Statement of Cash Flow

Statement of Cash Flow

The Statement of Cash Flow (SCF) is a crucial financial statement that provides insights into a company’s cash inflows and outflows during a specific period. It is one of the primary tools investors, analysts, and stakeholders use to assess a business’s financial health and sustainability. This statement classifies cash flows into three main sections: operating activities, investing activities, and financing activities.

Operating Activities:

The operating activities section of the SCF(Statement of Cash Flow) outlines the cash transactions related to a company’s core business operations. It starts with the net Income derived from the income statement. While the income statement provides a comprehensive view of a company’s profitability, the Statement of Cash Flow focuses on the actual Cash generated or used by these operations.

Positive cash flow from operating activities indicates that the company is generating sufficient Cash to sustain and grow its business. It includes customer cash receipts, payments to suppliers and employees, and operating expenses. Conversely, negative cash flow from operating activities may raise concerns about a company’s ability to meet its short-term obligations.

For example, if a manufacturing company receives customer payments for goods delivered, this would be recorded as a positive cash flow from operating activities. On the other hand, paying suppliers for raw materials or compensating employees would be considered cash outflows.

Operating Activities Example:

Let’s consider a retail company, XYZ Inc., for the operating activities section of the Statement of Cash Flows.

Favorable Cash Flow Scenario:

• XYZ Inc. receives $1,000,000 in Cash from customers for goods sold yearly.
• The company pays $600,000 in Cash to suppliers for inventory.
• XYZ Inc. pays $200,000 in Cash for operating expenses, including salaries, utilities, and rent.

In this scenario, the net cash flow from operating activities is $200,000 ($1,000,000 – $600,000 – $200,000), indicating that the company generated positive Cash from its core retail operations.

Adverse Cash Flow Scenario:

• XYZ Inc. experiences a delay in customer payments, resulting in only $800,000 in cash receipts.
• The company still pays $600,000 in Cash to suppliers for inventory.
• Operating expenses remain the same at $200,000 in Cash.

In this case, the net cash flow from operating activities is -$0 ($800,000 – $600,000 – $200,000). This negative cash flow may raise concerns about the company’s ability to meet short-term obligations.

Investing Activities:

The investing activities section focuses on cash transactions related to acquiring and disposing of long-term assets. It includes property, plant, equipment, and investments in other companies. Positive cash flow from investing activities signifies that a company is investing in its future growth, while negative cash flow may indicate divestment or asset sales.

For instance, if a technology company purchases new machinery to enhance production capabilities, the cash spent on acquiring these assets would be recorded as a negative cash flow from investing activities. Conversely, selling an old factory or equipment would result in a positive cash flow.

Investing Activities Example:

Now, let’s examine investing activities for XYZ Inc.

Favorable Cash Flow Scenario:

• The company invests $500,000 in new technology to improve its point-of-sale systems.
• XYZ Inc. sells an old warehouse for $300,000 in Cash.

Here, the net cash flow from investing activities is $200,000 ($300,000 – $500,000), indicating a positive cash flow from investments.

Adverse Cash Flow Scenario:

• XYZ Inc. decided to expand its retail footprint and spent $700,000 in Cash to acquire a new store location.

In this scenario, the net cash flow from investing activities is -$700,000, representing a significant cash outflow for the expansion.

Financing Activities:

The financing activities section reflects cash transactions associated with a company’s capital structure. It includes changes in debt, issuance of stock, and payment of dividends. Positive cash flow from financing activities suggests that the company is raising capital, whereas negative cash flow indicates shareholder repayments or distributions.

If a company issues bonds to raise funds for expansion, the Cash received from bondholders would be recorded as a positive cash flow from financing activities. Conversely, repurchasing stock or paying dividends to shareholders would be considered cash outflows.

Financing Activities Example:

Let’s explore financing activities for XYZ Inc.

Favorable Cash Flow Scenario:

• The company issues bonds and receives $1,000,000 in Cash to fund its expansion.
• XYZ Inc. decided to raise additional capital by issuing new shares, generating $500,000 in Cash.

In this case, the net cash flow from financing activities is $1,500,000 ($1,000,000 + $500,000), indicating positive cash flow.

Adverse Cash Flow Scenario:

• XYZ Inc. repurchases $300,000 worth of its shares.
• The company pays $200,000 in cash dividends to shareholders.

Here, the net cash flow from financing activities is -$500,000 ($300,000 + $200,000), representing cash outflows related to financing decisions.

Interpreting the Statement of Cash Flows:

Analyzing the Statement of Cash Flow is crucial for understanding a company’s liquidity, solvency, and ability to fund its operations. A healthy company should generate positive cash flow from operating activities, allowing it to cover operating expenses and invest in growth opportunities. Additionally, positive cash flow from financing activities indicates that the company can meet its debt obligations and reward shareholders.

However, consistent negative cash flow over multiple periods may be a red flag, signaling potential financial distress. It may indicate that the company relies heavily on external financing to sustain its operations, and prolonged negative cash flow could lead to liquidity challenges.

