The statement of cash flow's primary purpose is to provide information regarding a company's cash receipts and cash payments. The statement complements the income statement and balance sheet. When credit decisions are made, many factors must be assessed. The income statement and balance sheet provide information about some of these factors, the cash flow statement provides information about the other factors.
Over the life of a company, total net income and net cash inflow will equal. However, since income determination is based on accrual accounting, income and cash flow will rarely equal in an annual accounting period.
Cash Is King
The importance of cash flow to the short term credit grantor is based on a simple fact, trade obligations are satisfied with cash not profit. It is possible for a firm to be very profitable and not be able to service its obligations. Short-term liquidity can also be achieved by deferring payments of current obligations, however, eventually the company's ability to generate cash flow through the deferral of payment of current liabilities will be exhausted. This statement is useful for decision making because it provides relevant and reliable information for predicting cash flows.
The cash flow statement is an important analytical tool that the trade creditor can use to determine if a customer is able to generate sufficient cash to meet its trade obligations. The ability of a company to adapt during a period of financial adversity, to obtain financing, and generate adequate amounts of cash for specific purposes are very important factors in the review process. Using the cash flow statement in the credit analysis process can help users evaluate a customer's solvency, liquidity position, and its financial flexibility.
The significance of the cash flow analysis
The cash flow statement's importance to the analyst in identifying financially troubled companies is unquestioned. It provides valuable information about the quality of earnings. The higher the correlation between income and cash flow, the higher the earnings quality. The statement also provides insight into how effective the management team is at utilizing available resources and the firms ability to generate cash flows in the future. It provides a picture of where the cash comes from and where it goes.
The statement reports the cash provided and used by the operating, investing, and financing activities of a company during an accounting period. The usefulness of this information has been recognized for many years by statement users. In 1987, the Financial Accounting Standards Board issued Statement No. 95, which requires that a statement of cash flows accompany the income statement, balance sheet and statement of retained earnings.
The statement of cash flows explains the change during the period in cash and cash equivalents. Cash includes currency on hand and demand deposits. Cash equivalents are short-term, highly liquid investments that are readily convertible to cash. Statement No. 95 requires that cash receipts and payments be classified as operating, investing and financing activities. The statement of cash flows must summarize the cash flows so that net cash provided or used by each of the three types of activities is reported. Beginning and ending cash must be reconciled based on the net effect of these activities.
The statement provides information about the cash generated from a company's primary operating activities. Operating activities relate to a company's primary revenue-generating activities, and cash flows from operating activities are the cash effects of transactions and economic events included in the determination of income. Operating activities that generate cash inflows include customer collections from sales of their primary products or services, receipts of interest and dividends and other operating cash receipts. Operating activities that create cash outflows include payments to suppliers, payments to employees, interest payments, payment of income taxes and other operating cash payments.
Investing activities include lending money and collecting on those loans, buying and selling productive assets that are expected to generate revenues over long periods, and buying and selling securities not classified as cash equivalents. Cash inflows generated by investing activities include sales of long-lived assets such as property, plant, and equipment, sales of debt or equity instruments and the collection of loans.
Financing activities include borrowing and repaying money from creditors, obtaining resources from owners and providing both a return on their investment and a return of their investment. The return on investment is provided in the form of dividends.
The statement of cash flows provides information about how the company invests its cash on equipment and other long term investments, and the cash provided if it disposes of fixed assets. If the firm uses debt or equity to expand its operations, it is disclosed in the financing activities. Also, if the firm uses cash to retire debt, it appears in the statement.
Income flows and cash flows
The income statement and balance sheet are based on accrual accounting which was developed based on the concept of matching. The matching principle states that revenues generated and the expenses incurred to generate those revenues should be reported in the same income statement. This emphasizes the cause-and-effect association between revenue and expense. Many revenues and expenses result from accruals and allocations that do not affect cash. A company can operate at a profit and continually be short of cash. It can also generate huge inflows of cash from operations and still report a loss. The statement of cash flows can explain how these situations might occur. Answers to these questions cannot be found in the other financial statements.
Since net income is based on accrual accounting, income and cash flows are rarely equal in short time periods. A company may operate for several years because its cash inflows exceed its required cash payments, even though the company may not be profitable in the long run.
