Chapter 8
In This Chapter
Exploring the statement of cash flows
Understanding operating activities
Getting a grip on investments
Figuring out the financing section
Looking at other line items
Finding net cash from all company activities
Cash is a company's lifeblood. If a company expects to manage its assets and liabilities and to pay its obligations, it has to know the amount of cash flowing into and out of the business, which isn't always easy to figure out when using accrual accounting. (You can find out more about accrual accounting in Chapter 4.)
The reason accrual accounting makes it hard to figure out how much cash a company actually holds is that cash doesn't have to change hands for the company to record a transaction. The statement of cash flows is the financial statement that helps the financial report reader understand a company's cash position by adjusting for differences between cash and accruals. (See Chapter 4 for more information on cash and accruals.) This statement tracks the cash that flows into and out of a business during a specified period of time and lays out the sources of that cash. In this chapter, I explore the basic parts of the statement of cash flows.
Basically, a statement of cash flows gives the financial report reader a map of the cash receipts, cash payments, and changes in cash that a company holds, minus the expenses that arise from operating the company. In addition, the statement looks at money that flows into or out of the firm through investing and financing activities. As with the income statement (see Chapter 7), companies provide three years’ worth of information on the statement of cash flows.
Knowing the answers to these questions helps you determine whether the company is thriving and has the cash needed to continue to grow its operations or the company appears to have a cash-flow problem and may be nearing a point of fiscal disaster. In this section, I show you how to use the statement of cash flows to find the answers to these questions.
Transactions shown on the statement of cash flows are grouped in three parts:
Companies can choose between two different formats when preparing their statement of cash flows. Both arrive at the same total but provide different information to get there:
Using the indirect method, you just need the information from two years’ worth of balance sheets and income statements to make calculations. For example, you can calculate changes in accounts receivable, inventories, prepaid expenses, current assets, accounts payable, and current liabilities by comparing the totals shown on the balance sheet for the current year and the previous year. If a company shows $1.5 million in inventory in 2011 and $1 million in 2012, the change in inventory using the indirect method is shown easily: “Decrease in Inventory — $500,000.” The statement of cash flows for the indirect method summarizes information already given in a different way, but it doesn't reveal any new information.
With the direct method, the company has to reveal the actual cash it receives from customers, the cash it pays to suppliers and employees, and the income tax refund it receives. Someone reading the balance sheet and income statement won't find these numbers in other parts of the financial report.
In addition to having to reveal details about the actual cash received or paid to customers, suppliers, employees, and the government, companies that use the direct method must prepare a schedule similar to one used in the indirect method for operating activities to meet FASB requirements. Essentially, companies save no time, must reveal more detail, and must still present the indirect method. Why bother? You can see why you'll most likely see the indirect method used in the vast majority of financial reports you read.
The investing activities and financing activities sections for both the direct and indirect methods look something like Figure 8-3 and Figure 8-4, both of which show the basic line items. Read on to find out what each of these line items includes. If you're interested in finding out about line items that make their way onto the statement only in special circumstances, see “Recognizing the Special Line Items,” later in the chapter.
The operating activities section is where you find a summary of how much cash flowed into and out of the company during the day-to-day operations of the business.
The primary purpose of the operating activities section is to adjust the net income by adding or subtracting entries that were made in order to abide by the rules of accrual accounting that don't actually require the use of cash. In this section, I describe several of the accounts in the operating activities section of the statement and explain how they're impacted by the changes required to revert accrual accounting entries to actual cash flow.
A company that buys a lot of new equipment or builds new facilities has high depreciation expenses that lower its net income. This fact is particularly true for many high-tech businesses that must always upgrade their equipment and facilities to keep up with their competitors.
The bottom line may not look good, but all those depreciation expenses don't represent the use of cash. In reality, no cash changes hands to pay depreciation expenses. These expenses are actually added back into the equation when you look at whether the company is generating enough cash from its operations because the company didn't actually lay out cash to pay for these expenses.
For example, if the company's net income is $200,000 for the year and its depreciation expenses are $50,000, the $50,000 is added back in to find the net cash from operations, which totals $250,000. Essentially, the firm is in better shape than it looked to be before the depreciation expenses because of this noncash transaction.
Another adjustment on the statement of cash flows that usually adds cash to the mix is a decrease in inventory. If a company's inventory on hand is less in the current year than in the previous year, the company bought some of the inventory sold with cash in the previous year.
On the other hand, if the company's inventory increases from the previous year, then it spent more money on inventory in the current year, and it subtracts the difference from the net income to find its current cash holdings. For example, if inventory decreases by $10,000, the company adds that amount to net income on the statement of cash flows.
Accounts receivable is the summary of accounts of customers who buy their goods or services on direct credit from the company. Customers who buy their goods by using credit cards from banks or other financial institutions aren't included in accounts receivable. Payments by outside credit sources are instead counted as cash because the company receives cash from the bank or financial institution. The bank or financial institution collects from those customers, so the company that sells the good or service doesn't have to worry about collecting the cash.
When accounts receivable increase during the year, the company sells more products or services on credit than it collects in actual cash from customers. In this case, an increase in accounts receivable means a decrease in cash available.
The opposite is true if accounts receivable are lower during the current year than the previous year. In this case, the company collects more cash than it adds credit to customers’ credit accounts. In this situation, a decrease in accounts receivable results in more cash received, which adds to the net income.
Accounts payable is the summary of accounts of bills due that haven't yet been paid, which means the company must still lay out cash in a future accounting period to pay those bills.
When accounts payable increase, a company uses less cash to pay bills in the current year than it did in the previous one, so more cash is on hand. This has a positive effect on the cash situation. Expenses incurred are shown on the income statement, which means net income is lower. But in reality, the company hasn't yet laid out the cash to pay those expenses, so an increase is added to net income to find out how much cash is actually on hand.
