The cash flow statement explains the change in cash by three
activities: operating, investing and financing activities.
In this example the balance sheet is condensed. The same principle holds when the T-accounts are used.
Author: Joost Impink
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
- 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).
Naturally, total assets equal total liabilities plus total equity. Also, the business equation holds for the changes.
Naturally, total assets equal total liabilities plus total equity. Also, the business equation holds for the changes.
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.
- 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.