Cash Flow Statement
Components, Purpose and Examples of a Cash Flow Statement
Table of Contents
1. What is a Cash Flow Statement? A Definition
The cash flow statement measures how much cash or cash equivalents a company receives or spends during a certain period of time. It shows how well a company manages its cash position and what its abilities to fund debt obligations are. What’s more, it provides insight into a company’s ability to pay out dividends.
While the profit and loss statement accounts for all revenues and expenses, the cash flow statement only considers the parts that were already collected or paid. It, therefore, explicitly excludes all transactions that do not directly affect cash positions.
The cash flow statement is one of the three major financial statements next to the profit and loss statement as well as the balance sheet. It is sometimes also referred to as the statement of cash flows.
For most investors “cash is king”. Therefore, they place a great deal of importance on the cash flow statement.
2. Structure of a Cash Flow Statement
The cash flow statement consists of the following three segments:
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities
The sum of the cash flows from operating, investing and financing activities equals the total cash generated (or spent) over a certain period of time.
2.1. Cash Flow from Operating Activities
The cash flow from operating activities measures how much of net income is considered cash. In other words, if something was sold on credit, it will be deducted from the operating cash flow. At the same time, if costs have not yet been paid or don’t need to be paid (e.g. depreciation), the respective non-cash portion can be added back to the operating cash flow.
A Rule of Thumb:
Operating Cash Flow = Net income – non-cash revenue + non-cash expenses
Let’s have a quick look at what items are considered non-cash.
Based on the revenue recognition principle, revenue has to be recognized at the moment it is earned, even if the payment is still outstanding. As a purchase can be made either using cash or on credit, the latter would be removed from the operating cash flow, as it is considered non-cash. This item would show up on the balance sheet and cash flow statement as “accounts receivable”, so cash still to receive.
Direct Product Costs – Costs of Goods Sold (“COGS”)
When a company manufactures products, it has to purchase production materials. These production materials are paid using cash, which will subsequently lower the operating cash flow. At the same time, the balance sheet position “inventory” is built up. Once the products get manufactured and sold, the materials are used up and the inventory position decreases. As inventory goes down, either the cash position or accounts receivable increases, depending on whether the company already received the payment.
Operating Expenses (“OpEx”)
Operating expenses are basically the flip side to revenues. Either the company has already paid the invoice, then cash flow would decrease, or the invoice is still outstanding, then the invoice amount would be added back to net income and the operating cash flow.
This also includes compensation, for example. If compensation is paid not using cash but stock, there is no cash moving and, therefore, it should be added back to the operating cash flow.
Depreciation and Amortization
Depreciation and amortization are write-offs of tangible and intangible assets over their useful lives. The underlying principle behind depreciation and amortization is that assets lose value over time. This reduction of value should be accounted for on the balance sheet as well as the income statement. Not, however, on the cash flow statement, as no cash is involved. Therefore, depreciation and amortization is always added back to the operating cash flow
When the accounting and fiscal amount of taxable income differ, a so-called deferred tax position is created. This could either be a deferred tax asset or liability. If it’s an asset, it should be added back, and if it’s a liability, then it should reduce the operating cash flow.
2.2. Cash Flow from Investing Activities
Understanding the cash flow from investing and financing activities is much more straight-forward.
The cash flow from investing activities comprises cash spent or generated through purchasing or disposing of assets, businesses or parts thereof, or other investments. In particular:
- Investing or selling securities
- Buying or selling of tangible and intangible assets, e.g. machines, vehicles, property, trademarks
- Buying or selling businesses, e.g. subsidiaries or parts of a business
- Capital Expenditure, i.e. purchase, maintenance or improvement of assets
2.3. Cash Flow from Financing Activities
The cash flow from financing activities includes cash spent or generated through financing activities:
- Raising or repaying debt
- Issuing or repurchasing equity
- Paying out dividends or noncontrolling interest
2.4. The Formula for Cash Flow Statement Calculation
2.5. Total Change of Cash
The sum of the operating, investing and financing cash flow equals the total change of cash of a certain period. Therefore applies:
The total change of cash is the last item on the cash flow statement. It influences the cash position on the balance sheet.
3. Example of a Standardized Cash Flow Statement Format
4. The Benefits and Purpose of a Cash Flow Statement
The purpose of a cash flow statement is best described by the following:
- Informing on a company’s solvency and liquidity
- Eliminating the impacts of different accounting procedures of companies
- Providing information on a company’s various investing and financing activities
- Helping investors assess whether the company is able to generate future positive cash flows
- Providing support in evaluation changes in equity, liabilities and assets
- Giving explanations as to why income and cash inflow differ
5. Can a Cash Flow Statement be negative?
This is of course possible.
If we look at the example cash flow statement above, we can see that there are a couple of ways this can happen. Not every time a cash flow statement has a negative bottom line, this should be seen as critical.
Example 1: The first line on the cash flow statement could already be negative, i.e. the company has generated a net loss for the period. The subsequent cash adjustments are not material enough to get the cash flow back into the black figures.
Example 2: The company made numerous investments in PP&E or acquired a large competitor. The subsequently negative cash flow from investing activities pulls the overall change of cash into the red figures.
Example 3: The company repaid large amounts of debt at the same time, using not only the cash generated from the current period but also the remaining cash from the balance sheet.
Example 4: The company bought back a large number of its own shares from the public. This example would be of great advantage for investors, as their earnings per share increases.
6. Is a Cash Flow Statement mandatory?
Under the International Financial Reporting Standards (“IFRS”) and most of the national Generally Accepted Accounting Principles (“GAAP”), the cash flow statement is a required part of full financial reporting.
Although there are some differences between the different accounting standards, most of the approaches are very similar.
According to IAS7, which was implemented in December 1992 and became effective as of January 1994, all companies that present a report under IFRS have to prepare a statement of cash flows.
For more information, please refer to this overview.
7. Cash Flow Statement – Direct Method
A cash flow statement can be created using either the direct method or the indirect method.
The direct method of the cash flow statement directly presents the items that make up the cash flow.
Therefore, it does not start with net income/loss as it would, using the indirect method, but with cash collected from customers. There are no add-backs due to non-cash items. However, as net income already considers income tax, we would need to deduct income tax from our cash receipts when using the direct method.
As our example cash flow statement format above of the Example Company, LLC starts with net income, we clearly used the indirect method of calculating cash flow.
8. Cash Flow Statement – Indirect Method
As opposed to the direct method of calculating cash flow, the indirect method of the cash flow statement starts with net income and bit by bit adds back to or reduces the position due to non-cash items.
The indirect method has the advantage that the net income/loss can directly be obtained from the income statement.
The indirect method of calculating cash flow is generally considered to be easier to prepare and, therefore, used by most of the companies that report under IFRS.
9. Cash Flow Statement – Illustrative Examples
9.1. Simplified Example I (no costs, no tax)
- Company A purchases a product worth €100 from Company B
- Company B issues an invoice to Company A, payable within 30 days. Company A has, therefore, not yet paid.
- For simplifying reasons, let’s assume there are no costs to the product and no tax to be paid.
What happens to the cash flow statement of Company B?