Conversely, if accounts payable decrease, the company pays out more cash for this liability. A decrease in accounts payable means the company has less cash on hand, and it subtracts this number from net income.
To give you a taste of what all these line items look like in the statement of cash flows, see Table 8-1, where I roll together the information from the previous sections.
Table 8-1 Cash Flows from Operating Activities
Line Item |
Cash Received or Spent |
Net income |
$200,000 |
Depreciation |
50,000 |
Increase in accounts receivable |
(20,000) |
Decrease in inventories |
10,000 |
Decrease in accounts payable |
(10,000) |
Net cash provided by (used in) operating activities |
$230,000 |
In Table 8-1, the company has $30,000 more in cash from operations than it reported on the income statement, so the company actually generated more cash than you may have thought if you just looked at net income.
The investment activities section of the statement of cash flows, which looks at the purchase or sale of major new assets, is usually a drainer of cash. Consider what this section typically lists:
The sale of buildings, land, major equipment, and marketable securities also appears in the investment activities section. When any of these major assets are sold, they're shown as cash generators rather than as cash drainers.
If you believe that the firm is making the right choices to grow the business and improve profits, investing in its stock may be worthwhile. If the company is making most of its capital expenditures to keep old factories operating as long as possible, that may be a sign that it isn't keeping up with new technology.
Companies can't always raise all the cash they need from their day-to-day operations. Financing activities are another means of generating cash. Any cash raised through activities that don't include day-to-day operations appears in the financing section of the statement of cash flows.
When a company first sells its shares of stock, it shows the money it raises in the financing section of the statement of cash flows. The first time a company sells shares of stock to the general public, this sale is called an initial public offering (IPO; see Chapter 3 for more information). Whenever a company decides to sell additional shares to raise capital, all additional sales of stock are called secondary public offerings.
Usually, when companies decide to do a secondary public offering, they do so to raise cash for a specific project or group of projects that they can't fund by ongoing operations. The financial department must determine whether it wants to raise funds for these new projects by borrowing money (new debt) or by issuing stock (new equity). If the company already has a great deal of debt and finds that borrowing more is difficult, it may try to sell additional shares to cover the shortfall. I talk more about debt versus equity in Chapter 12.
Sometimes you see a line item in the financing section indicating that a company has bought back its stock. Most often, companies that announce a stock buyback are trying to accomplish one of two goals:
Sometimes a company buys back stock with the intention of going private (see Chapter 3). In this case, company executives and the board of directors decide that they no longer want to operate under the watchful eyes of investors and the government. Instead, they prefer to operate under a veil of privacy and not to have to worry about satisfying so many company outsiders. I discuss the advantages and disadvantages of staying private in Chapter 3.
For many firms, an announcement that they're buying back stock is an indication that they're doing well financially and that the executives believe in their company's growth prospects for the future. Because buybacks reduce the number of outstanding shares, a company can make its per-share numbers look better even though a fundamental change hasn't occurred in the business's operations.
Whenever a company pays dividends, it shows the amount paid to shareholders in the financing activities section. Companies aren't required to pay dividends each year, but they rarely stop paying dividends after the shareholders have gotten used to their dividend checks.
When a company borrows money for the long term, this new debt also appears in the financing activities section. This type of new debt includes the issuance of bonds, notes, or other forms of long-term financing, such as a mortgage on a building.
Debt payoff is usually a good sign, often indicating that the company is doing well. However, it may also be an indication that the company is simply rolling over existing debt into another type of debt instrument.
When you look at the financing activities on a statement of cash flows for younger companies, you usually see financing activities that raise capital. Their statements include funds borrowed or stock issued to raise cash. Older, more established companies begin paying off their debt and buying back stock when they've generated enough cash from operations.
Sometimes you see line items on the statement of cash flows that appear unique to a specific company. Businesses use these line items in special circumstances, such as the discontinuation of operations. Companies that have international operations use a line item that relates to exchanging cash among different countries, which is called foreign exchange.
If a company discontinues operations (stops the activities of a part of its business), you usually see a special line item on the statement of cash flows that shows whether the discontinued operations have increased or decreased the amount of cash the company takes in or distributes. Sometimes discontinued operations increase cash because the firm no longer has to pay the salaries and other costs related to that operation.
Other times, discontinued operations can be a one-time hit to profits because the company has to make significant severance payments to laid-off employees and has to continue paying manufacturing and other fixed costs related to those operations. For example, if a company leases space for the discontinued operations, it's contractually obligated to continue paying for that space until the contract is up or the company finds someone to sublease the space.
Whenever a company has global operations, it's certain to have some costs related to moving currency from one country to another. The U.S. dollar, as well as currencies from other countries, experiences changes in currency exchange rates — sometimes 100 times a day or more.
This is the big one, the highlight, the bottom line: Cash and short-term investments at end of year. This number shows you how much cash or cash equivalents a company has on hand for continuing operations the next year.
Cash equivalents are any holdings that the company can easily change to cash, such as cash, cash in checking and savings accounts, certificates of deposit that are redeemable in less than 90 days, money-market funds, and stocks sold on the major exchanges that can be easily converted to cash.
The top line of the statement starts with net income. Adjustments are made to show the impact on cash from operations, investing activities, and financing. These adjustments convert that net income figure to actual cash available for continuing operations. Remember that this is the cash on hand that the company can use to continue its activities the next year.
In Part III, I delve more deeply into how the cash results of these two companies differ. I also show you how you can use the figures on the statement of cash flows and other statements in the financial reports to analyze the results and make judgments about a company's financial position.