This reading introduces the readers to cash flow statements, one of the three major financial statements. We will learn about the structure and presentation of cash flow statements, calculation of various elements of cash flow statements, and common ratios associated with it.&nbsp;

Study Notes for Understanding Cash Flow Statements

Understanding Cash Flow Statements

Cash Flow is indicative of a company’s financial health. Problems in cash flow may point to issues in product pricing, operating efficiency and credit policy. Statements of cash flow give an indication of what needs to be rectified and realigned.

Below is the Statement of Cash Flow of Innovative Products Inc.

<img class="aligncenter size-full wp-image-9865" alt="Sample Cash Flow Statement" src="https://financetrain.com/wp-content/uploads/Sample-Cash-Flow-Statement.jpg" width="569" height="692">
<h3>Cash Flow by Activity</h3>
A business receives and distributes cash through the transactions that are carried out in its normal operations. These transactions can be categorized into three activities:
<ul>
 	<li>Operating activities: Operating activities are transactions that affect the net income, or the revenues and expenses. Cash flows in from selling goods or services. Cash flows out from expenses incurred to operate the business, such as rent, wages, insurance, payments to suppliers, and buying office supplies.</li>
 	<li>Investing activities: Investing activities are transactions that affect the assets. Cash flows in from selling land, buildings, plants, equipment, or intangible assets. Cash flows out from purchasing land, buildings, plants, equipment, or intangible assets.</li>
 	<li>Financing activities: Financing activities are transactions that affect the owner's equity and long-term creditors. Cash flows in from borrowing cash on a short-term basis, investments made by the owner, or issuance of notes payable. Cash flows out because of the owner's withdrawals or repayment of cash loans.</li>
</ul>
How Funds Come In?

There are several categories of cash that can flow into a business:
<ol start="1">
 	<li>Net income – This is the money the company makes from selling products and services to customers. Taxes and some basic operating expenses are deducted from this amount. This amount can be found on the company's income statement.</li>
 	<li>Depreciation expense – This is calculated when a company buys a fixed asset. The cost is deducted as an expense over time. However, this expense is a source of funds in the sense that the company makes back the money it spends over time as these costs are passed on to customers.</li>
 	<li>Bank notes – These represent short-term funding the company uses to raise money. Although this money has to be paid back, it is considered a source of funds in the short term.</li>
 	<li>Increase in accounts payable – Increase in accounts payable means the company is taking more time to pay bills, buying products on credit, or paying higher prices for credit purchases. This money is available as cash until it is used to pay these bills.</li>
 	<li>Decrease in investments – A decrease in investments appears any time an investment is sold. After the sale, more money is available to the business. Even if the investment is not profitable based on the original price, there is still some amount of money coming into the company.</li>
</ol>
By exploring a company's cash flow statement, you can gain a picture of the financial health of the company. For example, if the major source of funds is net income, then the company isn't relying on debt to fund its activities. You can also gain a picture of the debts and financial obligations that are current sources of funds, but will be costs for the company down the road.

Determining How Funds Are Used

You can control your personal budget by analyzing how you spend your money. The same is true for a company. You can learn a lot about how the company functions by examining the uses of funds.

There are several ways that a company can use money. A cash flow statement explains the different ways money is used at the company:
<ul>
 	<li>Capital expenditures – When a company has capital expenditures, it has spent money to either buy or improve fixed assets. This money is considered an investment and can vary considerably among time periods.</li>
 	<li>Increase in inventory – Inventory is the amount of product the company holds. It can increase because costs have changed, sales are down, or because more expensive products are being held in the company's inventory.</li>
 	<li>Decrease in long-term debt – Long-term debt can be decreased for a number of reasons. Interest rates may be high, so the company decides to pay off the loan. The company might have more money than usual, or it might use short-term debt to pay off the long-term debt.</li>
 	<li>Payment of cash dividends – This occurs when the company has made money. Companies often make payments to stockholders when a profit is produced.</li>
 	<li>Cash reconciliation – This is the company's cash balance, plus sources of funds, minus uses of funds, equals increase in cash, which accounts for the company's total cash balance.</li>
</ul>
You can use your company's cash flow statement to learn a lot about the business. Specifically, you can learn what kind of money comes into your business, and how this money is spent. Cash flow statements are one of the valuable tools you can use to evaluate the health of your company.

