Chapter 4
IN THIS CHAPTER
Presenting the statement of cash flows in two flavors
Linking cash flow and net income
Reading the remaining sections the statement of cash flows
Digging into “free cash flow”
Offering advice and observations on cash flow
You could argue that the income statement (Chapter 2 of Book 3) and balance sheet (Chapter 3 of Book 3) are enough. These two financial statements answer the most important questions about the financial affairs of a business. The income statement discloses revenue and how much profit the business squeezed from its revenue, and the balance sheet discloses the amounts of assets being used to make sales and profit, as well as its capital sources. What more do you need to know? Well, it’s also helpful to know about the cash flows of the business.
This chapter explains the third primary financial statement reported by businesses: the statement of cash flows. This financial statement has two purposes: It explains why cash flow from profit differs from bottom-line profit, and it summarizes the investing and financing activities of the business during the period. This may seem an odd mix to put into one financial statement, but it actually makes sense. Earning profit (net income) generates net cash inflow (at least, it should normally). Making profit is a primary source of cash to a business. The investing and financing transactions of a business hinge on its cash flow from profit. All sources and uses of cash hang together and should be managed in an integrated manner.
The income statement (introduced in Chapter 2 of Book 3) has a natural structure:
Revenue – Expenses = Profit (Net Income)
So does the balance sheet (see Chapter 3 of Book 3):
Assets = Liabilities + Owners’ Equity
The statement of cash flows doesn’t have an obvious natural structure, so the accounting rule-making body had to decide on the basic format for the statement. They settled on the following structure:
In the example, the business’s cash balance decreases $110,000 during the year. You see this decrease in the company’s balance sheets for the years ended December 31, 2018 and 2019 (refer to Figure 3-2 in Book 3, Chapter 3). The business started the year with $2,275,000 cash and ended the year with $2,165,000. What does the balance sheet, by itself, tell you about the reasons for the cash decrease? The two-year comparative balance sheet provides some clues about the reasons for the cash decrease. However, answering such a question isn’t the purpose of a balance sheet.
Figure 4-1 presents the statement of cash flows for the product business example introduced in Chapters 2 and 3 of Book 3. What you see in the first section of the statement of cash flows is called the direct method for reporting cash flow from operating activities. The dollar amounts are the cash flows connected with sales and expenses. For example, the business collected $25,550,000 from customers during the year, which is the direct result of making sales. The company paid $15,025,000 for the products it sells, some of which went toward increasing the inventory of products awaiting sale next period.
Note: Because the same business example in this chapter is used in Chapters 2 and 3 of Book 3, you may want to take a moment to review the 2019 income statement in Figure 2-1. And you may want to review Figure 3-3, which summarizes how the three types of activities changed the business’s assets, liabilities, and owners’ equity accounts during the year 2019. (Go ahead, take your time.)
The revenue and expense cash flows you see in Figure 4-1 differ from the amounts you see in the accrual accounting basis income statement (refer to Figure 2-1). Herein lies a problem with the direct method. If you, a conscientious reader of the financial statements of a business, compare the revenues and expenses reported in the income statement with the cash flow amounts reported in the statement of cash flows, you may get confused. Which set of numbers is the correct one? Well, both are. The numbers in the income statement are the “true” numbers for measuring profit for the period. The numbers in the statement of cash flows are additional information for you to ponder.
Notice in Figure 4-1 that cash flow from operating activities for the year is $1,515,000, which is less than the company’s $1,690,000 net income for the year (refer to Figure 2-1). The accounting rule-making board thought that financial report readers would want some sort of explanation for the difference between these two important financial numbers. Therefore, the board decreed that a statement of cash flows that uses the direct method of reporting cash flow from operating liabilities should include a reconciliation schedule that explains the difference between cash flow from operating activities and net income.
Having to read both the operating activities section of the cash flow statement and a supplemental schedule gets to be rather demanding for financial statement readers. Accordingly, the accounting rule-making body decided to permit an alternative method for reporting cash flow from operating activities. The alternative method starts with net income and then makes adjustments in order to reconcile cash flow from operating activities with net income. This alternative method is called the indirect method, which is shown in Figure 4-2. The rest of the cash flow statement is the same, no matter which option is selected for reporting cash flow from operating activities. Compare the investing and financing activities in Figures 4-1 and 4-2; they’re the same.
