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.
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
Before discussing the cash flow statement, consider the following example of a small company named USA Chairs in 2007. The example will present two scenarios:
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All the business transactions are conducted in cash.
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Some transactions are on credit.
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:
The balance sheet for the end of 2007 is as follows:
The company’s cash flow statement for 2007 is as follows:
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:
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Raw materials – $40,000 – to be paid in June 2008 (next year).
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Salaries – $10,000 – paid in cash.
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Fixed expenses – $10,000 – paid in cash.
The company’s profit and loss statement for 2007 is exactly the same as in Scenario 1:
(Assuming that the company is exempt from taxes).
The company’s balance sheet for the end of 2007 is as follows:
The company’s cash flow statement for 2007 is as follows:
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.
The Effect of Accounts Receivable and accounts Payable on Cash Flow
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).
The complete structure of the cash flow statement
The cash flow statement concerns three spheres of activity:
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Operating activity.
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Investment activity.
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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.
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).
Investment activity:
Investing cash flows are payments resulting from the use or sale of long-term assets. Movements of cash in this section include:
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Payments for the purchase of property, plant and equipment (PP&E).
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The disposal (sale) of assets.
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Payments related to mergers and acquisitions.
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Dividends received from equity investments.
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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:
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Sales – sales totaled $80,000, all of which was in cash.
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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 :
A shorter method of calculating cash flow 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:
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, $3,000 in 2009.
The cash flow statement by the long method is as follows:
The company has no cash flow in the other spheres (financing activity and investment activity). Cash flow by the short method ($) is as follows:
The company’s balance sheet as of the end of the year is as follows:
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).
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.
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:
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:
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:
