The cash flow statement reports movements of cash by the company. If the company has $100 in cash at the beginning of the year (date A) and $500 in cash at the end of the year (date B), the cash flow statement will explain what caused the $400 increase.

The purpose of the cash flow statement is to explain what caused the difference between the amount of cash the company had at the beginning of the period (date A) and the amount of cash it had at the end of the period (date B). The difference could also be 0.

Date A:      $100

Date B:       $500

Difference: $400

 

The term “cash flow” reflects a movement of cash: Receiving cash on the one hand (cash that flowed into the company) and the payment of cash on the other hand (cash that flowed out of the company).

The company usually keeps most of its cash in the bank in a current account or short-term deposit, and a small amount in the company treasury. When discussing cash activity in a company, it is important to distinguish between two important concepts:

Movements of cash – means both the entry and exit of cash.

Net movement of cash – presents the difference between the total cash that entered and the total cash that exited.

A background example

To give you a good overview on how to prepare a cash flow statement, consider the following example of a small company named USA Chairs in 2007.  The example will present two scenarios:

1. All the business transactions are conducted in cash.
2. Some transactions are on credit.

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

Assets		Liabilities + Equity
Cash	50	Bank loans	60
Machine	50	Equity	40
Total	100	Total	100

Scenario 1 – all activity is in cash

Sales:

Sales totaled $80,000. Payment terms: Cash.

Expenses:

Expenses totaled $60,000 according to the following list:

Purchases of raw materials (wood, glue, etc.) – $40,000

Salaries of production workers – $10,000

Fixed expenses (including management, marketing, advertising, financing and general expenses) — $10,000

All expenses were paid in cash.

The company’s profit and loss statement for 2007 is as follows:

USA Chairs’ 2007 Profit and Loss Statement ($)

Sales	80
Cost of sales (raw materials + salaries)	(50)
Gross profit	30
Fixed expenses	(10)
Net profit	20

The balance sheet for  the end of 2007 is as follows:

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

Assets		Liabilities + Equity
Cash	* 70	Bank loans	60
Machine	50	Equity	40
		Retained Earnings	20
Total	120	Total	120

* 50      +     (80 – 60)     =     70

Opening balance            Entry               Exit

The company’s cash flow statement for 2007 is as follows:

USA Chairs’ 2007 Cash Flow Statement ($)

Cash at beginning of the year		50
Money flows from (used in) operating activities		20
Cash receipts from customers	80
Cash paid to suppliers and employers	60
New cash balance (end of the year)		70

Scenario 2 – giving and receiving credit:

Sales:

Sales totaled $80,000.

Payment terms: $60,000 is due in June 2007 (during the year) and the balance ($20,000) is due in June 2008 (next year).

Expenses:

Expenses totaled $60,000, according to the following list:

1. Raw materials – $40,000 – to be paid in June 2008 (next year). 
2. Salaries – $10,000 – paid in cash.  
3. Fixed expenses – $10,000 – paid in cash.  

 

The company’s profit and loss statement for 2007 is exactly the same as in Scenario 1:

USA Chairs’ 2007 Profit and Loss Statement ($)

Sales	80
Cost of sales (raw materials + salaries)	(50)
Gross profit	(30)
Fixed expenses	(10)
Net profit	20

 

(Assuming that the company is exempt from taxes).

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

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

Assets		Liabilities + Equity
Cash	* 90	Account Payable	40
Account Receivable	20	Bank loans	60
Machine	50	Equity	40
		Retained Earnings	20
Total	160	Total	160

* 50         +                  [60                  –              (10              +     10)]      =     90

Opening balance        Receipts from customers        Fixed Expenditures        Salaries

The company’s cash flow statement for 2007 is as follows:

USA Chairs’ 2007 Cash Flow Statement ($)

Cash at beginning of the year		50
Money flows from (used in) operating activities		40
Cash receipts from customers	60
Cash paid to suppliers and employees	20
New cash balance (end of the year)		90

The Complete Structure of the Cash Flow Statement

The cash flow statement concerns three spheres of activity:

1. Current 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.

From now on, the cash flow statement will be referred to in short as “flow”.

The spheres of activity will be presented and explained below, starting with the third sphere.

1. 1.     Financing Activity

Movement of cash in this sphere is due primarily to the following activities:

1. Issuing of new share capital.
2. Bank loans (taking or repayment of loans).
3. Loans from the general public (taking or repayment of 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).

1. 2.     Investment Activity

The word “investment” refers to transactions involving fixed assets.

Movements of cash in this sphere are due mostly to purchases and/or sale of equipment, machinery, and buildings. Assume that USA Chairs sold an old machine for $2,000, and bought a new one for $10,000. The company’s cash from investment activity decreased by $8,000 ($10,000 exited and $2,000 entered).

1. 3.     Current Activity

Movements of cash in this sphere are due to the company’ regular business activity (sales and expenditures). Assume that the activity of USA Chairs this year was as follows:

• Sales:

Sales totaled $80,000, all of which was in cash.

• Expenditures:

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).

 

1. 4.     The Complete Cash Flow Statement of USA Chairs
   USA chaire’s Cash Flow Statment for 2007

Cash flow from current 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 of calculating cash flow from current activity will now be explained.

A Shortcut for Calculating Cash Flow from Current Activity

This calculation method assumes that all the company’s sales and expenditures 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 expenditures 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 “customers” item in the balance sheet (on the assets side). When the company has expenditures for which it has not yet paid, the unpaid balance is listed in the suppliers ledger account and in the “suppliers” item in the balance sheet (on the liabilities side). These two items, “suppliers” and “customers”, can therefore be used to calculate what sums have not yet been paid in cash.

The “customers” item indicates the amount of sales that have not yet been paid in cash. The “suppliers” item indicates the amount of expenditures 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 now be explained in more detail.

 

The Company’s Profit and Cash Flow

The company’s profit is not affected by whether or not customers paid their full debt to the company. Similarly, the profit is not affected by whether or not the company paid its full debt to its suppliers. This can be seen in the previous lesson.