The indirect method for reporting cash flow from operating activities focuses on the changes during the year in the assets and liabilities that are directly associated with sales and expenses. These connections between revenue and expenses and their corresponding assets and liabilities are explained in Chapter 2 of Book 3. (You can trace the amounts of these changes back to Figure 3-2.)
Both the direct method and the indirect method report the same cash flow from operating activities for the period. Almost always, this important financial metric for a business differs from the amount of its bottom-line profit, or net income, for the same period. Why? Read on.
The amount of cash flow from profit, in the large majority of cases, is a different amount from profit. Both revenue and expenses are to blame. Cash collected from customers during the period is usually higher or lower than the sales revenue booked for the period. And cash actually paid out for operating costs is usually higher or lower than the amounts of expenses booked for the period. You can see this by comparing cash flows from operating activities in Figure 4-1 with sales revenue and expenses in the company’s income statement (Figure 2-1 in Book 3, Chapter 2). The accrual-based amounts (Figure 2-1) are different from the cash-based amounts (Figure 4-1).
Now, how to report the divergence of cash flow and profit? A business could present only one line for cash flow from operating activities (which in the example is $1,515,000). Next, the financial report reader would move on to the investing and financing sections of the cash flow statement. But this approach won’t do, according to financial reporting standards.
The business in the example experienced a strong growth year. Its accounts receivable and inventory increased by relatively large amounts. In fact, all its assets and liabilities intimately connected with sales and expenses increased; their ending balances are larger than their beginning balances (which are the amounts carried forward from the end of the preceding year). Of course, this may not always be the case in a growth situation; one or more assets and liabilities could decrease during the year. For flat, no-growth situations, it’s likely that there will be a mix of modest-sized increases and decreases.
This section explains how asset and liability changes affect cash flow from operating activities. As a business owner or manager, you should keep a close watch on the changes in each of your assets and liabilities and understand the cash flow effects of these changes. Investors and lenders should focus on the business’s ability to generate a healthy cash flow from operating activities, so they should be equally concerned about these changes. In some situations, these changes indicate serious problems!
Note: Instead of using the full phrase “cash flow from operating activities” every time, this section uses the shorter term “cash flow.” All data for assets and liabilities are found in the two-year comparative balance sheet of the business (refer to Figure 3-2 in Book 3, Chapter 3).
Synopsis: An increase in accounts receivable hurts cash flow; a decrease helps cash flow.
The business started the year with $2.15 million and ended the year with $2.6 million in accounts receivable. The beginning balance was collected during the year, but the ending balance hadn’t been collected at the end of the year. Thus, the net effect is a shortfall in cash inflow of $450,000. The key point is that you need to keep an eye on the increase or decrease in accounts receivable from the beginning of the period to the end of the period. Here’s what to look for:
In the business example, accounts receivable increased $450,000. Cash collections from sales were $450,000 less than sales revenue. Ouch! The business increased its sales substantially over the last period, so its accounts receivable increased. When credit sales increase, a company’s accounts receivable generally increases about the same percent, as it did in this example. (If the business takes longer to collect its credit sales, then its accounts receivable would increase even more than can be attributed to the sales increase.) In this example, the higher sales revenue was good for profit but bad for cash flow.
Synopsis: An increase in inventory hurts cash flow; a decrease helps cash flow.
Inventory is usually the largest short-term, or current, asset of businesses that sell products. If the inventory account is greater at the end of the period than at the start of the period — because unit costs increased or because the quantity of products increased — the amount the business actually paid out in cash for inventory purchases (or for manufacturing products) is more than what the business recorded in the cost of goods sold expense for the period. To refresh your memory here: The cost of inventory is not charged to cost of goods sold expense until products are sold and sales revenue is recorded.
In the business example, inventory increased $725,000 from start-of-year to end-of-year. In other words, to support its higher sales levels in 2019, this business replaced the products that it sold during the year and increased its inventory by $725,000. The business had to come up with the cash to pay for this inventory increase. Basically, the business wrote checks amounting to $725,000 more than its cost of goods sold expense for the period. This step-up in its inventory level was necessary to support the higher sales level, which increased profit even though cash flow took a hit.
Synopsis: An increase in prepaid expenses (an asset account) hurts cash flow; a decrease helps cash flow.
