Every dollar in the “AR” item in the balance sheet is a dollar of sales that has not yet been collected. It increases the net profit in the profit and loss statement by $1 beyond the cash accumulated by the company during the period.

For example, if the net profit during the period was $10, and the “AR” item grew by $1, then the cash accumulated by the company during the period was $9 ($1 less than its net profit). The customer who is due to pay the $1 to the company shortly possesses the missing dollar (see Scenario 2 in the following illustration).

On the other hand, every $1 in the “AR” item in the balance sheet represents $1 in expenses that the company has not yet paid, and increases the company’s cash by $1, in relation to the net profit.

Example: If the net profit for the period was $10, and the “AR” item grew by $1, then the cash accumulated by the company during the period totaled $11 ($1 more than its net profit). The extra Dollar belongs to the supplier whom the company is due to pay shortly (see Scenario 3 in the following illustration).

Scenario 1 All transactions are in cash		Scenario 2 $1 in customer credit		Scenario 3 $1 in credit from suppliers
Added Cash	Net Profit	Added Cash	Net Profit	Added Cash	Net Profit
$10	$10	$9	$10	$11	$10
				●
●	●	○	●	●	●
●	●	●	●	●	●
●	●	●	●	●	●
●	●	●	●	●	●
●	●	●	●	●	●
●	●	●	●	●	●
●	●	●	●	●	●
●	●	●	●	●	●
●	●	●	●	●	●
●	●	●	●	●	●
		The customer has this dollar		The supplier owns this dollar

Key

$1 = ●

$0 = ○

The complete structure of the cash flow statement

Learning how to prepare a cash flow statement requires mastering these three spheres of activity:

1. Operating activity.
2. Investment activity.
3. Financing activity.

Movements of cash take place in each of these spheres during the period. Movements of cash in each sphere are independent of activity in the other spheres. 

Movements of cash and the net movement of cash (entry of cash minus exit of cash) are listed separately in each sphere. The sum of the net movements of cash in each of the three spheres of activity reflects the difference between the company’s cash at the beginning of the period and its cash at the end of the period.

1. Financing activity : 
Financing cash flows include the movement of cash associated with issuing and buying-back shares in the company, paying dividends to shareholders and borrowing or repaying loans. Assume that USA Chairs received a $10,000 bank loan, and repaid $2,000. The company’s cash from financing activity grew by $8,000 during the period ($10,000 entering minus $2,000  exiting).
2. Investment activity:
 Investing cash flows are payments resulting from the use or sale of long-term assets. Movements of cash in this section include: 
• Payments for the purchase of property, plant and equipment (PP&E).
• The disposal (sale) of assets.
• Payments related to mergers and acquisitions.
• Dividends received from equity investments.
3. Operating activity: 
These cash movements come from the firm’s operations. Operating cash flows include cash sales, payments from customers for credit sales, payments to suppliers, and paid employee wages. Accounting standards such as IAS 7 and US GAAP allow some flexible categorization for some cash flows, particularly for financial institutions. Cash interest paid, cash paid for dividends, retiring debt or equity instruments, and collecting cash from dividend income or interest income are sometimes classified as operating cash flows and sometimes not. 

In the case of USA Chairs, assume that its current activity was as follows:

• Sales – sales totaled $80,000, all of which was in cash. 
• Expenses – purchases of raw materials + payment  of salaries totaled $60,000, all of which was in cash. Net cash flow from current activity  therefore grew by $20,000 ($80,000 entered and $60,000 left)

The complete cash flow statement of USA Chairs :

USA Chairs’ Cash Flow Statement for 2007 ($)

Cash flow from operating activity	$ 20,000 (increase)
Cash flow from investment activity	– $ 8,000 (decrease)
Cash flow from financing activity	$ 8,000 (increase)
Total increase in cash flow	$ 20,000

A shorter method on how to prepare a  cash flow statement from current activity will now be explained.

The current activity section of the cash flow statement is also commonly referred to as the operating cash flow.

A shortcut for calculating cash flow from current activity

This calculation method assumes that all the company’s sales and expenses during the period are in cash, except for transactions for which the full proceeds were not paid, which must be traced and analyzed. 

Had all sales and expenses during the period been in cash, then the net profit (or net loss) listed in the profit and loss statement would also have reflected the change in cash (assuming that there was no depreciation). Had the company earned a $1,000 profit, then its cash on hand would have grown by $1,000. 

When a company sells on credit, the unpaid balance is listed in the customers ledger account and in the “AR” item in the balance sheet (on the assets side). When the company has expenses for which it has not yet paid, the unpaid balance is listed in the suppliers ledger account and in the “AP” item in the balance sheet (on the liabilities side). 

These two items, “AP” and “AR”, can therefore be used to calculate what sums have not yet been paid in cash. The “AR” item indicates the amount of sales that have not yet been paid in cash. 

The “AP” item indicates the amount of expenses that have not yet been paid in cash. The change in the company’s cash during the period can be deduced from these two items. This will be explained in more detail .

An important comment

It is important to remember that individual customers and suppliers are unimportant in cash flow; what is important is the total picture, i.e. the balances of the “AR” and “AP” items.

Assume that USA Chairs was founded on December 31, 2007, and the founder invested $40,000 of his own money. He bought a machine for $30,000, and deposited the remaining $10,000 in the company’s bank account. He received share capital from the company in return for his investment.

The balance sheet of USA Chairs Ltd. on the day that the company was founded is as follows:

USA Chairs’ Balance Sheet as of December 31, 2007 ($)

Assets		Liabilities + Equity
Cash	10,000
Machine	30,000	Equity	40,000
Total	40,000	Total	40,000

Activity during the 1st year:

Activity during the 1st year (2008) was as follows:

Sales: $10,000.  Payment terms: Cash.

