Introduction to Financial Statements – Cash Flow Statement

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Financial Statement Analysis

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The final financial statement is the Statement of Cash Flows. It is sometimes referred to as the sources and uses statement, as it shows the sources of cash for the company and then how it was used over a period of time. The time period measured is typically a month or quarter or year. Many people don’t focus on the Statement of Cash Flows. They simply want to know if the company is profitable and how strong and liquid it is. Other people will say that the statement of cash flow is the most important statement, because they get paid for what they sell to companies through cash flow. For those in the credit industry, we constantly hear “we can’t pay right now because we’re having cash flow problems”, so understanding cash flow is very important to understanding the company’s overall financial health and its operating profitability.

CASH FLOW STATEMENT

The cash flow statement is broken into three categories and then a final summary section. The three categories are cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Once these cash flows are calculated, they are added together to arrive at net cash flow, and then this is added to the cash balance at the beginning of the period to calculate the cash balance at the end of the period. We will now review each of these sections.

CASH FLOWS FROM OPERATING ACTIVITIES

The first section of the cash flow statement is cash flows from operating activities, which is the key measure on the company’s core business activities. We normally think the primary source of cash flow from operations is the company’s net income. However, net income is a profitability measure, not a cash measure, so we need to make adjustments for various non-cash items on the income statement.

For example, when the company purchases equipment they do not expense the full purchase price in the year that it was purchased. Instead, it is depreciated over the useful life of the asset. In the balance sheet video, we talked about a $1,000 computer having depreciation expense of $200 per year. This depreciation expense is an accounting calculation and not an actual cash expense, so depreciation expense included in the income statement is added back to net income.

Another example of a non-cash income or expense item is unrealized gains or losses on assets. The fact that they are unrealized means we are recognizing their change in fair market value on the income statement but the company has not actually sold the asset so this is an accounting entry and not a cash transaction.

CASH FLOWS FROM OPERATING ACTIVITIES

The net income amount also does not take into account changes is the value of the company’s operating assets and liabilities. Changes in these accounts have an impact on cash flow. For example, sales are recorded on the income statement, but any sales not yet collected are shown as accounts receivable on the balance sheet. If the amount of accounts receivable goes up during a year, the amount of the increase represents cash that was earned but not yet collected. Therefore, the increase needs to be subtracted from Net Income to arrive at actual cash flow. This same type of adjustment needs to be made for all other operating assets and liabilities. To do this, we need to calculate the change during the period in the amounts of such operating items as inventory, prepaid expenses, accounts payable and accrued expenses. Increases in operating assets result in a cash use or reduction in cash flow, while decreases in operating assets result in a cash source or increase in cash flow. These increases and reductions are reflected on the cash flow statement in this section to arrive at a final number representing cash flow from operating activities.

CASH FLOWS FROM INVESTING ACTIVITIES

The next section of the cash flow statement is sources and uses of cash from investing activities. There are two types of investing activities. One is the purchase of equipment and fixed assets by the company. This investment is a cash use or outflow and is not reflected on the income statement. So, to capture the cash use that resulted in purchasing the $1,000 computer in our example, that cash outflow is reflected here.

The other type of investing activity has to do with money invested in financial instruments, such as loans to employees, deposits paid to landlords and utility companies, and amounts recorded as notes receivable. Any increase in the amounts of these items during a period would be a use of cash, while any decrease would result in a cash inflow. All these changes are reflected in this section of the cash flow statement to get a net cash increase or decrease from investing activities.

CASH FLOWS FROM FINANCING ACTIVITIES

The next section of the cash flow statement is sources and uses from financing activities. In most cases, financing of the business is unrelated to the company’s operating performance. In this section, any new borrowings or sales of stock are shown as cash sources. Any repayment of debt, purchase of company stock, or dividends would be shown as cash uses. These are all added to come up with a net cash increase or decrease from financing activities.

CASH FLOW SUMMARY

The final section of the cash flow statement is the summary. This is the summation of cash flows from operating, investing and financing activities. This particular company had a decrease in cash and cash equivalents of $886,000 over the last year. While initially this might be alarming, we can see that they repaid over $1 million of debt, so this negative cash flow is not a concern as long as other company ratios indicate sufficient liquidity and strength. The summary section then shows the cash balance at the beginning of the period and at the end. In this case, there was $1,367,000 at the beginning and after using $886,000 in cash there was $481,000 at the end.

PROFIT VS. CASH FLOW

The cash flow statement does not lend itself to some of the same easy ratio analysis that we discussed for the income statement and balance sheet. However, there are certain things that we want to focus on. A key item is comparing profitability versus operating cash flow. If they are vastly different, a credit manager evaluating credit risk will want to understand the reasons and how this might impact the company’s ability to pay invoices. The cash flow from operations less the cost for new equipment allows us to compare operating cash flow versus net income

PROFIT VS. CHANGES IN WORKING CAPITAL

Another key issue is the change in working capital and therefore the cash required to operate the business. This is especially relevant for growing businesses.

Sales and profit may be increasing, but cash flow may be negative due to the investments required to fund and achieve the growth. Sales people are always justifiably excited about the prospect of selling to fast growing companies, but credit managers need to make sure these customers have sufficient financial capital available to fund the growth. If they don’t, you can expect that they will be slow in paying their vendors during these periods of high growth. Essentially, vendors become lenders in this situation, so careful credit analysis is required.

Thanks For Reading

This completes our Introduction to Financial Statement Analysis series. Remember, you can download the Financial Statement Analysis eBook, which includes over 50 definitions and ratio calculations and an Excel spreadsheet to help calculate key ratios. If you need debt collection assistance, we are experts at collecting large business-to-business claims, and can offer you referral suggestions to other agencies if our skills don´t fit your needs. Just fill out the Request A Quote form or give us a call.

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