URDANETA CITY

UNIVERSITY COLLEGE OF BUSINESS MANAGEMENT

Owned and operated by the City Government of Urdaneta AND ACCOUNTANCY

Lesson 5&6: Statement of Cashflow

What is the Statement of Cash Flows?

The statement of cash flows (also referred to as the cash flow statement) is one of the three key financial
statements. The cash flow statement reports the cash generated and spent during a specific period of time
(e.g., a month, quarter, or year). The statement of cash flows acts as a bridge between the income statement
and balance sheet by showing how cash moved in and out of the business.

Why is the Cash Flow Statement Important?

“Cash is king” is an old saying about business. Since the income statement and balance sheet are based on
accrual accounting, those financials don’t directly measure what happens to cash over a period. Therefore,
companies typically provide a cash flow statement for management, analysts and investors to review.

Another useful aspect of the cash flow statement is to compare operating cash flow to net income. This
comparison measure how well a company is running its operations. The cash flow statement reflects the
actual amount of cash the company receives from its operations.

What Can the Statement of Cash Flows Tell Us?

 Cash from operating activities can be compared to the company’s net income to determine the
quality of earnings. If cash from operating activities is higher than net income, earnings are said to
be of “high quality.”
 This statement is useful to investors because, under the notion that cash is king, it allows investors
to get an overall sense of the company’s cash inflows and outflows and obtain a general
understanding of its overall performance.
 If a company is funding losses from operations or financing investments by raising money (debt or
equity) it will quickly become clear on the statement of cash flows.

Cash Flow Definitions

Cash flow: Inflows and outflows of cash and cash equivalents

Cash balance: Cash on hand and demand deposits (cash balance on the balance sheet).

Cash equivalents: Cash equivalents include cash held as bank deposits, short-term investments, and any
very easily cash-convertible assets — includes overdrafts and cash equivalents with short-term maturities
(less than three months).

3 Major Cash Flow Activities/Cash Flow Statement Sections

Below is a breakdown of each section in a statement of cash flows. While each company will have its own
unique line items, the general setup is usually the same.

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1. Operating cash flow

Operating activities are the principal revenue-producing activities of the entity. Cash flow from operations
typically includes the cash flows associated with sales, purchases, and other expenses.

The company’s chief financial officer (CFO) chooses between the direct and indirect presentation of
operating cash flow:

Direct presentation: Operating cash flows are presented as a list of cash flows: cash in from sales, cash out
for operating expenses, etc. This is a simple but rarely used method, as the indirect presentation is more
common.

Indirect presentation: Operating cash flows are presented as a reconciliation from profit to cash flow.

The items in the operating cash flow section are not all actual cash flows but include non-cash items and
other adjustments to reconcile profit with cash flow.

Plus: depreciation and amortization (D&A)

The value of various assets declines over time when used in a business. As a result, D&A are expenses that
allocate the cost of an asset over its useful life. Depreciation involves tangible assets such as buildings,
machinery, and equipment, whereas amortization involves intangible assets such as patents, copyrights,
goodwill, and software. D&A reduces net income in the income statement. However, we add this back into
the cash flow statement to adjust net income because these are non-cash expenses. In other words, no cash
transactions are involved.

Plus/(less): changes in working capital

Working capital represents the difference between a company’s current assets and current liabilities. Any
changes in current assets (other than cash) and current liabilities (other than debt) affect the cash balance in
operating activities.

For instance, when a company buys more inventory, current assets increase. This positive change in
inventory is subtracted from net income because it is a cash outflow. It’s the same case for accounts
receivable. When it increases, it means the company sold their goods on credit. There was no cash
transaction even though revenue was recognized, so an increase in accounts receivable is also subtracted
from net income.

Conversely, if a current liability, like accounts payable, increases this is considered a cash inflow. This is
because the company has yet to pay cash for something it purchased on credit. This increase is then added
to net income (a decrease would be subtracted).

2. Investing cash flow

Cash flow from investing activities includes the acquisition and disposal of non-current assets and other
investments not included in cash equivalents. Investing cash flows typically include the cash flows
associated with buying or selling property, plant, and equipment (PP&E), other non-current assets, and
other financial assets.

(Less): investments in PP&E

Cash spent on purchasing PP&E is called capital expenditures (CapEx). CapEx investments might mean
purchases of new office equipment such as computers and printers for a growing number of employees, or
the purchase of new land and a building to house business operations and logistics of the company. These
items are necessary to keep the company running. These investments are a cash outflow, and therefore will
have a negative impact when we calculate the net increase in cash from all activities. Learn how to calculate
CapEx with the CapEx formula.

CapEx = PP&E (current period) – PP&E (prior period) + Depreciation (current period)

3. Financing cash flow

Cash flow from financing activities results from changes in a company’s capital structure. Financing cash
flows include cash flows associated with borrowing and repaying bank loans or bonds and issuing and
buying back shares. The payment of a dividend is also treated as a financing cash flow.

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Issuance (repayment) of debt

A company issues debt as a way to finance its operations. The issuance of debt is a cash inflow, because a
company finds investors willing to act as lenders. However, when these debt investors are paid back, then
the repayment is a cash outflow.

Issuance (repayment) of equity

This is another way of financing a company’s operations. Issuance of equity is an additional source of cash,
so it’s a cash inflow. Conversely, an equity repurchase is a cash outflow. This is buying back, through cash
payment, the equity from its investors.

