From this post we begin a series of posts covering the various aspects of the cash flow statement. Over the next few posts we will cover the format of the Cash flow statement or the statement of cash flows as they are also known , the different types of cash flows and the different methods of preparation of cash flow statements. Today we start with the overview of the topic…. So let’s begin…
Cash flow statement – Understanding the basics
Cash flow statement records the receipts and payments of cash during an accounting period. Cash flow statements help to tie up the beginning cash balance on the balance sheet with the ending cash balance. The Statement of cash flows, as they are also called, differs from income statements in that they do not follow accrual accounting. (Read more about accrual accounting here). They record cash receipts when they are collected as against when they are earned.
A comparison of the income statement and cash flow statement of an accounting period will give you insights into how and when and whether cash is being generated from the operating activities of the firm. For example, a firm may have huge sales, but if all its sales are made on credit with no guarantee of collecting its account receivables, it would have no cash to survive.
In addition to operating activities, the statement of cash flows also provides information about a firm’s investing and financing activities. It gives important answers to questions such as is the firm financing new asset purchases through cash generated from its operations or through issuance of new debt, does the firm have enough cash on hand to take advantage of new opportunities that crop up, does it have enough cash to meet unexpected obligations, does the firm pay dividends to shareholders from cash generated from its operations or by issuing fresh debt and does it have enough cash to run its day to day operations.
The Statement of cash flows: Components
Items in a cash flow statement come either from the items recorded on the income statement or from changes in balance sheet items. Cash flows are classified into three categories on the statement of cash flows;
Operating cash flows
Operating cash flows on cash flow statements are those that result from the main operations of the firm. Operating cash inflows include cash receipts from sales made on credit, receipts of royalties, commissions, sales proceeds from trading securities. Cash outflows include payments to suppliers, salaries paid, taxes paid, payment of accounts payable and acquisition of trading securities.
Investing cash flows
Investing cash flows on cash flow statements are those cash flows resulting from acquisition or sale of assets and investments (non-trading). Investing cash inflows include proceeds from sale of property plant and machinery, sale of intangible assets, proceeds from sale of debt and equity investments (other than securities held for trading). Cash outflows include acquisition of property plant and machinery and intangible assets, acquisition of non trading securities.
Financing cash flows
Financing cash flows on cash flow statements are cash flows resulting from transactions that affect the capital structure of the firm. They include issuance or repayment of debt and issuance or buyback of stock.
Ideally, interest and dividend should be classified as operating cash flows by a financial company and as non operating cash flows by non financial companies. However, IFRS grants some flexibility in classification of interest and dividend to all firms. Under IFRS, interest or dividend received may be classified as either an operating or investing cash flow while interest or dividend paid may be classified as either operating or financing cash flow.
Other than this, IFRS classifies income tax expense as operating cash flow unless the tax expense is found to be related to investing or financing activities. However, whichever classification they choose, firms should be consistent in their approach across accounting periods.
GAAP does not grant any flexibility in classification of cash flows. Under GAAP, interest received and paid is reported as operating cash flows for all firms. Dividend received is classified as operating cash flow while dividend paid is always reported as financing cash flow. Under GAAP, all income tax expenses are classified as operating cash flows.
Reporting of non cash activities on cash flow statements
Non cash transactions do not get reported on the cash flow statement. However, significant non cash transactions should be disclosed as either a footnote or a supplementary schedule to the statement of cash flows.
Non cash transactions include barter transactions, issuance of stock dividends, and conversion of convertible debt or preferred stock into common stock.
That’s all in this post…thanks for reading…if you liked the post don’t forget to share it…in the next post we will cover direct and indirect formats of the cash flow statement…stay posted…
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
This post contains affiliate links. Please see the disclosure policy for more information.