Cash Flow Statement

A <a title="Cash Flow Statement" href="https://financetrain.com/cash-flow-statement/">cash flow statement</a> can be presented using two methods:
<ul>
 	<li>Indirect Method</li>
 	<li>Direct Method</li>
</ul>
The two methods differ in terms of how the cash flow from operating activities is calculated.

In the indirect method, the operating cash flows are not directly reported. Instead you start with the net income taken from the income statement and then adjust it for the items that do not affect the cash flows. The adjustments will be made for:
<ul>
 	<li>Non-cash items such as depreciation and amortization.</li>
 	<li>Gains and losses reported under other activities in cash flow statement.</li>
 	<li>Converting current assets and liabilities from accrual to cash basis.</li>
</ul>
In the direct method, the cash flow from operating activities is computed directly as the net sum of all operating cash flows.

While the indirect method is easy to do, most banks prefer a cash flow statement prepared using direct method as it contains more information.

Cash Flow Statements - Direct and Indirect Method

If a company has a high demand for its product, the product has high margins, makes purchases and pays on time, shows an increasing trend in profits, the business is a hit, right? Well, not always.

In most businesses cash is used to buy raw materials, produce value added goods, buy assets and turn it back into more cash than when they started. A newly set up company is more likely to use its cash in setting-up: renting its facilities, and installing utilities, all of which are made in cash. Parallel to this they acquire assets to begin operations. Activities such as hiring staff are not always done by using cash on hand, but through bank finance. This means cash is going out.

Production, where raw materials are purchased, labor comes at a cost, and taxes are all a further drain on the business. Other costs include marketing, sales and distribution costs. Even before the first product rolls out, the company incurs all these expenses and purchases. Cash is yet to come in. Once the product comes out, most businesses offer them on credit and not ‘cash and carry’. Till this money is collected it is cash in the customer’s hand. Till this happens it is not cash back in the hands of the company.

Every company must keenly note its cyclic process of cash to increased cash. That is, it must track its working capital needs carefully. This involves a process of clearly understanding the company’s cash needs, forecasting any delays and finally contingency plans for additional cash.

Some of the factors companies can control to keep their cash flow smooth include:

Pricing: Accounting for all costs direct and indirect related to the product. Filing taxes may not be a direct cost, but hiring a CPA who does the same needs to be factored in.

Accounts receivable cycle: Bill discounting, factoring and other accounts receivable techniques help better cash flow.

Contingency plan: A reserve fund raised from angel investors would help in a situation of tight cash flow. Further costly loans could be paid off with loans from friends and family, freeing cash.

Forecasting: Proper forecasting of orders would reduce inventory build-up and thus cash. A forecast of cash needs in the investment heavy period leads to better flow of cash and therefore profits.
<h3>How transactions affect profit and net cash flow?</h3>
Transactions can:
<ul>
 	<li>Increase profits but not give cash until later</li>
 	<li>Decrease profits but not reduce cash until later</li>
 	<li>Put cash in the bank but affect profits</li>
 	<li>Take away cash but may or may not affect profits</li>
</ul>
Transactions that increase but not give cash until later: When a sale is made on credit, while you record the sale, the cash flows in later. This sale shows a profit currently, but does not immediately translate into cash. So between the sale and till you receive cash you must arrange for cash to take care of operating expenses.

Transactions that decrease profits but not reduce cash until later: When raw materials are purchased on credit, no cash outflow occurs. These materials are used typically before they are paid for. The resulting sale may have recorded a profit, but leads to a reduction of cash when the credit period is over.

