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The Cash Flow Statement

The Cash Flow Statement is the third report in the Financial Statement package (the financial triumvirate if you will). The Statement is fairly new to the financial statements financial package, as it was only added in 1987 when SFAS 95 (Statement of Cash Flows) was issued.

Prior to 1987, companies were allowed to provide financial on a working capital or cash basis. For a while, many accepted that the adding back of depreciation to net income was an appropriate substitute for a cash flow statement, while others, especially creditors chose to use EBITDA (earnings before interest, taxes, depreciation and amortization). EBITDA is of course a measurement that maintained wide usage up to the late 1990s, before a string of corporate scandals (led by Enron and Worldcom) removed it from business pages.

The Cash Flow Statement is divided into three distinct sections:

  • Cash flow from operations
  • Cash flow from investing activities
  • Cash flow from financing activities
The first section is widely regarded as the most important section of the cash flow statement. This is so as this section shows whether the company was able to generate cash from its operating activities. On the typical cash flow statement, the cash flow from operations section is divided into two sub-sections:
  • The first subsection adds back to/minus from net income all non-cash operating items that were subtracted/added in arriving at net income
  • The second sub-section calculates the net change in working capital and adds it back to net income.
The following example will provide some clarity:

Sales	                            $20,000
Less depreciation          	    $4,000
Plus profit fr sale of fixed assets $2,000
   Net Income		            $18,000

Balance sheet info:
Accounts receivable increased by    $3,000
Inventory fell by 	            $5,000
Accounts payable increased by	    $4,000
Net change in working capital	    $6,000

From the above we prepared the following cash flow statement (cash flow from operations section):

Net Income				$18,000
Plus depreciation 			 $4,000
Less profit from sale of fixed asset 	-$2,000
Net change in working capital		 $6,000
	Cash flow from operations	$26,000

As is the case with the balance sheet, the cash flow statement does not form part of the double entry system of accounting. As a result, some students are often challenged in their attempts to prepare the statement, confusing the sources (income statement and balance sheet) from which the information should be drawn and where to place the information on the cash flow statement.

The following will help you as you prepare your next cash flow statement:

  • Financial information thatyou'll need:
  •    The most recent income statement
  •    The most recent balance sheet
  •    The prior period balance sheet
  •    Any additional notes pertaining to the transactions of the company during the periods under consideration.
  • Note all the non-cash charges that were applied against revenue. The most common of these is Depreciation
  • Note all the non-cash income that was added to revenue. A common one is Profit from sale of fixed assets. This is usually "paper" profit that does not represent the flow of cash, and should therefore be deducted from income.
  • Compare the two balance sheets. Given the sectional nature of the cash flow statement (see above), you should divide your balance sheets into the three cash flow statement sections.
  • Deduct line items (except cash) on the prior period balance sheet from similar line item on the most recent balance sheet.
  • Deduct line items (except cash) on the prior period balance sheet from similar line item on the most recent balance sheet.
  • Use the following rule with changes in assets, liabilities and equity:
  •    An increase in an asset - A use of cash
  •    An increase in liability - a source of cash
  •    An increase in equity - a source of cash
  •    A decrease in asset - a source of cash
  •    A decrease in liability - a use of cash
  •    A decrease in equity - a use of cash
After completing the above, you may first test the accuracy of your calculation by adding the change in cash to the opening cash balance (cash balance from the prior year balance sheet), which should sum to the cash balance on the most recent balance sheet.

In the example below, a Sources and Uses of Fund report (two extreme right columns) is prepared from the balance sheet (first two columns). The Sources and Uses Fund report is a convenient and helpful first step that helps to make the preparation of the cash flow statement a little easier.

The importance of liquidity to a company's future cannot be overstated, and the cash flow statement is the report that indicates to reviewers of financial statements, the success or failure of a company to generate what it needs most to survive....cash!

Sources & Uses of Fund
Current and Fixed Assets
Current Assets:
2002
2001
Sources
Uses
Cash and cash equivalents    $155    $170     -     -
Short-term investments    $80    $70     -    $10
Accounts receivable, net    $250    $190     -    $60
Inventory    $210    $170     -    $40
Prepaid expenses/other assets    $15    $40    $25     -
   Total Current Assets    $710    $640     -     -
Fixed Assets:
Property, plant and equipment, net    $1,020    $810     -    $210
   Total Assets    $1,730    $1,450     -     -
Liabilities & Shareholder's Equity
Current liabilities:
Accounts payable    $380    $290    $90     -
Accrued expenses    $120    $160     -    $40
Wages Payable    $170    $80    $90     -
Income Tax Payable    $80    $40    $40     -
   Total current liabilities    $750    $570     -     -
Long-term liabilities:
Long-term debt    $220    $190    $30     -
   Total Liabilities    $970    $760     -     -
Shareholder's equity:
Common Stock    $540    $480    $60     -
Retained Earnings    $220    $210    $10     -
   Total stockholders' equity    $760    $690     -     -
Total liabilities & Equity    $1,730    $1,450     -     -
Total Sources & Uses     -     -    $345    $360
Decrease in Cash & Cash equivalents     -     -    $15     -

The Sources and Uses Fund report provides the launching pad (so to speak) for the preparation of the cash flow statement, as it tests the accuracy of the balance sheet and distinguishes the sources of fund (sources) from the use of fund (uses). Of course, before the cash flow statement can be prepared, additional information will be needed. Information will be needed from the income statement, as well as any other information (usually found in the notes to the accounts) that pertains to charges against/addition to income as well as changes to other line items on the balance sheet.

Cash flow from Investing Activities focuses on the flow of cash in and out of the company as a result of changes in the company's long-term assets (tangible assets and investments). Generally speaking, cash flow from investing activities will be negative as the company replaces old equipment and as it carries out its capital expenditure program. In a few cases, cash flow from investing activities will be positive as the company experience significant cash inflow from the sale of fixed assets and other investing activities.

A company will from time to time need to generate external financing to expand its business, build new factories, launch a national marketing campaign etc. The cash for such major activities is usually not forthcoming from earnings and is usually financed by either the sale of debt or the issuing of equity. Cash flow from Financing activities will include this and other similar cash inflows. Cash outflow in this section includes debt payments (principal), stock repurchase etc.

From the Sources and Uses Fund report, the construction of the cash flow statement The Sources and Uses Fund report provides the launching pad (so to speak) for the preparation of the cash flow statement, allowing the person constructing the statement to concentrate solely on the sectioning process. Of course, before the cash flow statement can be prepared, additional information will be needed. Information will be needed from the income statement, as well as any other information (usually found in the notes to the accounts) that pertains to charges against/addition to income as well as changes to other line items on the balance sheet.

The Sources and Uses Fund report provides the launching pad (so to speak) for the preparation of the cash flow statement, as it tests the accuracy of the balance sheet and distinguishes the sources of fund (sources) from the use of fund (uses). Of course, before the cash flow statement can be prepared, additional information will be needed. Information will be needed from the income statement, as well as any other information (usually found in the notes to the accounts) that pertains to charges against/addition to income as well as changes to other line items on the balance sheet.

An accounting of funds related to the company's investments, reported on the cash flow statement of a company's annual report. This number shows how much money the company has received (or lost) from its investing activities. It includes money that the company has made (or lost) by investing its excess cash in different investments (stocks, bonds, etc), money the company has made (or lost) from buying or selling subsidiaries, and all the money the company has spent on its physical property, such as plants and equipment.

Cash flow from Investing Activities focuses on the flow of cash in and out of the company as a result of changes in the company's investing activities. The company will be engaged in investments of many types and will experience cash inflow from some, and cash outflow from others and this is reflected in this section on the cash flow statement.

The first line item in this section of the cash flow statement is usually Capital Expenditure. The company's cash outlay on capital expenditure is given significant focus between of the importance of capital expenditure to the continued competitiveness of the company. As a result of this, capital expenditure is deducted from Cash Flow from Operations to arrive at FREE CASH FLOW.

The company's free cash flow is therefore viewed as the cash available to the company for discretionary spending. "Discretionary" may be too strong a word to use, however it indicates that along with its operating activities, a company must treat expenditure on capital projects as mandatory if it is to continue as a going concern.

The final section of the cash flow statement is the Cash Flow from Investing activities section. From time to time, a company will seek external financing to expand its business, build new factories, launch a national marketing campaign and so on, and it is this process that is recorded in the cash flow from investing section of the cash flow statement.

An example of a Cash Flow Statement is shown below.

Statement of Cash Flow - Indirect Method
12/31/02
Net Income    $29,437
Adjustment to reconcile net income to net cash provided by operating activities:                
Depreciation & Amortization    $6,542
Gain on sale of fixed assets    $2,327
Changes in current assets and current liabilities:                
Receivables    $(19,451)
Inventories    $134
Prepaid Expenses    $1,844
Accounts Payable    $4,228
Accrued Wages    $1,093
Curr. portion of L/T debt    ($8,676)
   Cash provided by operating activities    $17,478
Investing Activities:
Proceeds from sale of fixed assets    $25,144
Capital expenditures    ($40,936)
Short term investments    $2,788
   Net cash from (used in) investing activities    ($13,004)
Financing activities:
Proceeds from long-term debt    $19,011
Payments of dividends    ($9,552)
Issue of common stock    $12,021
Exercise of stock options    $6,300
   Net cash from (used in) Financing activities    $27,780
Effect of changes in exchange rate on cash    $2,710
Net increase/decrease in cash and cash equivalents    $34,964
Cash & cash equivalents at the beginning of the period    $17,225
Cash & cash equivalents at the end of the period    $52,189

Cash flow from the three categories will be added together to produce the net increase/decrease in cash. This will then be added to cash at the beginning of the accounting period and the result will be total cash at the end of the period. Cash and cash equivalents at the end of the period (as shown on the Cash Flow Statement) should be equaled to the cash and cash equivalents total on the balance sheet for the same accounting period. If this is not so, then the there is a problem with the cash flow statement. Go to: Cash Flow - part II
Go To: Cash Flow - part III

More On Cash Flow

Free Cash Flow: This is a commonly used term that points to the net cash available for distribution to the company's investors.

Free Cash Flow therefore implies positive cash flow from operations. From this the company will spend on new capital equipment (or upgrade on old equipment) necessary to maintain the present and future success of the company. The balance remaining is the Free Cash Flow.

Free Cash Flow formula:
Cash flow from operations less capital expenditure Burn Rate: This is another of those cash flow related terms used on a regular basis by the great financial minds.

The burn rate is the rate at which a company uses up (burn through) its cash. It is usually used to describe how emerging companies burn through their initial financing.

However, it may also be used to describe the pace at which any company experiencing declining financial performance is burning through its cash.

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