A change in the prepaid expenses asset account works the same way as a change in inventory and accounts receivable, although changes in prepaid expenses are usually much smaller than changes in the other two asset accounts.
The beginning balance of prepaid expenses is charged to expense this year, but the cash of this amount was actually paid out last year. This period (the year 2019 in the example), the business paid cash for next period’s prepaid expenses, which affects this period’s cash flow but doesn’t affect net income until next period. In short, the $75,000 increase in prepaid expenses in this business example has a negative effect on cash flow.
Synopsis: No cash outlay is made in recording depreciation. In recording depreciation, a business simply decreases the book (recorded) value of the asset being depreciated. Cash isn’t affected by the recording of depreciation (keeping in mind that depreciation is deductible for income tax).
Recording depreciation expense decreases the value of long-term, fixed operating assets that are reported in the balance sheet. The original costs of fixed assets are recorded in a property, plant, and equipment type account. Depreciation is recorded in an accumulated depreciation account, which is a so-called contra account because its balance is deducted from the balance in the fixed asset account (refer to Figure 3-2 in Book 3, Chapter 3). Recording depreciation increases the accumulated depreciation account, which decreases the book value of the fixed asset.
For measuring profit, depreciation is definitely an expense — no doubt about it. Buildings, machinery, equipment, tools, vehicles, computers, and office furniture are all on an irreversible journey to the junk heap (although buildings usually take a long time to get there). Fixed assets (except for land) have a finite life of usefulness to a business; depreciation is the accounting method that allocates the total cost of fixed assets to each year of their use in helping the business generate sales revenue. In the example, the business recorded $775,000 depreciation expense for the year.
For example, when you go to a supermarket, a very small slice of the price you pay for that quart of milk goes toward the cost of the building, the shelves, the refrigeration equipment, and so on. (No wonder they charge so much!) Each period, a business recoups part of the cost invested in its fixed assets. In the example, $775,000 of sales revenue went toward reimbursing the business for the use of its fixed assets during the year.
Synopsis: An increase in a short-term operating liability helps cash flow; a decrease hurts cash flow.
The business in the example, like almost all businesses, has three basic liabilities inextricably intertwined with its expenses:
When the beginning balance of one of these liability accounts is the same as its ending balance (not too likely, of course), the business breaks even on cash flow for that liability. When the end-of-period balance is higher than the start-of-period balance, the business didn’t pay out as much money as was recorded as an expense in the year. You want to refer back to the company’s comparative balance sheet of the business in Figure 3-2 to compare the beginning and ending balances of these three liability accounts.
In the business example, the business disbursed $640,000 to pay off last year’s accounts payable balance. (This $640,000 was the accounts payable balance at December 31, 2018, the end of the previous fiscal year.) Its cash this year decreased $640,000 because of these payments. But this year’s ending balance sheet (at December 31, 2019) shows accounts payable of $765,000 that the business won’t pay until the following year. This $765,000 amount was recorded to expense in the year 2019. So the amount of expense was $125,000 more than the cash outlay for the year, or, in reverse, the cash outlay was $125,000 less than the expense. An increase in accounts payable benefits cash flow for the year. In other words, an increase in accounts payable has a positive cash flow effect (until the liability is paid). An increase in accrued expenses payable or income tax payable works the same way.
Taking into account all the adjustments to net income, the company’s cash balance increased $1,515,000 from its operating activities during the course of the year. The operating activities section in the statement of cash flows (refer to Figure 4-2) shows the stepping stones from net income to the amount of cash flow from operating activities.
Recall that the business experienced sales growth during this period. The downside of sales growth is that assets and liabilities also grow — the business needs more inventory at the higher sales level and also has higher accounts receivable. The business’s prepaid expenses and liabilities also increased, although not nearly as much as accounts receivable and inventory. Still, the business had $1,515,000 cash at its disposal. What did the business do with this $1,515,000 in available cash? You have to look to the remainder of the cash flow statement to answer this very important question.
After you get past the first section of the statement of cash flows, the remainder is a breeze. Well, to be fair, you could encounter some rough seas in the remaining two sections. But generally speaking, the information in these sections isn’t too difficult to understand. The last two sections of the statement report on the other sources of cash to the business and the uses the business made of its cash during the year.
