What can the Statement of Cash Flows tell you?

The statement of cash flows, as its name implies, summarizes a company’s cash flows for a period of time. The statement of cash flows explains how a company’s cash was generated during the period and how that cash was used. Even if the statement of cash flows seems to be a replacement for the income statement, the two statements have distinct objectives.

The income statement measures the results of operations for a period of time. Net income is the reporting entity’s best estimate representing a company’s economic performance for a period. The income statement provides details as to how the retained earnings account changed during a period and ties together, in part, the changes in the owner’s equity section of period-to-period balance sheets (the income statement started as a disclosure (sheet) of movements in shareholder’s equity).

The statement of cash flows provides details as to how the cash account changed during a period. The statement of cash flows reports the period’s transactions and events in terms of their impact on cash (the true cash in- and outflows). As such, this statement (as one of the four main statements) provides important information from a cash-basis perspective that complements the income statement and balance sheet, thus providing a more complete picture of a company’s operations and financial position.

It is important to note that the statement of cash flows does not include any transactions or accounts that are not already reflected in the balance sheet or the income statement. Rather, the statement of cash flows simply provides information relating to the cash flow effects of those transactions.

Users of financial statements, particularly investors and creditors, can use information about a company’s cash flows in order to evaluate the company’s ability to generate positive net cash flows in the future to meet its obligations and to pay dividends. In some cases, careful analysis of cash flows can provide early warning of impending financial problems.

But also it provides insight in the longer (short) term future, is a company attracting new loans (inflow in the cash from financing activities section), to balance a cash outflow used in the cash flows used in operating activities section?

If yes, that is quite a different story than using that financing cash inflow to invest in new equipment, increasing production capacity through the cash used in investing activities section.

This reasoning is quite over the top, but how many companies arrange new loans because cash from operating activities is lower than the historical benchmark?

Just as a reminder, what is a cash flow statement in short:
Cash flows from (used in):

  • operating activities,
  • investing activities, and
  • financing activities.

Net increase (decrease) in cash and cash equivalents

Or break it up in only in- and outflows:

Operating activities include those transactions and events that are the ultimately only reason for existence and survival of a business. Cash receipts from the sale of goods or services are the major cash inflows for most businesses. Other inflows are cash receipts for interest revenue, dividend revenue, and similar items.

Major outflows of cash in operating activities are for the purchase of inventory and for the payment of wages, taxes, interest, utilities, rent, and similar expenses.

Transactions and events that involve the purchase and sale of securities, property, buildings, equipment and other assets not generally held for resale and the making and collecting of loans are classified as investing activities. These activities occur regularly and result in cash inflows and outflows. They are not classified under operating activities because they relate only indirectly to the entity’s central, ongoing operations, which usually involve the sale of goods and services. The analysis of investing activities involves identifying those accounts on the balance sheet relating to investments (typically long-term asset accounts, such as property, plant and equipment) and then explaining how those accounts changed and how those changes affected the cash flows for the period.

Financing activities include transactions and events whereby resources are obtained from or paid to owners (equity financing) and lenders (debt financing). Dividend payments, for example, fit this definition. The receipt of dividends and interest and the payment of interest are classified under operating activities simply because they are an integral part of operating the business. The receipt or payment of the principal amount borrowed or repaid (but not the interest) is a financing activity.

Cash inflows from:

Cash outflows to:

Operating Activities

Sales of goods and services
Interest revenue
Dividend revenue
Sale of investments in trading securities
Suppliers for inventory purchases
Employees for services
Governments for taxes
Lenders for interest expense
Brokers for purchase of trading securities
Others for other expenses (utilities, rent)

Investing Activities

Sale of property, plant and equipment
Sale of a business segment
Sale of investments in securities other than trading securities
Collection of principal on loans made to other entities
Purchase property, plant and equipment
Purchase debt or equity securities of other entities
Make loans to other entities

Financing Activities

Issuance of company shares
Borrowing (bonds, notes, mortgages)
Shareholders as dividends
Repay principal amounts borrowed
Repurchase an entity’s own stock (treasury stock)

Significant non-cash investing and financing transactions have to be disclosed in a separate schedule or in a narrative disclosure. The disclosure may be presented below the statement of cash flows or in the notes to the financial statements (with a clear cross-reference (IAS 1.113)).

Although the statement of cash flows, like the other financial statements, reports information about the past and careful analysis of this information can help investors, creditors and others assess the amounts, timing and uncertainty of future cash flows. Specifically, the statement helps users answer questions such as how a company is able to pay dividends when it had a net loss or why a company is short of cash despite increased earnings. A statement of cash flows may also show that external borrowing or the insurance of capital stock provided the cash from which dividends were paid even though a net loss was reported for that year. Similarly, a company may be short on cash, even with increased earnings, because of increased inventory purchases, plant expansion or debt retirement.

Trends are often more important than absolute numbers for anyone period. Accordingly, cash flow statements are usually presented on a comparative basis. This enables users to analyze a company’s cash flows over time. Because companies are required to highlight cash flows from operating, investing and financing activities, a company’s operating cash flows and investing and financing policies can be compared with those of other companies. It could be learned much about a company by examining patterns that appear among the three cash flow categories in the statement of cash flows. Thus, there are more patterns regarding the cash flows from the three types of activities. The exhibit from below shows eight possible cash flow strategies and provides some insight into what each cash flow strategy might imply about the company:

No.

Cash flow from operating activities

Cash flow from investing activities

Cash flow from financing activities

Possible company strategy

1

+

+

+

A company is using cash generated from operations, from the sale of assets and from financing to build up a pile of cash (very liquid company) possibly looking for an acquisition.

2

+

A company is using cash flows generated from operations to buy fixed assets and to pay down debt or pay owners.

3

+

+

A company is using cash from operations and from the sale of fixed assets to pay down debt or pay owners.

4

+

+

A company is using cash from operations and from borrowing (or from owner investment) to expand.

5

+

+

Company’s operating cash flow problems are covered by the sale of fixed assets, by borrowing or by stockholder contributions.

6

+

Company is growing rapidly, but has shortfalls in cash flows from operations and from a purchase of fixed assets financed by long-term debt or new investment.

7

+

A company is financing operating cash flow shortages and payments to creditors and/or stockholders via the sale of fixed assets.

8

A company is using cash reserves to finance operation shortfall and pay long-term creditors and/or investors.

The most common pattern is a positive cash flow from operating activities and negative cash flows used in investing and financing activities. Companies use cash flows from operations to purchase fixed assets or to pay down debt.

Growing companies generally show a positive financing activities cash flow and negative cash flows from operating and investing activities. Cash is being borrowed to cover a shortage of cash from operations as well as to purchase fixed assets to facilitate growth.

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