Expenses: $8,000.  Payment terms: $5,000 in 2008, $3,000 in 2009.

The USA Chairs’ Profit in 2008 was as follows ($):

Sales	10,000
Expenditures	(8,000)
Net profit	2,000

This is how to prepare a cash flow statement in long method:

Cash Flow from Current Activity ($)

Incoming cash	10,000
Outgoing cash	(5,000)
Net cash flow from current activity	5,000

The company has no cash flow in the other spheres (financing activity and investment activity). Cash flow by the short method ($) is as follows:

Cash Flow from Operating Activity ($)

Net profit	2,000
Increase in suppliers item	+3,000	(expenditures not paid in cash)
Net cash flow from current activity	5,000

The company’s balance sheet as of the end of the year is as follows:

USA Chairs’ Balance Sheet as of December 31, 2008 ($)

Assets		Liabilities + Equity
Cash	15,000	AP	3,000
Machine	30,000	Equity	40,000
		Retained Earnings	2,000
Total	45,000	Total	45,000

            

Activity in the 2nd year:

Activity in the 2nd year (2009) is as follows:

Sales – $20,000 Payment terms: $15,000 in cash, $5,000 in June 2010 (the following year).

Expenses – in $12,000 Payment terms: $4,000 in cash, $8,000 June 2010 (the following year).

Net profit in 2009 is as follows (figures in $):

Sales	20,000
Expenditures	(12,000)
Net profit	8,000

The cash flow by the long method is as follows (figures in $):

Incoming cash	15,000
Outgoing cash	(4,000)
Net cash flow from current activity	11,000

The cash flow by the short method is as follows (figures in $):

Net profit	8,000
Increase in AP item	+8,000	(unpaid expenditures)
Increase in AR item	-5,000	(uncollected revenue)
Net cash flow from current activity	11,000

The Effect of Depreciation on Cash Flow

As explained above, provision for depreciation in a given period reflects the value of the wear on fixed assets resulting from their use during that period. Depreciation expenses are treated as expenditure in the profit and loss statement, although no cash actually leaves the company in the case of depreciation.

In other words, in the profit and loss statement, depreciation expenses are an element of cost of sales, and decrease the company’s profit, although no cash is actually paid for them. Cash actually left the company when the asset was purchased.

Example:

Company A conducts all its transactions in cash, and has no depreciation expenses. It earned a $10 profit in 2007, and therefore added $10 to its cash. Company B also conducts all of its transactions in cash, but it has $1 in annual depreciation expenses.

The company also earned a $10 profit in 2008, excluding depreciation. Following provision for depreciation, however, its net profit fell to $9.

Company A No provision for depreciation		Company B $1 provision for depreciation
Added Cash	Net Profit	Added Cash	Net Profit
$10	$10	$10	$9
●	●	●	○
●	●	●	●
●	●	●	●
●	●	●	●
●	●	●	●
●	●	●	●
●	●	●	●
●	●	●	●
●	●	●	●
●	●	●	●
		This dollar was a provision for depreciation

To summarize, every dollar that the company lists as a provision for depreciation in the profit and loss statement decreases the net profit by $1, without a corresponding decrease in cash. This will be demonstrated through a simple example, in which the activity of USA Toys Company in 2008 is analyzed.  

Example: 

USA Toys’ Balance Sheet as of December 31, 2006 ($)

Assets		Liabilities + Equity
Current Assets		Liabilities
Cash	50,000	Bank loans	60,000
Fixed Assets
Machine	90,000	Equity	80,000
Total	140,000	Total	140,000

The balance sheet of USA Toys at the beginning of 2007 is as follows:         

Activity in 2007:

Sales:

$80,000. Payment terms: Cash.

Expenses:

Raw materials – $30,000.   Payment terms: Cash. 

Salaries – $10,000.     Payment terms: Cash. 

Miscellaneous expenses – $10,000.   Payment terms: Cash.

Depreciation:

$10,000 (10% of the $100,000 purchase price of the machine).  The company’s profit and loss statement for 2007 is as follows:

The company’s balance sheet as of the end of 2007 is as follows:

USA Toys’ Profit and Los Statement for 2007 ($)

Revenues	80,000
Raw materials	(30,000)
Salaries	(10,000)
Overhead expenditures	(10,000)
Depreciation expenditures	(10,000)
Total cost of sales	(60,000)
Net profit	(20,000)

The company’s balance sheet as of the end of 2007 is as follows:

USA Toys’ Balance Sheet as of December 31, 2007 ($)

Assets		Liabilities + Equity
Current Assets		Liabilities
Cash	(1) 80,000	Bank loans	60,000
Fixed Assets		Equity	80,000
Machine	(2) 80,000	Retained earnings	20,000
Total	160,000	Total	160,000

(1)                 50,000                 +            (80,000          –        50,000)       =     80,000

          Cash – opening balance               Cash entering             Cash exiting

(2)                  90,000                –     10,000 = 80,000

        Machine- opening balance        Annual depreciation

 

The company’s cash flow includes $80,000 in entering cash (sales) and $50,000 in exiting cash (cost of sales, net of depreciation).

The company’s cash from current activities therefore grew by $30,000. This cash flow can be shown as follows:

USA Toys’ Cash Flow Statement for 2007 ($)

Cash flow from operating activity:		30,000
Net profit	20,000
Plus depreciation expenditures	10,000
Cash flow from investment activity		0
Cash flow from financing activity		0
Total increase in cash flow in 2007		30,000
Balance of cash at the beginning of the period (January 1, 2007)		50,000
Balance of cash at the end of the period (December 31, 2007)		80,000