The second section of the statement of cash flows (refer to Figure 4-1 or 4-2) reports the investment actions that a business’s managers took during the year. Investments are like tea leaves indicating what the future may hold for the company. Major new investments are sure signs of expanding or modernizing the production and distribution facilities and capacity of the business. Major disposals of long-term assets and shedding off a major part of the business could be good news or bad news for the business, depending on many factors. Different investors may interpret this information differently, but all would agree that the information in this section of the cash flow statement is very important.
Certain long-lived operating assets are required for doing business. For example, FedEx and UPS wouldn’t be terribly successful if they didn’t have airplanes and trucks for delivering packages and computers for tracking deliveries. When these assets wear out, the business needs to replace them. Also, to remain competitive, a business may need to upgrade its equipment to take advantage of the latest technology or to provide for growth. These investments in long-lived, tangible, productive assets, which are called fixed assets, are critical to the future of the business. In fact, these cash outlays are called capital expenditures to stress that capital is being invested for the long haul.
One of the first claims on the $1,515,000 cash flow from operating activities is for capital expenditures. Notice that the business spent $1,275,000 on fixed assets, which are referred to more formally as property, plant, and equipment in the cash flow statement (to keep the terminology consistent with account titles used in the balance sheet; the term fixed assets is rather informal).
A typical statement of cash flows doesn’t go into much detail regarding what specific types of fixed assets the business purchased (or constructed): how many additional square feet of space the business acquired, how many new drill presses it bought, and so on. Some businesses do leave a clearer trail of their investments, though. For example, in the footnotes or elsewhere in their financial reports, airlines generally describe how many new aircraft of each kind were purchased to replace old equipment or to expand their fleets.
Note that in the annual statement of cash flows for the business example, cash flow from operating activities is a positive $1,515,000, and the negative cash flow from investing activities is $1,275,000 (refer to Figure 4-1 or 4-2). The result to this point, therefore, is a net cash increase of $240,000, which would have increased the company’s cash balance this much if the business had no financing activities during the year. However, the business increased its short-term and long-term debt during the year, its owners invested additional money in the business, and it distributed some of its profit to stockholders. The third section of the cash flow statement summarizes these financing activities of the business over the period.
The managers didn’t have to go outside the business for the $1,515,000 cash increase generated from its operating activities for the year. Cash flow from operating activities is an internal source of money generated by the business itself, in contrast to external money that the business raises from lenders and owners. A business doesn’t have to go hat in hand for external money when its internal cash flow is sufficient to provide for its growth. Making profit is the cash flow spigot that should always be turned on.
The term financing refers to a business raising capital from debt and equity sources — by borrowing money from banks and other sources willing to loan money to the business and by its owners putting additional money in the business. The term also includes the flip side — that is, making payments on debt and returning capital to owners. The term financing also includes cash distributions by the business from profit to its owners. (Keep in mind that interest on debt is an expense reported in the income statement.)
Most businesses borrow money for the short term (generally defined as less than one year) as well as for longer terms (generally defined as more than one year). In other words, a typical business has both short-term and long-term debt. (Chapter 3 in Book 3 explains that short-term debt is presented in the current liabilities section of the balance sheet.)
The business in the example has both short-term and long-term debt. Although this isn’t a hard-and-fast rule, most cash flow statements report just the net increase or decrease in short-term debt, not the total amounts borrowed and total payments on short-term debt during the period. In contrast, both the total amounts of borrowing from and repayments on long-term debt during the year are generally reported in the statement of cash flows — the numbers are reported gross, instead of net.
In the example, no long-term debt was paid down during the year, but short-term debt was paid off during the year and replaced with new short-term notes payable. However, only the $100,000 net increase is reported in the cash flow statement. The business also increased its long-term debt by $150,000 (refer to Figure 4-1 or 4-2).
The financing section of the cash flow statement also reports the flow of cash between the business and its owners (stockholders of a corporation). Owners can be both a source of a business’s cash (capital invested by owners) and a use of a business’s cash (profit distributed to owners). The financing activities section of the cash flow statement reports additional capital raised from its owners, if any, as well as any capital returned to the owners. In the cash flow statement, note that the business issued additional stock shares for $150,000 during the year, and it paid a total of $750,000 cash dividends from profit to its owners.
The business lender or investor’s job is to ask questions (at least in your own mind) when reading an external financial statement. You should be an active reader, not a ho-hum passive reader, when reading the statement of cash flows. You should mull over certain questions to get full value out of the financial statement.
