Accounting: The Language of Business (Part 95)

Republicans and Democrats have used accounting gimmicks and competing government analyses to deceive the public into believing that 2 + 2 = 6. If our leaders cannot agree on the numbers, if 'facts' are fictional, how can they possibly have a substantive debate on solutions?

J. C. Watts

Statement of Cash Flows (Part A)

by

Charles Lamson

How much cash do you have in the bank or in your wallet or purse? How much cash did you have at the beginning of the month? The difference between these two amounts is the net change in your cash during the month. Knowing the reasons for the change in cash may be useful in evaluating whether your financial position has improved and whether you will be able to pay your bills in the future.

For example, assume that you had $200 at the beginning of the month and $550 at the end of the month. The net change in cash is $350. Based on this net change, it appears that your financial position has improved. However, this conclusion may or may not be valid, depending upon how the change of $350 was created. If you borrowed $1,000 during the month and spent $650 on living expenses, your cash would have increased by $350 by living off borrowed funds. On the other hand, if you earned $1,000 and spent $650 on living expenses, your cash would have also increased by $350, but your financial position is improved compared to the first scenario.

In previous posts, we have used the income statement, balance sheet, and retained earnings statement and other information to analyze the effects of management decisions on a business's financial position and operating performance. In the next several posts, we present how to prepare and use the statement of cash flows.

Reporting Cash Flows

The statement of cash flows reports a firm's major cash inflows and outflows for a period (As used in the next several posts, cash refers to cash and cash equivalents. Examples of cash equivalents include short-term, highly liquid investments, such as money market funds, commercial paper, and treasury bills.) The statement of cash flows provides useful information about a firm's ability to generate cash from operations, maintain and expand its operating capacity, meet its financial obligations, and pay dividends.

The statement of cash flows is one of the basic financial statements. It is useful to managers in evaluating past operations and in planning future investing and financing activities. It is useful to investors, creditors, and others in assessing a firm's profit potential. In addition, it is a basis for assessing the firm's ability to pay its maturing debt.

The statement of cash flows reports cash flows by three types of activities:

1. Cash flows from operating activities are cash flows from transactions that affect net income. Examples of such transactions include the purchase and sale of merchandise by a retailer.

2. Cash flows from investing activities are cash flows from transactions that affect the investments in noncurrent assets. Examples of such transactions include the sale and purchase of fixed assets, such as equipment and buildings.

3.  Cash flows from financing activities are cash flows from transactions that affect the equity and debt of the business. Examples of such transactions include issuing or retiring equity and debt securities.

The cash flows from operating activities are normally presented first, followed by the cash flows from investing activities and financing activities. The total of the net cash flow from these activities is the net increase or decrease in cash for the period. The cash balance at the beginning of the period is added to the net increase or decrease in cash, resulting in the cash at the end of the period. The ending cash balance on the statement of cash flows equals the cash reported on the balance sheet.

Exhibit 1 shows the common cash flow transactions reported in each of the three sections of the statement of cash flows. By reporting cash flows by operating, investing, and financing activities, significant relationships within and among the activities can be evaluated. For example, the receipts from issuing bonds can be related to repayments or borrowings when both are reported as financing activities. Also, the impact of each of the three activities (operating, investing, and financing) on cash flows can be identified. This allows investors and creditors to evaluate the effects of a firm's profits on cash flows, and the ability to generate cash flows for dividends and to pay debts.

EXHIBIT 1 Cash Flows

Cash Flows from Operating Activities

The most important cash flows of a business often relate to operating activities. There are two alternative methods for reporting cash flows from operating activities in the statement of cash flows. These methods are (1) the direct method and (2) the indirect method.

The direct method reports the sources of operating cash and the uses of operating cash. The major source of operating cash is cash received from customers. The major uses of operating cash include cash paid to suppliers for merchandise and services and cash paid to employees for wages. The difference between these operating cash receipts and cash payments is the net cash flow from operating activities.

The primary advantage of the direct method is that it reports the sources and uses of cash in the statement of cash flows. Its primary disadvantage is that the most necessary data may not be readily available and may be costly together.

The indirect method reports the operating cash flows by beginning with net income and adjusting it for revenues and expenses that do not involve the receipt or payment of the cash. In other words, accrual net income is adjusted to determine the net amount of cash flows from operating activities.

A major advantage of the indirect method is that it focuses on the differences between net income and cash flows from operations. In this sense it shows the relationship between the income statement, the balance sheet, and the statement of cash flows. Because the data are readily available, the indirect method is normally less costly to use than the direct method. Because of these advantages, most firms use the indirect method to report cash flows from operations.

Exhibit 2 illustrates the cash flow from operating activities section of the statement of cash flows under the direct and indirect methods. Both statements are for NetSolutions for the month ended November 2022. Both methods show the same amount of net cash flow from operating activities, regardless of the method. We will illustrate both methods in detail in later posts.

EXHIBIT 2 Cash Flow from Operations: Direct and Indirect Methods

Cash Flows from Investing Activities 

Cash inflows from investing activities normally arise from selling fixed assets, investments, and intangible assets. Cash outflows normally include payments to acquire fixed assets, investments, and intangible assets.

Cash flows from investing activities are reported on the statement of cash flows by first listing the cash inflows. The cash outflows are then presented. If the inflows are greater than the outflows, net cash flow provided by investing activities is reported. If the inflows are less than the outflows, net cash flow used for investing activities is reported.

The cash flows from investing activities section in the statement of cash flows for NetSolutions is shown below.

Cash Flows from Financing Activities

Cash inflows from financing activities normally arise from issuing debt or equity securities. Examples of such inflows include issuing bonds, notes payable, and preferred and common stocks. Cash outflows from financing activities include paying cash dividends, repaying debt, and acquiring treasury stock.

Cash flows from financing activities are reported on the statement of cash flows by first listing the cash inflows. The cash outflows are then presented. If the inflows are greater than the outflows, net cash flow provided by financing activities is reported. If the inflows are less than the outflows, net cash flow used for financing activities is reported.

The cash flows from financing activities section in the statement of cash flows for NetSolutions is shown below.

Noncash Investing and Financing Activities

A business may enter into investing and financing activities that do not directly involve cash. For example, it may issue common stock to retire long-term debt. Such a transaction does not have a direct effect on cash. However, the transaction does eliminate the need for future cash payments to pay interest and retire the bonds. Thus, because of their future effect on cash flows, such transactions should be reported to readers of the financial statements.

When noncash investing and financing transactions occur during a period, their effect is reported in a separate schedule. The schedule usually appears at the bottom of the statement of cash flows. Examples of noncash investing and financing transactions include issuing common stock, acquiring fixed assets by issuing bonds or capital stock, and issuing common stock in exchange for convertible preferred stock.

No Cash Flow per Share

The term cash flow per share is sometimes reported in the financial press. Often, the term is used to mean "cash flow from operations per share." Such reporting may be misleading to users of the financial statements. For example, users might interpret cash flow per share as the amount available for dividends. This would not be the case if most of the cash generated by operations is required for repaying loans or for reinvesting in the business. Users might also think that cash flow per share is equivalent or perhaps superior to earnings per share. For these reasons, the financial statements, including the statement of cash flows, should not report cash flow per share. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 641-644*

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