Transactions that put cash in the bank but affect profits: A loan taken from a bank shows increase in cash balance. Put to productive revenue generating options this will lead to profits, else reduction .If the borrowing is used to purchase equipment it will lead to increased profits later. Further, this borrowing needs to be paid back at some later point of time.

Transactions that take cash but may or may not affect profits: Items such as pre-paid expenses and repayments of borrowings on assets do not directly affect profits. In these cases there is a time difference between expense and cash flow. This can lead to a shortfall in cash if not carefully planned.

It is important that managers do not overlook the importance of timing in <a title="Cash Flow Statement" href="https://financetrain.com/cash-flow-statement/">cash flow management</a>. This is especially important in the short term when most of the financial planning is done.

Significance of Cash Flows

Investing and financing activities that do not involve cash are not reported in the cash flow statement since there is no cash flow involved.



For example, capital items of property, plant and equipment are often acquired through non-cash investing and financing activities. An equipment is purchased (investing activity) which is financed by equipment-purchase financing (financing activity). This will increase the company’s productive capacity; however, it will not be reported as capital expenditure in the statement of cash flows.&nbsp;



These non-cash investing and financing activities are reported in a separate disclosure supplement to the statement of cash flows. Examples include stock issued to make an acquisition or items of property, plant and equipment acquired in transactions in which the seller provides debt financing. These transactions result in a transfer of assets, but no cash is involved.&nbsp;

Noncash Investing and Financing Activities

With respect to the treatment of activities in cash flow statements, there are some differences in IFRS and US GAAP.



<figure class="wp-block-table"><table><tbody><tr><td>Activity</td><td>US GAAP</td><td>IFRS</td></tr><tr><td>Dividend paid to shareholders</td><td>Financing activity</td><td>Operating or financing activity</td></tr><tr><td>Interest paid on loans</td><td>Operating activity</td><td>Operating or financing activity</td></tr><tr><td>Interest and dividend received</td><td>Operating activity</td><td>Operating or investing activity</td></tr><tr><td>Taxes paid</td><td>All taxes reported as operating activity</td><td>Income tax reported as operating activity except when tax is an expense related to investing or financing activity</td></tr></tbody></table></figure>



An example of the tax treatment is provided below. Assume that a company sold land for $100,000 and paid taxes worth $10,000. Under US GAAP, we will report $100,000 as inflow from investing activity and $10,000 as outflow from operating activity. Under IFRS, we will report net inflow of $90,000 from investing activity.

Cash Flow Statements: US GAAP Vs. IFRS

As we learned earlier, we can prepare a statement of cash flows using direct or indirect method. The two methods differ in terms of how the cash flow from operating activities is calculated. In the direct method, the cash flow from operating activities is computed directly as the net sum of all operating cash flows. In the indirect method, the operating cash flows are not directly reported. Instead you start with the net income taken from the income statement and then adjust it for the items that do not affect the cash flows.&nbsp;



As a general rule:&nbsp;



<ul><li>Operating activities involve income statement items.&nbsp;</li><li>Investing activities involve cash flows resulting from changes in investments and long-term asset items.&nbsp;</li><li>Financing activities involve cash flows resulting from changes in long-term liability and stockholders' equity items.</li></ul>



To prepare the cash flow statement, we take the information from the income statement for the current year and balance sheets for the past two years. In the indirect method, the net income is adjusted for the deferrals and accruals to convert the accrual basis statement into a cash flow statement.



The first step in preparing the cash flow statement is to determine the net change in cash and cash equivalents. This forms our basis and the cash inflows and outflows in our cash flow statement will reconcile with this value. We will take the example of a fictional company called Always Ahead Inc. to demonstrate how to prepare the cash flow statement.



The next two pages show the Income Statement and Balance Sheet for Always Ahead Inc.