There are two classes of items that cause differences between income flows and cash flows: items that appear on the income statement that do not represent inflows and outflows of cash, such as depreciation, or items whose cash effects do not relate to operating activities, such as gains on the sale of depreciable assets; and operating cash inflows and outflows that do not appear on the income statement, that must be reported on the statement of cash flows. For example a company may collect in the current period cash arising from credit sales made in a previous period.
Preparing the Statement of Cash Flows
Information used to prepare this statement is obtained from the income statement for the year and comparative balance sheets for the last two years. Net income is adjusted for deferrals and accruals. The purpose of these adjustments is to convert the accrual basis income statement to cash flows.
As discussed earlier, the statement follows an activity format and is divided into three sections: operating, investing and financing activities. There are two methods of calculating and reporting the net cash flow from operating activities. The direct method reports gross cash inflows and gross outflows from operating activities. The indirect method reconciles net income with net cash flow from operating activities by adjusting net income for deferrals, accruals, and items that effect investing and financing cash flows. Both indirect and direct methods yield identical figures for net cash flow from operating activities because the underlying accounting concepts are the same.
Cost of Goods Sold
Depreciation and Amortization
Other Income (Expense)
Gain on the Sale of Equipment
A practical approach for preparing the statement of cash flows is to first determine the net increase in cash and cash equivalents for the period. This amount serves as a control figure, the net cash inflow or outflow must agree with the net change in the cash account on the comparative balance sheets. For illustrative purposes, we will use the Income Statement data from the current year (Exhibit 1) and the balance sheets from the prior two years that have been combined on the Cash Flow Worksheet (Exhibit 2) of Star Light Corporation. To complete our first step we begin with the balance sheet data, by taking the cash balance of $90,000 from the most recent balance sheet and subtracting the cash balance of $50,000 from the prior year, which results in an increase in cash of $40,000. The cash flow statement must balance to this control number.
|Comparative Balance Sheets Assets||1998||1999||Account
|Plant and Equipment||200,000||190,000||(10,000)||Inflow||Investing|
|Bonds Payable||100,000||100,000||0||No Change||Financing|
|Premium on Bonds Payable||10,000||8,000||(2,000)||Outflow||Financing|
| Contributed Capital in Excess
|Retained Earnings||100,000||125,000||25,000||Inflow||* Operating -
|Total Liabilities and
Next we calculate the change in each balance sheet account, determine if the change is a cash inflow or outflow, and the activity that the account should be included in. The change in account balances is reflected in the Account Balance Change column (Exhibit 2) of our worksheet. It is calculated by subtracting the prior year account balance from the current year balance. For example, Accounts Receivable in 1996 was $60,000 compared to $70,000 in 1995, which resulted in a $10,000 decrease in receivables. This process is continued for each of the balance sheet accounts.
After calculating the account balance change, we have to determine if the balance change is an inflow or an outflow of cash. To make this task simple we can use Table I as a guide to determine the effect of each balance change. The table states that a decrease in an asset balance and an increase in a liability or equity account are cash inflows. The opposite holds true for increases in an asset balance or a decrease in a liability or equity account, which results in a cash outflow.
|Cash Inflow||Cash Outflow|
|A Decrease in an Asset Account||An Increase in an Asset Account|
|An Increase in a Liability Account||A Decrease in a Liability Account|
|An Increase in an Equity Account||A Decrease in an Equity Account|
The chart is straightforward if you think about the effect a change on an account has on cash. For example, Table I indicates that a decrease in an asset account is a cash inflow. Accounts receivable decreased by $10,000 from 1995 to 1996. If there was a decrease in accounts receivable it would make sense that we collected cash. The impact of the balance sheet flow changes appears in the Inflow/Outflow column. (Exhibit 2)
To complete the development of our Cash Flow Worksheet (Exhibit 2), we must determine if each account balance change is an operating, investing or financing activity. Using Table II as our guide, beginning with the asset section of our Cash Flow Worksheet, we review each account. As was discussed earlier, the change in cash and cash equivalents is the control number that we must balance to. Accounts receivable would be categorized as an operating activity, because it is related to collections from customers. The change in inventory is classified as an operating activity, because it is a component of our core operating activities. Plant and Equipment transactions would be classified as investing, because the sale or purchase of productive assets that are expected to generate revenues in the future are defined as Investing Activities in Table II. We continue this process until we define the activity for each of the balance sheet accounts. (Exhibit 2)
Cash Flows from Operating Activities
Generally accepted accounting procedures require that the operating activities section of the cash flow statement be reported first. A company's operating activities include the transactions associated with the company's primary products or services. There are two approaches that may be used to report operating activities - the direct method and the indirect method.
