Key Takeaways
- A company’s statement of cash flows shows in detail the cash inflows and cash outflows related to the operating, investing and financing activities of the company over a period of time.
- Financing activities are transactions related to debt and equity financing that change the size of the company’s contributed equity and its borrowings.
- Investing activities are transactions related to the acquisition and disposal of long-term assets such as property, plant and equipment, intangible assets and long-term investments.
- Operating activities are transactions related to the principal revenue-producing activities of a company and are not classified as investing or financing activities.
Introduction to the Statement of Cash Flows
The Statement of Cash Flows is a financial statement that shows in detail the cash inflows and cash outflows of an entity and the net change in cash over a specific period.
The Statement of Cash Flows is one of the financial statements that you need to prepare at the end of every accounting period. It presents the cash receipts or inflows, and cash payments or outflows related to the operating, investing and financing activities of your company during a period of time.
Having information about your company’s cash is very important especially during the early stages of business operations. Cash will keep your business afloat as you build it that’s why it is very important that you monitor all the cash inflows and outflows that result from the different activities and transactions of your company.
Cash flow is the flow of money into and out of your company. An increasing cash flow is preferred because it represents the ability of your company to pay obligations and to grow.
But before we continue, let’s first understand what is considered as cash. A company’s cash includes the following:
- Cash on hand
- Cash in bank such as demand deposits.
- Cash equivalents such as short-term highly liquid investments that are readily convertible to a known amount of cash, and that are subject to an insignificant risk of changes in value. This means that the value of these investments won’t increase or decrease significantly over short-term and long-term periods of time.
Purpose of the Statement of Cash Flows
Aside from startup businesses, the statement of cash flows is also an important report for large companies and various stakeholders. Its purpose is to help you:
- Assess your company’s ability to generate future cash inflows that, ideally, should be more than the cash outflows.
- Assess management’s stewardship function over the assets of your company. This includes their ability to obtain and spend cash.
- Understand your company’s operating activities and their ability to generate cash.
- Evaluate your company’s investing activities and financing activities from which cash funds are also provided or used.
- Develop models to assess and compare the present value of future cash flows of different entities.
In addition to the above uses of the statement of cash flows, it can also guide the finance officer and management to plan for the company’s future cash flows. Historical cash flow information can be used as an indicator of the amount, timing and certainty of future cash flows. Effective and proper planning will ensure sustainable and positive cash flows.
As your company operates, it will enter into a variety of business transactions to support its goals. These business transactions fall into three main types of business activities that affect the cash amounts of your company.
Business activities are the economic transactions that are undertaken by a business for the purpose of generating profits and improving its financial condition.
Some common business activities are as follows:
- Investment of cash and property by the owners and investors
- Sale of goods and services
- Purchase of property, plant and equipment;
- Raising of funds through debt financing
- Distribution of profits to owners and investors
- Purchase of office supplies
- Payment of employee salaries
The three main types of business activities that are presented in the statement of cash flows are financing, investing and operating.
Financing Activities
Financing activities are activities that result in changes in the size and composition of the contributed equity and borrowings of the entity. (IAS 7)
Every company needs some source of financing to fund its operations. The two major sources of financing that your company can have are equity financing and debt financing.
Equity financing refer to the investments made by the owners or shareholders of a company. On the other hand, debt financing refers to additional financing obtained by a business through borrowings from lenders.
The financing activities of your company will always involve any of the following transactions:
- Obtaining business capital via equity financing and debt financing. They result in cash inflows under financing activities.
- Distribution or return of company resources to owners in the form of corporate dividends or withdrawal of assets by a partner or a sole proprietor. This also includes amortization payments to creditors. Both should result in cash outflows under financing activities.
A key factor that could help you determine if a transaction is a financing activity is that it is either equity-related or debt-related. Equity-related are transactions made between the business and its owners while debt-related transactions are those entered between the business and its creditors.
Analyzing cash flows arising from financing activities are important because it helps when you need to predict claims on future cash flows by the providers of equity and debt financing such as shareholders and creditors.
Some examples of financing activities that result in inflows of cash to the company are:
- Cash investments made by owners and shareholders. This includes issuance of new shares by a corporation when raising capital.
- Capital received when borrowing money from lenders.