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/steps-1.png" alt="" class="wp-image-28784"/></figure></div>



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/steps-2.png" alt="" class="wp-image-28785"/></figure></div>



The first step is to calculate the increase in cash balance from the balance sheet, which is $52,000 (222,000 – 170,000). Our cash flow statement should reconcile with this figure.



The next step is to calculate the change in each balance sheet account. This is shown in the Balance Change column in the Balance Sheet table. For example, the accounts payable have increased by $89,000 (443,000 – 354,000). Similarly calculate the change in each balance sheet account.



The next step is to determine if the change in account balance is a cash inflow or a cash outflow, that is, whether, is a source or a use of cash. The following table summarizes what constitutes a cash inflow and what constitutes a cash outflow.



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/steps-3-1024x267.png" alt="" class="wp-image-28788"/></figure></div>



We will also need to categorize each change in account balance as operating, investing or financing activity. The following guide will help you do that.



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/steps-4-1024x878.png" alt="" class="wp-image-28789"/></figure></div>



Presented below is the cash flow worksheet created from the balance sheet that shows the balance change, cash source/use, and the activity type.



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/step-5.png" alt="" class="wp-image-28790"/></figure></div>



We are now ready to construct the cash flow statement using either Direct or Indirect method. We will first calculate the cash flow from operating activities using both the methods. After that we will calculate the cash flow from investing and financing activities.

Steps to Prepare Statement of Cash Flows

<h3>Direct Method</h3>



In the direct method, the cash flow from operating activities is computed directly as the net sum of all operating cash flows. The following table shows examples of calculating cash flow from operating activities.



<figure class="wp-block-table"><table><tbody><tr><td>Cash Flows from Operating Activities Using the Direct Method</td></tr><tr><td>Cash Collections from Sales</td><td>Sales - increase (+ decrease) in Accounts Receivable - Bad Debt Expense</td></tr><tr><td>Cash Payments to Suppliers</td><td>Cost of Goods Sold + increase (- decrease) in Inventory - increase (+ decrease) in Accounts Payable</td></tr><tr><td>Cash Payments for Operating Expenses</td><td>Total Operating Expense (excluding Bad Debt Exp) - other noncash expenses (depreciation/amortization) + increase (-decrease) in Other Accrued Liabilities</td></tr><tr><td>Other Income/Expense</td><td>+/- Other Income/Expense</td></tr><tr><td>Cash paid for Interest</td><td>Interest Expense</td></tr><tr><td>Dividends Withdrawals</td><td>Dividends/Withdrawals Paid + increase (-decrease) in Dividends Payable</td></tr><tr><td>Cash paid for Taxes</td><td>Tax Expense — increase (+ decrease) in Accrued Taxes Payable — decrease (+ increase) in Prepaid Tax</td></tr></tbody></table></figure>



The cash from operations using the direct method are presented below:



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/cash-flow-ops-direct-1024x651.png" alt="" class="wp-image-28793"/></figure></div>



<h3>Cash Flow from Operations – Indirect Method</h3>



To calculate cash flow from operating activities using indirect method, we will start with the net income and reconcile it to net cash provided by operating activities as follows:



Net Income



(+) Depreciation



(-) Amortization of Bond Premium



(+) Amortization of Bond Discount



(-) Gain on Sale of Equipment



(+) Loss on Sale of Equipment



(+) Decrease in Accounts Receivable



(-) Increase in Accounts Receivable



(+) Decrease in Inventory



(-) Increase in Inventory



(-) Decrease in Accounts Payable



(+) Increase in Accounts Payable



(-) Decrease in Accrued Expenses



(+) Increase in Accrued Expenses



(+) Decrease in Prepaid Expenses



(-) Increase in Prepaid Expenses



(-) Decrease in Taxes Payable



(+) Increase in Taxes Payable



The cash from operations using the indirect method are presented below:



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/cash-flow-ops-indirect.png" alt="" class="wp-image-28794"/></figure></div>



As you can see, both direct and indirect methods produce the same results.