|Operating Activities||Investing Activities||Financing Activities|
|Collections from Customers||Collection on Loans||Issuance of long-term Debt|
|Interest Income||Sale of Debt Instruments||Issuance of Equity Securities|
|Dividends Receipts||Sale of Equity Instruments|
|Other Operating Cash Receipts||Sale of Productive Assets|
|Payments to Suppliers||Purchase of Productive Assets||Payment of Dividends|
|Payments to Employees||Purchase of Debt Instruments||Acquisition of an Entity's
Own Equity Securities
|Interest Payments||Purchase of Equity Instruments||Repayment of Amounts
|Payment of Income Taxes||Making Loans|
|Other Operating Cash
The Direct Method
Our analysis will begin by preparing the Cash Flows from Operating Activities using the Direct Method. Under the Direct Method the following sources of operating cash inflows and outflows are reported:
It is important to remember that we are using financial statements that were created using accrual accounting and we are converting these statements into cash accounting. Net income (accrual accounting) and net cash flow (cash accounting) will almost never be the same because of noncash transactions that impact the performance of a business. For example, depreciation expense, a noncash expense, appears on the income statement under accrual accounting but is not part of net cash flow. Using Table III as a guide, and extracting data from the Income Statement (Exhibit 1) and the Cash Flow Worksheet (Exhibit 2), we can now prepare the Cash Flows from Operating Activities.
|Cash Collections from
|Sales - increase (+ decrease) in Accounts Receivable + increase
( - decrease) in Deferred Revenue
|Cash Payments to
|Cost of Goods Sold + increase ( - decrease) in Inventory -
increase ( + decrease) in Accounts Payable
|Cash Payments for
|Salary expense - increase ( + decrease) in Accrued Salaries
|Cash Payments for Other
|Other Operating Expenses - Depreciation and Amortization
Expense for Period + increase ( - decrease) in Prepaid Expenses -
increase ( + decrease) in Accrued Operating Expenses
|Cash Revenue from
|Interest Revenue - increase (+ decrease) in Interest Receivable|
|Cash Paid for Interest||Interest Expense - increase ( + decrease) in Accrued Interest
|Cash Revenue from Dividends||Investment Income - increase ( + decrease) in Investment
|Cash Paid for Taxes||Tax Expense - increase (+ decrease) in Accrued Taxes Payable -
decrease ( + increase) in Prepaid Tax
Based on the formulas provided in Table III, Star Light has the following cash flows from its Operating Activities:
* Interest expense for the period equals interest paid during the period plus the decrease in Premium on Bonds Payable
By combining the above cash transactions into statement form, we complete the Operating Activities section of the statement using the Direct Method. (Exhibit 3)
|Cash Flows from Operating Activities (Direct Method)|
|Cash collections from Customers
Cash Payments to Suppliers
Cash Payments for Salaries
Cash Payments for Interest
Net Cash Provided by Operating Activities
The Indirect Method
The second method that can be used to calculate the Cash Flows from Operating Activities is referred to as the Indirect Method. Using the Indirect Method, cash flows from Operating Activities are reported by adjusting net income for revenues, expenses, gains, and losses that appear on the income statement but do not have an effect on cash.