Examples of financing activities that result in outflows of cash from the company are:
- Withdrawal of resources by a sole proprietor or a partner.
- Buying back or redemption by a corporation of corporate shares from its shareholders.
- Repayment of the amounts borrowed.
- Cash dividends paid to shareholders. However, this can also be classified as cash outflows from operating activities to determine the ability of the company to pay dividends out of operating cash flows.
Investing Activities
Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents. (IAS 7)
After your company has acquired the necessary funds and after it has accumulated enough profits, it can invest in long-term assets that are intended to generate future income and cash flows.
The investing activities of your company will always involve transactions related to capital expenditures and financial assets that are being used by the business. These activities are important for the growth, expansion and modernization of your business that could result in increased profits and capital gains in the future.
A key factor for identifying investing activities is that they usually involve investments in long-term assets.
The following are examples of investing activities:
- Purchase and sale of property, plant and equipment such as land, buildings, machinery, and vehicles.
- Purchase and sale of long-term debt instruments of other entities such as corporate bonds and treasury bonds.
- Purchase and sale of equity instruments such as shares of other corporations.
- Purchase and sale of intangible assets such as patents and copyrights.
- Cash advances and loans made to other parties which also include collections from those advances and loans. This does not include advances and loans made by a financial institution since they relate more to the operations of those entities.
Operating Activities
Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities. (IAS 7)
Operating activities are those transactions involved in the principal revenue-producing activities of your business. These activities represent the core, common and day-to-day activities that affect the financial performance of the business.
The cash that flows from operating activities represent cash received from customers and cash paid for the expenses incurred by the business. The amount of the cash flow is an indicator of the extent to which the operations of your company have generated sufficient cash to pay its loans, maintain its operations, pay dividends, and make new investments without using and relying on external sources of financing.
A key factor in determining an operating activity is that they enter into the determination of operating income and are not classified as either investing or financing activity.
The following are examples of operating activities:
- Production and sale of goods and services to customers. This also includes refunds to customers.
- Receipt of royalties, fees, commissions and other revenue.
- Purchase of goods and services from suppliers.
- Payment of expenses involved in the management and overall administration of the business.
- Payment of expenses involved in the promotion, sale and delivery of goods and services.
- Payment and refund of income taxes unless they can be specifically identified with financing and investing activities.
- Interest payments to creditors. However, the portion of amortizations applied to the principal of the loan is classified as financing activities.
- Cash advances and loans made by a financial institution such as a bank.
If you’ll notice in the above examples, some transactions such as the payment and receipt of interests and dividends can be classified into different activities depending on how the company views its purpose or function. Some examples are as follows:
- Interest received from investments that are usually classified as an operating activity can alternatively be classified as investing activity if the management considers it as a return on its investment.
- Interest payment on a loan that is considered as an operating activity can instead be classified as financing activity as a cost of borrowing capital.
Whatever way your business classifies its activities, IAS 7 requires that your company’s classification of business activities should be consistent from period to period when it prepares the statement of cash flows.
Flow of Business Activities
While the three major categories of business activities discussed above work differently from one another, they are also connected and can affect each other in several ways. The flow chart below shows an illustrative example of how they could work with each other in your business.
- The flow of business activities typically starts with a financing activity that involves obtaining business capital through equity and/or debt financing for your business.
- After raising the initial capital, your company can then start to invest in fixed assets that can help generate income and cash flows for your business. This transaction is classified as an investing activity.
- Throughout the year, your business can enter into different transactions that include buying supplies for use in its operations, selling goods or services, and paying administrative and selling expenses. These transactions are classified as operating activities.
- At the end of the year, let’s assume that the activities of your business resulted in net income where total revenues exceeded total expenses.
- Your company can reinvest a portion of the profits back to the business by investing in more fixed assets and financial assets. These transactions are again classified as investing activities.
- Some of the profits may be used to repay a portion of the loan that your business has acquired. It can also be distributed to shareholders as dividends. These transactions are classified as financing activities.
Presentation of Statement of Cash Flow Items
As you’ve already learned above, the statement of cash flows reports the cash flows during the period classified by operating, investing and financing activities. By classifying information by activities, the statement of cash flows could allow you to assess their impact on your company’s financial position and the amount of cash and cash equivalents it has.
