the title of the statement, and the period of time covered. Because we are reporting flows of cash into and out of the firm, the statement covers a period in time (e.g., month) rather than being prepared at a point in time (e.g., September 30, 2014).

Preparation of the statement of cash flows involves showing separately the three categories of cash flows (operating, investing, and financing), along with appropriate information regarding the cause of the net change from each category.

[1] Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 95, “Statement of Cash Flows,” November 1987. This chapter is based on the requirements set forth in SFAS No. 95.

[2] Ibid., 5.