Using Table IV as a guide, and Table I and Table V to determine if the change is an inflow or outflow, we can extract data from the Income Statement (Exhibit 1) and Cash Flow Worksheet (Exhibit 2) to prepare the Cash Flows from Operating Activities using the Indirect Method. (Exhibit IV)
|Adjustments to reconcile net income to net
cash provided by operating activities
|- 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|
|Cash Inflow||Cash Outflow|
|Revenue Accounts are Sources of Cash||Expense Accounts are Uses of Cash|
Based on the formula provided in Table IV, we are able to reconcile Star Light's net income with net cash provided by its Operating Activities. (Exhibit 4)
|Cash Flows from Operating Activities
Adjustments to reconcile net income to net cash
provided by operating activities
Amortization of Bond Premium
Gain on Sale of Equipment
Decrease in Accounts Receivable
Decrease in Inventories
Increase in Accounts Payable
Increase in Salaries Payable
|Net Cash Provided by Operating Activities||$128,000|
A comparison of the Direct Method with the Indirect Method indicates that either method will generate the same results. The Operating Activities of Star Light Corporation generated $128,000 in net cash during 1996.
Cash Flows from Investing Activities
As we have discussed, Investing Activities include purchases and sales of productive assets that are expected to generate revenues over long periods of time, purchases and sales of securities that are not classified as cash equivalents, and lending money and collecting the interest and principal on those loans. An analysis of Star Light Corporation's Investing Activities using the Cash Flow Worksheet (Exhibit 2) reveals a decrease in the plant and equipment account and an increase in the land account. However, a review of the Income Statement (Exhibit 1) reveals a gain on the Sale of Equipment. After further investigation you determine that during 1996 machinery with an original cost of $50,000 and accumulated depreciation of $30,000 was sold for $30,000, resulting in a noncash gain that has already been adjusted out of the operating activities. However, the sale of the equipment generated $30,000 in cash.
Using this information we must determine if any equipment was purchased in 1996. From the Cash Flow Worksheet (Exhibit 2) we determine that the plant and equipment account decreased by $10,000. Since the equipment that was sold had an original cost of $50,000, which was removed from the account when the equipment was sold, additional equipment costing $40,000 must have been purchased for cash. This purchase of equipment decreased cash by $40,000.
From a review of the Cash Flow Worksheet (Exhibit 2) we can infer that land was purchased for $8,000 cash. By combining these three transactions we can develop the investing section of the cash flow statement.
|Cash Flows from Investing Activities|
|Sale of Equipment
Purchase of Equipment
Purchase of Land
Cash Flows from Financing Activities
The financing activities are the final category of transactions that result in cash inflows and outflows. Financing activities include borrowing money from creditors and repaying the amounts borrowed, and obtaining resources from owners and providing them with both a return of their investment and a return on their investment in the form of dividends.
A review of the Cash Flow Worksheet (Exhibit 2) indicates that there was a reduction in the common stock account. After an investigation it is determined that Star Light Corporation retired common stock with a book value of $30,000 for $35,000. On the statement of cash flows, this financing transaction would be reported as the retirement of common stock requiring $35,000 in cash. This transaction would have also reduced retained earnings by $5,000. Cash dividends for 1996 totaled $35,000. This financing transaction also reduced cash. By combining these two transactions we can develop the financing section of the cash flow statement. (Exhibit 6)
|Cash Flows from Financing Activities|
|Retirement of Common Stock
Payment of Dividends
Reconciling the Cash Account
To complete the statement of cash flow we combine the operating, investing and financing activities into one statement. The final step is to reconcile the cash account. As was discussed earlier, the beginning cash balance less the ending cash balance is our control number. A review of the Cash Flow Worksheet (Exhibit 2) indicates that the cash account increased $40,000 from 1995 to 1996. Since the cash flow statement provides information about how cash moved within the organization during the year, it makes sense that the sum of these changes should equal the change in the cash account.
| Cash Flows from Operating Activities
Cash collections from Customers
Cash payments to Suppliers
Cash Payments for Salaries
Cash Payments for Interest
Net Cash Provided by Operating Activities
| Cash Flows from Investing Activities
Sale of Equipment
Purchase of Equipment
Purchase of Land
Net Cash Provided by Operating Activities
| Cash Flows from Financing Activities
Retirement of Common Stock
Payment of Dividends
Net Cash Used by Financing Activities
Net Increase in Cash
Cash at Beginning of Year
Cash at End of Year
The primary purpose of the cash flow statement is to provide information about a company's cash inflows and outflows. A secondary purpose is to provide information about the investing and financing activities of the company. The Star Light Corporation provided an excellent illustration of the basic concepts and procedures required to prepare a statement of cash flows. Information reported in the statement, when used with other financial statements provides the analyst with insights about the company's ability to generate future cash flows. It helps the user understand the differences between a company's income flows and cash flows. The information provided by the cash flow statement will also help you assess a company's ability to pay its debts and to meet its external financing needs.