Similar to the income statement, the statement of cash flows covers a certain period of time. This period of time can be one year, six months, one quarter, or one month.
The statement of cash flows starts with the beginning cash balance amount and ends with the ending cash balance amount. In between these two amounts are the net cash amounts provided by each of the three activities.
To compute for the ending cash balance during the period, the net cash flows for each of the three activities are either added to (in case of cash inflow) or subtracted from (in case of cash outflow) the beginning cash balance during the period. The resulting amount will be the ending cash balance which should also equal the ending balance of your cash and cash equivalents.
Reporting of cash flows from operating activities
When reporting the cash flows from your company’s operating activities, you can use either the Direct Method or the Indirect Method of presenting information.
Direct Method
Under the direct method, major classes of gross cash receipts and gross cash payments are disclosed. This is done by listing every operating activities of your company during the period that have produced cash receipts and cash payments. The difference in their amounts are the net cash flows from operating activities.
Below is an example of how cash flows from operating activities are presented using the direct method.
Under IAS 7, companies are encouraged to report using the direct method since it is useful in estimating future cash flows from operating activities.
Indirect Method
Under the indirect method, the amount of net income or net loss of your company during the period is adjusted by the following:
- Effects of non-cash transactions (e.g. depreciation, amortization, provisions, deferred taxes, unrealized foreign currency gains and losses, and undistributed profits of associates).
- Any deferrals or accruals of past or future operating cash receipts or payments (e.g. increases and decreases in inventories and operating receivables and payables such as trade non-cash current assets and trade current liabilities, respectively).
- Items of income or expense associated with investing or financing cash flows.
To compute for the net cash flows from operating activities using the indirect method, start with the net income or net loss from your company’s income statement then make the necessary adjustments by adding or deducting the above items from it. Here’s an example of how it should look.
Observe that when using the indirect method, the net income or net loss that was computed using accrual accounting is converted to cash basis after applying the adjustments.
IAS 7 specifies the indirect method as an alternative method to present cash flows from operating activities. However, take note that the direct and indirect method only applies to operating activities.
Reporting of cash flows from investing and financing activities
Similar with the direct method of reporting cash flows from operating activities, your company shall report separately major classes of gross cash receipts and gross cash payments arising from investing and financing activities, as stated in IAS 7.
To compute for the net cash flow arising from investing activities, list all investing activities that have produced cash receipts and cash payments during the period. Below is an example of reporting cash flows arising from investing activities.
The similar approach applies with computing the net cash flow arising from financing activities.
Non-cash transactions
Sometimes, your company could have transactions that can be related to investing and financing activities but without any cash involved. Some examples of these non-cash transactions are as follows:
- When your company acquires assets either by assuming directly related liabilities or by means of a lease.
- When your company acquires an entity or assets by means of issuing equity shares.
- When your company owns a debt instrument such as bonds payable that can be converted to equity shares.
How would you treat these non-cash transactions? Can you include them in the statement of cash flows?
According to IAS 7, investing and financing transactions that do not require the use of cash or cash equivalents shall be excluded from the statement of cash flows. These transactions can be disclosed separately in a way that provides all the relevant information about these investing and financing activities.
Since non-cash transactions do not involve cash flows during the current accounting period, they are excluded from the statement of cash flows, which is consistent with the objective of the financial statement.
To complete the statement of cash flows, we will combine the examples above for operating, investing and financing activities incorporate them with the beginning balance of cash and cash equivalents. Below is an example of the statement of cash flows prepared using the direct method.
Here’s an example of the statement of cash flows prepared using the indirect method.
Observe that using any of the two methods would still yield the same bottom line amount of cash and cash equivalents.
To verify the ending amount in the statement of cash flows, compare it to the total balance of the cash and cash equivalent ledger accounts in your general ledger. Both the statement of cash flows and the ledger accounts should reveal the same ending amounts.
Review Questions
- What are the three types of business activities? Name some business transactions that can be classified under each business activity.
- How can the statement of cash flows help its users?
- How can you verify the correctness of the ending amount of cash and cash equivalents in the statement of cash flows?
- What are the key factors that differentiate the operating, investing and financing activities?
- Give some examples of adjustments to be applied to net income to compute for the net cash flows from operating activities.