Methods of preparing cash flow statement

Direct Method:

The Direct Method directly tracks and records the actual cash transactions related to operating activities. It provides a more detailed and transparent view of cash flows. The main steps include:

Cash Inflows:

• Cash received from customers
• Interest and dividends received

Cash Outflows:

• Money paid to suppliers and employees
• Interest paid
• Income taxes paid

Net Cash Flow from Operating Activities:

Subtract total cash outflows from total cash inflows.

Investing and Financing Activities:

Similar to the Indirect Method, investing and financing activities are presented separately.

Advantages:

• It offers a more detailed breakdown of operating cash flows.
• It provides clarity on the sources and uses of Cash.

Disadvantages:

• It can be time-consuming and resource-intensive due to the need for detailed transaction tracking.

Indirect Method:

The Indirect Method begins with the net income, then makes adjustments for non-cash items and working capital changes.

Adjustments to Net Income:

• Add back non-cash expenses (e.g., depreciation)
• Subtract non-operating gains and add non-operating losses

Changes in Working Capital:

• Adjustments for changes in current assets (e.g., accounts receivable) and current liabilities (e.g., accounts payable)

Net Cash Flow from Operating Activities:

Combine adjusted net Income with adjustments to working capital.

Investing and Financing Activities:

Investing and financing activities are presented separately.

Advantages:

• It is easier to implement as it starts with net Income.
• Less detailed transaction tracking is required.

Disadvantages:

• It may need to provide more detailed insights into operating cash flows.

How to develop cash flow statement

Developing a cash flow statement involves summarizing a business’s cash inflows and outflows during a specific period. The information is typically divided into three sections: operating activities, investing activities, and financing activities. Here’s a step-by-step guide on how to build a cash flow statement:

Step 1: Gather Financial Information

Collect the relevant period’s financial information, including the income statement and balance sheet. You’ll need this data to identify cash transactions.

Step 2: Identify Operating Activities

a. Cash Inflows (Operating Activities):

• Start with the net Income from the income statement.
• Add back non-cash expenses (e.g., depreciation and amortization).
• Adjust for changes in working capital, including accounts receivable, accounts payable, and inventory.

b. Cash Outflows (Operating Activities):

• Subtract non-cash revenue (e.g., interest income).
• Adjust for changes in working capital.

Step 3: Analyze Investing Activities

a. Cash Inflows (Investing Activities):

• Include Cash from the sale of assets (e.g., property, equipment, or investments).

b. Cash Outflows (Investing Activities):

• Account for cash payments related to the purchase of assets.

Step 4: Examine Financing Activities

a. Cash Inflows (Financing Activities):

• Include Cash received from issuing stock or borrowing.

b. Cash Outflows (Financing Activities):

• Account for cash payments for dividends, stock repurchases, or debt repayments.

Step 5: Summarize and Calculate

Calculate the net cash flow for each section:

• Operating Activities: Cash Inflows – Cash Outflows
• Investing Activities: Cash Inflows – Cash Outflows
• Financing Activities: Cash Inflows – Cash Outflows

Step 6: Combine Sections

Combine the net cash flows from operating, investing, and financing activities to calculate the overall net increase or decrease in Cash for the period.

Step 7: Adjust for Beginning and Ending Cash

Add the net cash flow to the beginning cash balance to get the ending cash balance.

Step 8: Check Accuracy

Ensure that the ending cash balance matches the balance reported on the balance sheet. Reconcile any discrepancies.

Example for Statement of Cash Flow preparation

Let’s consider the financial data for ABC Grocery Store for the year ending December 31, 20X2:

Income Statement:

• Net Income: $80,000
• Depreciation Expense: $10,000

Balance Sheet:

• Accounts Receivable (20X1): $15,000
• Accounts Receivable (20X2): $12,000
• Accounts Payable (20X1): $8,000
• Accounts Payable (20X2): $10,000

Investing Activities:

• Purchase of Delivery Van: $15,000

Financing Activities:

• Issuance of Bank Loan: $20,000
• Dividend Payments: $8,000

Step 1: Operating Activities

a. Cash Inflows:

• Net Income: $80,000
• Add back non-cash expenses (Depreciation): $10,000
• Adjust for changes in working capital:
  • Decrease in Accounts Receivable: $3,000 (20X2 – 20X1)
  • Increase in Accounts Payable: $2,000 (20X2 – 20X1)

Total Cash Inflows (Operating Activities): $91,000

Total Cash Outflows (Operating Activities): $0

Net Cash Flow from Operating Activities: $91,000

Step 2: Investing Activities

a. Cash Inflows:

• Sale of Old Office Furniture: $2,000

b. Cash Outflows:

• Purchase of Delivery Van: $15,000

Net Cash Flow from Investing Activities: -$13,000

Step 3: Financing Activities

a. Cash Inflows:

