6.1. Seeing the Big Picture of Cash Flows
People generally understand that a business increases its cash by increasing its debt and by its owners investing more money in the business. They understand that a business can also sell some of its assets to provide cash. They know that its cash decreases when a business pays down its debt, returns some of the capital that its owners had previously invested in the business, and invests in new fixed assets (buildings, machines, equipment, vehicles, and so on).
NOTE
Most people also know there is another important source of cash: making profit. However, things get a little tricky regarding this source of cash. One problem is this: Instead of saying that a business "earns profit," people say that a business "makes money." Therefore, many people assume that the bottom-line profit for the year increases cash exactly the same amount — no more, and no less. Not true: The actual amount of cash flow from making profit is invariably different than the amount of profit earned for the period. Earning profit and generating cash flow from the profit are two different things. You're talking about apples and oranges when you're talking about profit and cash flow from profit.
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Note: Because I use the same business example in this chapter that I use in Chapters 4 and 5, you may want to take a moment to review its 2009 income statement in Figure 4-1. And you may want to review Figure 5-1, which summarizes how the three types of activities changed its assets, liabilities, and owners' equity accounts during the year 2009. (Go ahead, I'll wait.)
Suppose the president of the business asks me, the chief accountant (controller), for an executive summary of the company's sources and uses of cash during the year ended December 31, 2009. The president does not want a formal, detailed financial statement with all the bells and whistles. He wants a very brief summary that speaks to him as the very busy chief executive of the business. Here's what I would prepare for him:
| Executive Summary for Company's President Sources and Uses of Cash During the Year 2009 | ||
|---|---|---|
| Cash flow from making profit | $1,515,000 | |
| Cash distributions from profit to shareowners | ($750,000) | $765,000 |
| Cash flow from increasing debt | $250,000 | |
| Cash flow from capital invested by owners | $150,000 | |
| Cash available for general business purposes | $1,165,000 | |
| Capital expenditures during year | ($1, 265,000) | |
| Cash decrease during year | ($110,000) | |
The president would do a critical review of the strategic decisions that were made during the year. For example, was it prudent to take on more debt? Why did the shareowners invest an additional $150,000 in the business, and will they invest additional capital during the coming year? Should the business have distributed about half of the cash flow from profit to its owners? I return to these issues in the last section of the chapter, "Being an Active Reader."
You may be wondering how I got the information to prepare the executive summary of cash flows for the president. I extracted the relevant information from the company's asset, liability, and owners' equity accounts. I examined the increases and decreases entered in the accounts during the year to determine the amounts you see in the executive summary. This is no problem; I'm an accountant, you know. Accountants prepare detailed spreadsheets in which changes in the asset, liability, and owners' equity accounts are analyzed and classified in order to prepare a statement of cash flows, or an executive summary such as the one I show here. Computer software programs can be used for this purpose.
NOTE
The president of the business can request any particular accounting report or summary that he wants. The president is not limited or restricted to the format and content of the three financial statements that are prepared for external reporting. If the president wants an executive summary of cash flows, as opposed to a formal statement of cash flows as it is presented in the external financial report of the business, then as controller I prepare the executive summary. I know which side my bread is buttered on. There are no restrictions regarding how to report cash flows internally (inside the business to its managers). If the president doesn't like or doesn't understand the information I give him in the executive summary of cash flows, he will let me know in no uncertain terms.
You may be wondering in particular how I got the $1,515,000 amount for cash flow from making profit (see the executive summary). And, you may be wondering why this cash flow amount is different than the $1.69 million bottom-line profit number reported in the company's income statement for the year (see Figure 4-1 in Chapter 4).
NOTE
One purpose of the statement of cash flows is to report the cash flow from making profit and to explain the difference between the cash flow number and the bottom-line profit number in the income statement. The cash flow number is based on actual cash inflows and outflows; the profit number is based on accounting for sales revenue and expenses. Remember the following points:
If a business makes credit sales, the total cash inflow from customers is different than the total sales revenue recorded in the year (unless the business collects all its credit sales before the end of the year).
The total cash outlay for expenses during the year is different than the total amount of expenses recorded in the year.
The statement of cash flows begins with the cash flow from making profit, or cash flow from operating activities as accountants call it. Operating activities is the technical term that accountants have adopted for sales and expenses, which are the "operations" that a business carries out to earn profit. I don't think it's the best term in the world, but we are stuck with it; it's part of the official language of accounting.