4. Net increase/(decrease) in cash and closing cash balance

We sum up the three sections of the cash flow statement to find the net cash increase or decrease for the
given time period. This amount is then added to the opening cash balance to derive the closing cash
balance. This amount will be reported in the balance sheet statement under the current assets section. This is
the final piece of the puzzle when linking the three financial statements.

Opening cash balance

The opening cash balance is last year’s closing cash balance. We can find this amount from last year’s cash
flow statement and balance sheet statement.

How Cash Flow Is Calculated

There are two methods of calculating cash flow: the direct method and the indirect method.

 Direct Cash Flow Method

The direct method adds up all of the cash payments and receipts, including cash paid to suppliers, cash
receipts from customers, and cash paid out in salaries. This method of CFS (Cash Flow Statement) is easier
for very small businesses that use the cash basis accounting method.

These figures can also be calculated by using the beginning and ending balances of a variety of asset and
liability accounts and examining the net decrease or increase in the accounts. It is presented in a
straightforward manner.

Most companies use the accrual basis accounting method. In these cases, revenue is recognized when it is
earned rather than when it is received. This causes a disconnect between net income and actual cash flow
because not all transactions in net income on the income statement involve actual cash items. Therefore,
certain items must be reevaluated when calculating cash flow from operations.

 Indirect Cash Flow Method

With the indirect method, cash flow is calculated by adjusting net income by adding or subtracting
differences resulting from non-cash transactions. Non-cash items show up in the changes to a company’s
assets and liabilities on the balance sheet from one period to the next. Therefore, the accountant will
identify any increases and decreases to asset and liability accounts that need to be added back to or removed
from the net income figure, in order to identify an accurate cash inflow or outflow.

Changes in accounts receivable (AR) on the balance sheet from one accounting period to the next must be
reflected in cash flow:

If AR decreases, more cash may have entered the company from customers paying off their credit accounts
—the amount by which AR has decreased is then added to net earnings.
An increase in AR must be deducted from net earnings because, although the amounts represented in AR
are in revenue, they are not cash.
What about changes in a company's inventory? Here's how they are accounted for on the CFS:

An increase in inventory signals that a company spent more money on raw materials. Using cash means the
increase in the inventory's value is deducted from net earnings.
A decrease in inventory would be added to net earnings. Credit purchases are reflected by an increase in
accounts payable on the balance sheet, and the amount of the increase from one year to the next is added to
net earnings.
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Owned and operated by the City Government of Urdaneta AND ACCOUNTANCY

The same logic holds true for taxes payable, salaries, and prepaid insurance. If something has been paid off,
then the difference in the value owed from one year to the next has to be subtracted from net income. If
there is an amount that is still owed, then any differences will have to be added to net earnings.

Differences between the direct and indirect methods

Regardless of the method, the cash flows from the operating section will give the same result. However, the
presentation will differ. Below is an illustrative comparison of the two approaches.

The difference lies in how the cash inflows and outflows are determined.

Using the direct method, actual cash inflows and outflows are known amounts. The cash flow statement is
reported in a straightforward manner, using cash payments and receipts.

Using the indirect method, actual cash inflows and outflows do not have to be known. The indirect method
begins with net income or loss from the income statement, then modifies the figure using balance sheet
account increases and decreases, to compute implicit cash inflows and outflows.

Is the Indirect Method of the Cash Flow Statement Better Than the Direct Method?
Neither is necessarily better or worse. However, the indirect method also provides a means of reconciling
items on the balance sheet to the net income on the income statement. As an accountant prepares the CFS
using the indirect method, they can identify increases and decreases in the balance sheet that are the result
of non-cash transactions.

It is useful to see the impact and relationship that accounts on the balance sheet have to the net income on
the income statement, and it can provide a better understanding of the financial statements as a whole.

What Is Included in Cash and Cash Equivalents?

Cash and cash equivalents are consolidated into a single line item on a company's balance sheet. It reports
the value of a business’s assets that are currently cash or can be converted into cash within a short period of
time, commonly 90 days. Cash and cash equivalents include currency, petty cash, bank accounts, and other
highly liquid, short-term investments. Examples of cash equivalents include commercial paper, Treasury
bills, and short-term government bonds with a maturity of three months or less.

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UNIVERSITY COLLEGE OF BUSINESS MANAGEMENT
Owned and operated by the City Government of Urdaneta AND ACCOUNTANCY

The Bottom Line

A cash flow statement is a valuable measure of strength, profitability, and the long-term future outlook of a
company. The CFS can help determine whether a company has enough liquidity or cash to pay its expenses.
A company can use a CFS to predict future cash flow, which helps with budgeting matters.

For investors, the CFS reflects a company’s financial health, since typically the more cash that’s available
for business operations, the better. However, this is not a rigid rule. Sometimes, a negative cash flow results
from a company’s growth strategy in the form of expanding its operations.

By studying the CFS, an investor can get a clear picture of how much cash a company generates and gain a
solid understanding of the financial well-being of a company.

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Reference:
https://www.investopedia.com/terms/f/financialperformance.asp
https://corporatefinanceinstitute.com/resources/accounting/statement-of-cash-flows/

(075) 600 - 1507

San Vicente West, Urdaneta City, Pangasinan
Bright future starts here ucu.edu.ph | [email protected]