• Issuance of Bank Loan: $20,000

b. Cash Outflows:

• Dividend Payments: $8,000

Net Cash Flow from Financing Activities: $12,000

Step 4: Combine Sections

• Net Cash Flow from Operating Activities: $91,000
• Net Cash Flow from Investing Activities: -$13,000
• Net Cash Flow from Financing Activities: $12,000

Step 5: Summarize

• Net Increase in Cash: $90,000

Treatment of changes in Account receivable and payables

Decrease in accounts receivable A decrease in accounts receivable on the cash flow statement indicates that more cash has been collected from customers than sales made during the period. Increase in accounts receivable An increase in accounts receivable on the cash flow statement indicates more sales made on credit. While it boosts revenue, it can strain cash flow as funds are tied up awaiting payment. Increase in accounts payable The cash flow statement reflects an increase in accounts payable as a source of cash from operating activities. Decrease in accounts payable As reflected on the cash flow statement, a decrease in accounts payable indicates reduced liabilities owed by a company to suppliers. It is a cash outflow for a cash flow statement.

Treatment of category in cash flow statement

Category	Operating Activities	Financing Activities
Net Income	Included	Not applicable
Adjustments for Non-Cash Items	Included	Not applicable
Changes in Other Working Capital Items	Included	Not applicable
Cash Flows from Operating Activities	Included	Not applicable
Proceeds from Issuance of Debt	Not applicable	Included
Repayment of Debt	Not applicable	Included
Dividends Paid	Not applicable	Included
Cash Flows any other from Financing Activities	Not applicable	Included

Treatment of changes in account payable and receivables

Category	Change	Treatment	Remarks
Accounts Receivable	Decrease	Add in cash flow	AR collected and cash flow increased
Accounts Receivable	Increase	Subtract from cash flow	AR not collected and cash flow decreased
Accounts Payable	Decrease	Subtract from cash flow	AP paid and and cash decreased
Accounts Payable	Increase	Add in cash flow	AP not paid Positive cashflow

Example of preparing a Statement of Cash Flow statement

Operating Activities	Amount ($)
Net Income	$300,000
Depreciation	$50,000
Changes in Working Capital
– Increase in Accounts Receivable	($20,000)
– Decrease in Inventory	$10,000
– Increase in Accounts Payable	$15,000
Net Cash from Operating Activities	$335,000

Investing Activities	Amount ($)
Purchase of Equipment	($100,000)
Sale of Investments	$30,000
Net Cash from Investing Activities	($70,000)

Financing Activities	Amount ($)
Issuance of Common Stock	$50,000
Repayment of Long-Term Debt	($25,000)
Payment of Dividends	($40,000)
Net Cash from Financing Activities	($15,000)

| Net Increase in Cash | $250,000 |

| Beginning Cash Balance| $120,000 |

| Ending Cash Balance | $370,000 |

Explanation:

1. Operating Activities:
   • Start with Net Income.
   • Add back non-cash items like Depreciation.
   • Adjust for changes in working capital (increase in Accounts Receivable, decrease in Inventory, and increase in Accounts Payable).
2. Investing Activities:
   • Include cash flows related to the purchase and sale of long-term assets (e.g., Equipment and Investments).
3. Financing Activities:
   • Capture cash flows from transactions with the company’s owners and creditors (e.g., Issuance of Common Stock, Repayment of Long-Term Debt, and Payment of Dividends).
4. Net Increase in Cash:
   • Sum the cash flows from operating, investing, and financing activities to determine the overall change in cash.
5. Ending Cash Balance:
   • Add the net increase in cash to the beginning cash balance to find the ending cash balance.

Core Concepts

Statement of Cash Flow Importance: It is a crucial financial statement offering insights into cash inflows and outflows, aiding stakeholders in assessing a company’s financial health and sustainability. Operating Activities Significance: Focuses on core business transactions, starting with Net Income and assessing actual cash generated or used. Positive cash flow indicates business sustainability. Investing Activities Impact: Tracks cash transactions related to long-term assets, showcasing investments in growth or divestments. Positive cash flow implies growth-oriented investments. Financing Activities Role: Reflects cash transactions related to a company’s capital structure, signaling capital raising or shareholder repayments. Positive cash flow indicates healthy financial strategies. Interpreting Statement of Cash Flow: Analyzing liquidity, solvency, and operational funding capabilities is crucial. Consistent negative cash flow may signal financial distress and reliance on external financing. Cash Flow Statement Preparation: Outlines a step-by-step guide on developing a cash flow statement, including gathering financial information, identifying activities, summarizing, and checking for accuracy. Treatment of Categories: Explains the treatment of categories like Net Income, Adjustments, and Changes in Working Capital in the cash flow statement, emphasizing their impact on operating and financing activities. Critical Considerations in Statement of Cash Flow Interpretation: Stresses the importance of positive cash flows from operating and financing activities, while consistent negative cash flows may indicate financial challenges.

Test your understanding