Cash Flow from Operating Activities

Investing Activities



The cash flow from investing activities is the net cash flow provided or used in the investing activities. It is calculated as follows:



+ Proceeds from Sale of Assets



- Purchases of Property and Equipment



= Total Net Cash Provided (Used) by Investing Activities



Financing Activities



The cash flow from financing activities is the net cash flow provided or used in the investing activities. It is calculated as follows:



+ Net Borrowing under Line of Credit Agreement



+ Proceeds from New Borrowings



- Repayment of Loans



- Principal Payments under Capital Lease Obligations



- Dividends/Distributions/Withdrawals Paid



+ Proceeds from Issuance of Stock



+ Partner/Owner Capital Contributions



=Total Net Cash Provided (Used) by Financing Activities



We will combine the cash flow from investing and financing activities with the cash flow from operations to construct our statement of cash flows.



The complete cash flow statement for Always Ahead Inc. is presented below:



<div class="wp-block-image"><figure class="aligncenter size-large"><img src="https://financetrain.com/wp-content/uploads/cash-flow-493x1024.png" alt="" class="wp-image-28797"/></figure></div>

Cash Flow from Investing and Financing Activities

The discounted cash flow model is the most advocated model for valuing a stock. Under this model, an analyst will estimate the future cash flows for the company, and discount it with the appropriate discount rate.



Traditionally, analysts have used dividends as the proxy for cash flows, hence the dividend discount model. However, the problem with dividends is that it does not fully reflect the cash flow earned by the firm.



The two new cash flow measures used to value a firm are&nbsp;Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE).



FCFF represents the free cash flow available to both equity and debt holders, while FCFE represents free cash flow available for only equity holders.



A firm can be valued by estimating the Free Cash Flow to Firm and discounting them by the&nbsp;Weighted Average Cost of Capital (WACC). The value we arrive at will represent the value of the entire firm. We can then deduct the value of debt to arrive at the value of equity alone.



FCFF valuation is more suitable compared to FCFE when the company has high leverage, and/or negative FCFE. FCFF is also suitable for firms that have a tendency to frequently change their degree of financial leverage.



FCFF can be calculated from Net Income using the following formula:



FCFF from Net Income = Net Income + Non-cash Charges + (Interest Expense * (1-tax rate)) – Fixed Capital Investment – Working Capital Investment



One can easily extract the information required to value a firm using FCFF from the company’s financial statements.



FCFF can also be calculated using Cash Flow from Operations as follows:



FCFF from Cash Flow from Operations&nbsp;= Cash Flow from Operations – Fixed Capital Investment +&nbsp;Interest expense * (1 – tax)



FCFE is defined as the amount of free cash flow the firm has after meeting all its obligations. This includes debt obligations, capital expenditure to maintain existing assets, and new asset purchases to maintain the growth rate assumed. This is the cash that can be paid to shareholders after paying for all expenses, debt repayments, and reinvestments.&nbsp;Free Cash Flows to Equity are available to stock holders only; return of these cash flows to stock investors does not threaten the company’s existence as a going concern.



FCFE is calculated using the following formula:



FCFE = Net Income – (Capital Expenditure – Depreciation) – Change in Non-cash Working Capital + (New Debt Issued – Debt Repayments)



FCFE can also be calculated using Cash Flow from operations as follows:



FCFE from Cash Flow from Operations&nbsp;= Cash Flow from Operations – Fixed Capital Investment + Net Borrowing



Note that if we already have FCFF, we can use the value of FCFF to calculate FCFE as follows:



FCFE = FCFF – Interest expense * (1 – tax) + Increase in debt

Free Cash Flow to the Firm and Equity

This quiz is a part of the CFA Level 1 reading 'Understanding Cash Flow Statements'. 

This frontmatter description will appear below the title

Understanding Cash Flow Statements

Course Resources

Course Quizzes

Lessons

Data Science for Finance Bundle: 43% OFF

Checkout our eBooks and Templates

Course Resources

Course Quizzes