Why Am I Always So Short Of Cash, Even Though I'm Selling More Than Ever Before?
Frequently Asked Question - Why am I always so short of cash, even though I'm selling more than ever before?
The quick answer is that you are so short of cash BECAUSE things are going so well with your business. While this may sound impossible, rapid growth often causes a cash strain on your business.
A growing business can be called a "cash sponge". The demands of increasing sales, support services, inventory, labor costs, etc. can rapidly soak up all those extra dollars a business manager expects to see flowing in when the sales numbers are rising. Not only does the business have to invest more resources in inventory and labor, but receivables typically grow along with sales. So, while you are getting busier and busier, you have more and more tied up in receivables.
For example, if you are able to turn your inventory over five times in a year, you would need an inventory level of approximately $20,000 to support sales of $100,000. If sales grow to $125,000 then inventory levels would probably need to rise to $25,000. The demands on the business infrastructure and staff may require overtime from the present staff or the hiring of more employees. In addition to the increased wages, other costs (unemployment taxes, workers' compensation, employer's portion of social security payments, supplies, freight, etc.) also rise. While these costs are all expected, if you sell on terms other than COD, your receivables will also increase from perhaps $12,500 to roughly $15,600 assuming a constant average receivable period of 45 days. The net result is that your sales are up, but you are "lending" about $3,000 more to your customers while investing something in excess of $5,000 more in your business. This $8,000 to $9,000 may represent all or more than the extra profit from your increased sales. Faster rates of growth and/or lower rates of inventory turnover produce even larger effects meaning that the cash demands of growth exceed the cash supplies from that growth. These increasing net cash demands are continuous for as long as the business is growing. If sales become steady, then the extra profits begin to emerge as extra cash since the costs and receivables levels also stop growing.
So, how does a business finance growth? There are only two basic sources of financing -- externally generated funds and internally generated funds. External sources are the ones we all think of when it's time to raise money and include more investment from the present ownership, bringing others in as investors, borrowings in the form of loans, or by increasing your obligations to vendors (accounts payable).
The only true long term internal source of funds is profits. The business manager must be constantly vigilant in maintaining profit margins by watching both pricing and purchasing. However, most businesses are not able to make as high a percentage profit as would be needed to provide all the funds necessary for rapid growth. So, growth must occur at a controlled rate or the management must find more external capital. If profits are not constantly generated, the implications for business longevity are pretty clear. We have seen several mature businesses who complained of "being undercapitalized and if they could just get a loan" or come up with an investor, they "would be all right". After digging a bit deeper, we often find that a more than adequate amount of capital has been invested but the company has not been generating profits for such a long time that they are, in effect, consuming their capital in supporting the present operations. As an excuse for business difficulty or failure, "undercapitalization" ranks right up there with "poor management" as being one of those catch-all terms which is often used when one is unsure what's wrong.
As the investment in machinery, equipment, and inventory rise, so, too must the amount of permanent capital generated by or invested in the business rise. Even with seasonal or cyclical fluctuations, a growing business generally has growing demands for permanent capital. There is an old rule of business finance that advocates matching the length of financing of an asset to the useful life of that asset. It is very dangerous to attempt to finance long term capital needs with short term capital sources. The manager who uses a short term loan or, worse yet, line of credit, to finance permanent increases in inventory or the purchase of equipment, is virtually guaranteeing a future cash crisis. Short term sources of financing should be used only for the purchase of short terms assets like that portion of inventory that is truly seasonal and will, therefore, be sold during the term of the financing.
This publication was produced by the Delaware Small Business Development Center Network and can be found on their web site: http://www.be.udel.edu/sbdc. The Center can be contacted at: 102 MBNA America Hall, University of Delaware, Newark, DE 19716. Phone: (302) 831-1555; Fax: (302) 831-1423
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