The statement of cash flows reveals what financial decisions the business’s managers made during the period. Of course, management decisions are always subject to second-guessing and criticism, and passing judgment based on reading a financial statement isn’t totally fair because it doesn’t capture the pressures the managers faced during the period. Maybe they made the best possible decisions in the circumstances. Then again, maybe not.
The company’s $1,515,000 cash flow from operating activities is enough to cover the business’s $1,275,000 capital expenditures during the year and still leave $240,000 available. The business increased its total debt $250,000. Combined, these two cash sources provided $490,000 to the business. The owners also kicked in another $150,000 during the year, for a grand total of $640,000. Its cash balance didn’t increase by this amount because the business paid out $750,000 in dividends from profit to its stockholders. Therefore, its cash balance dropped $110,000.
The board of directors of this business certainly could ask the chief executive why cash dividends to shareowners weren’t limited to $240,000 in order to avoid the increase in debt and to avoid having shareowners invest additional money in the business. They could probably ask the chief executive to justify the amount of capital expenditures as well.
Rather, free cash flow is street language, and the term appears in The Wall Street Journal and The New York Times. Securities brokers and investment analysts use the term freely (pun intended). Unfortunately, the term free cash flow hasn’t settled down into one universal meaning, although most usages have something to do with cash flow from operating activities.
The term free cash flow can refer to the following:
One definition of free cash flow is quite useful: cash flow from operating activities minus capital expenditures for the year. The idea is that a business needs to make capital expenditures in order to stay in business and thrive. And to make capital expenditures, the business needs cash. Only after providing for its capital expenditures does a business have “free” cash flow that it can use as it likes. For the example in this chapter, the free cash flow is $1,515,000 cash flow from operating activities minus $1,275,000 capital expenditures: a total of $240,000 free cash flow.
In many cases, cash flow from operating activities falls short of the money needed for capital expenditures. To close the gap, a business has to borrow more money, persuade its owners to invest more money in the business, or dip into its cash reserve. Should a business in this situation distribute any of its profit to owners? After all, it has a cash deficit after paying for capital expenditures. But, in fact, many businesses make cash distributions from profit to their owners even when they don’t have any free cash flow (as it was just defined).
In 1987, the cash flow statement was made mandatory. Most financial report users thought that this new financial statement would be quite useful and should open the door for deeper insights into the business. However, over the years, serious problems have developed in the actual reporting of cash flows.
Focusing on cash flows is understandable. If a business runs out of money, it will likely come to an abrupt halt and may not be able to start up again. Even running low on cash (as opposed to running out of cash) makes a business vulnerable to all sorts of risks that could be avoided if it had enough sustainable cash flow. Managing cash flow is as important as making sales and controlling expenses. You’d think that the statement of cash flows would be carefully designed to make it as useful as possible and reasonably easy to read so that the financial report reader could get to the heart of the matter.
Would you like to hazard a guess on the average number of lines in the cash flow statements of publicly owned corporations? Typically, their cash flow statements have 30 to 40 or more lines of information. So it takes quite a while to read the cash flow statement — more time than the average reader probably has available. Each line in a financial statement should be a truly useful piece of information. Too many lines baffle the reader rather than clarify the overall cash flows of the business. You have to question why companies overload this financial statement with so much technical information. One could even suspect that many businesses deliberately obscure their statements of cash flows.
The main problem in understanding the statement of cash flows is the first section for cash flow from operating activities. What a terrible way to start the statement of cash flows! As it is now, the financial report reader has to work down numerous adjustments that are added or deducted from net income to determine the amount of cash flow from operating activities (refer to Figure 4-2). You could read quickly through the whole balance sheet or income statement in the time it takes to do this. In short, the first section of the cash flow statement isn’t designed for an easy read. Something needs to be done to improve this opening section of the cash flow statement.
You don’t hear a lot of feedback on the cash flow statement from principal external users of financial reports, such as business lenders and investors. We wonder how financial report users would react if the cash flow statement were accidently omitted from a company’s annual financial report. How many would notice the missing financial statement and complain? The Securities and Exchange Commission (SEC) and other regulators would take action, of course. But in our view, few readers would even notice the omission. In contrast, if a business failed to include an income statement or balance sheet, the business would hear from its lenders and owners, that’s for sure.