What is it and what are the components?
A Cash Flow Statement shows the amount of cash coming in and going out of a company. It allows users to understand a company’s operational activity and usage of cash. We would argue that this may be the most important financial statement because it tells the most complete story on an individual basis. If you have heard “Cash is King” then you may have heard correctly. Especially operating cash flow as it is directly linked to liquidity.
The Cash Flow Statement is categorized into three categories
1. Cash Flow from Operating Activities (CFO), other known as Operational Cash Flow (OCF)– In and outflows of cash that directly impact a firm’s net income. In this case, you would add net income, depreciation and amortization, and changes in working capital. Working capital includes current assets such as cash, marketable securities, accounts receivables, inventory, pre-paid expenses; and current liabilities, such as short-term debt, portion of long-term debt due in less than a year, accounts payable, accrued expenses, income taxes, and accrued liabilities.
2. Cash Flow from Investing Activities (CFI) – In and outflows of cash from acquisition or disposal of long-term assets and other certain investments. When you see changes in acquisitions, joint ventures, or changes capital expenditures such as plant, property, and equipment or contractual instruments of value, you may associate it with changes in investing activities.
3. Cash Flow from Financing Activities (CFF) – In and outflows of cash from transactions affecting a firm’s capital structure. Increases in bonds payable, debt issue costs, repurchases of corporate bonds, issuance of equity or repurchases of stock, minority interest, book overdraft, and cash dividends paid are all examples.
A Use or Source of Cash
When we hear a use of cash, it is simply telling us a decrease in the amount of our cash; while a source of cash is an increase in the amount of our cash. Use the following as a rule of thumb:
1. Increase in assets is a use of cash (i.e. purchasing more inventories)
2. Increase in liabilities is a source of cash (i.e. purchasing more long-term debt for cash)
3. Increase in equity is a source of cash (i.e. selling common stock for cash)
4. Decrease in assets is a source of cash (i.e. decrease in accounts receivable and receiving cash)
5. Decrease in liabilities is a use of cash (i.e. paying back the principle of a corporate bond)
6. Decrease in equity is a use of cash (i.e. repurchasing treasury stock for cash)
It is important to think about cash movements in terms of the accounting equation. Note that in the following equation, the triangles signify the “changed of” (aka delta): Δ Cash Assets = Δ Liabilities + Δ Owner’s Equity - Δ Non-cash Assets.
Mathematically we can assume the following:
An increase in Δ Assets leads to an increase in either Δ Liabilities and/or Δ Owner’s Equity, or a decrease in Δ Non-Cash Assets. The opposite applies for the other direction.
What is Free Cash Flow?
In short, it is available cash.
There are two ways in looking at free cash flow. You have Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE). FCFF is the available cash to all investors, both debt holders and equity owners. FCFE is available cash available to all common shareholders after all the more senior obligations have been met. For illustrative purposes refer to the formulas below:
1. Cash Flow From Operating Activities (CFO) = Net Income + Depreciation – Taxes +/- Changes in Working Capital.
2. Free Cash Flow to Firm (FCFF) = CFO + [Interest Expense * (1-Tax Rate)] – Fixed Capital Investments
3. Free Cash Flow to Equity (FCFE) = CFO – Fixed Capital Investments + Net Borrowing
Formats of the Cash Flow Statement: Direct or Indirect
For either the direct or indirect method, the amount of operating cash flow is identical, only the presentation of operating cash flow section differs. Investing and financing activities are the same for both formats.
The direct method shows the specific cash inflows and outflows that result in reported cash flow from operating activities. The indirect method uses accounting and account information. Users of financial statements prefer the direct format due to the importance of operating receipts, payments to asset financing needs, and capacity obligations. To convert a direct cash flow statement to indirect, it is done by (1) adjusting each separate income statement account for changes that associate with the balance sheet accounts and (2) eliminating non-cash items.
The following is a quick snapshot to preparing a Cash Flow Statement using the Direct Method:
1. Cash received from customers: Revenue – Increases in AR
2. Cash paid to suppliers: COGS + Increases in Inventory – Increases in AP
3. Cash paid to employers: Salary and Wage Expense – Increases in Salary and Wage Payable
4. Cash paid for other operating expenses: Other Operating Expenses + Increase of Prepaid Expense – Increase of Accrued Liabilities
5. Cash paid for interest: Interest Expense – Increase in Interest Payable
6. Cash paid for income tax: Income Tax Expense – Increase in Income of Tax Payable
7. Cash paid for investing activities (i.e. equipment purchase): Gain on Sale + Book Value (Book Value = Purchase Price – Depreciation)
8. Cash paid for financing activities (i.e. dividends paid): Beginning Retained Earnings – Ending Retained Earnings + Net Income
Key Differences between GAAP and IFRS Treatments in Cash Flow Statement
1. Interest received: GAAP – Operating, IFRS – Operating Cash Flow or Investing Cash Flow
2. Interest paid: GAAP – Operating, IFRS – Operating Cash Flow or Financing Cash Flow
3. Dividends Received: GAAP – Operating, IFRS – Operating Cash Flow or Investing Cash Flow
4. Dividends paid: GAAP – Financing, IFRS – Operating Cash Flow or Financing Cash Flow
5. Bank Overdrafts: GAAP – Financing Cash Flow, IFRS – Cash Equivalents
6. Taxes Paid: GAAP – Operating Cash Flow, IFRS – Generally operating, but some cases a portion may be allocated to Investing Cash Flow or Financing Cash Flow
7. Earnings starting point: GAAP starts with Net Income, IFS starts with Operating Income