Statement of Cash Flows: Structure, Analysis, and Application

Statement of Cash Flows

Introduction to the Statement of Cash Flows

The Statement of Cash Flows is a core financial statement that provides information about a company's cash inflows and outflows during an accounting period. It is essential for understanding a company's liquidity, solvency, and overall financial health. The statement is developed using data from the balance sheet and income statement, typically requiring two years of balance sheets and one year of income statement data.

Importance of Cash Flow

• Cash flow is critical because it determines a company's ability to pay employees, suppliers, and creditors.

• It is possible for a company to report positive net income but still face liquidity problems if it cannot convert earnings into cash.

• Cash flow analysis helps identify whether a company is generating sufficient cash from its operations or relying on external financing.

Example: The collapse of Lehman Brothers illustrates the importance of cash flow. Despite reporting rising net income, the company failed to generate cash from operations and relied on borrowings, ultimately leading to bankruptcy.

Sections of the Statement of Cash Flows

The statement is divided into three main sections, each reflecting different types of cash activities:

• Operating Activities: Cash flows related to the core business operations, such as cash received from customers and cash paid to suppliers and employees.

• Investing Activities: Cash flows from the acquisition and disposal of long-term assets and investments, such as purchasing equipment or selling securities.

• Financing Activities: Cash flows related to borrowing, repaying debt, issuing shares, and paying dividends.

Cash and Cash Equivalents

• Cash includes currency, bank deposits, and highly liquid investments (cash equivalents) such as T-bills, notes, commercial paper, and certificates of deposit (CDs).

• The statement measures cash at the beginning and end of the year, both found on the balance sheet.

Details of Cash Flow Activities

Operating Activities

• Inflows: Revenues from sales of goods and services, returns from suppliers, and interest received.

• Outflows: Payments for inventory, taxes, operating expenses (SG&A), and interest on debt.

Investing Activities

• Inflows: Proceeds from the sale of assets and securities.

• Outflows: Capital expenditures, acquisitions, and purchases of securities.

Financing Activities

• Inflows: Proceeds from borrowing and issuing shares.

• Outflows: Repayment of debt, purchase of own shares, and payment of dividends.

Methods for Preparing the Statement of Cash Flows

• Direct Method: Lists major classes of gross cash receipts and payments.

• Indirect Method: Starts with net income and adjusts for non-cash items and changes in working capital.

Formula (Indirect Method):

$\text{Net Income} + \text{Non-cash Expenses} - \text{Non-cash Revenues} + \text{Decrease in Current Assets} - \text{Increase in Current Assets} + \text{Increase in Current Liabilities} - \text{Decrease in Current Liabilities}$

Classifying Cash Flow Activities: Case Study Example

In practice, companies must classify each cash flow as operating, investing, or financing. For example, in the Nike Inc. case study, students are asked to assign each financial activity to the correct section of the cash flow statement and determine its effect on cash balance.

Activity	Amount (in millions)	Classification
A subsidiary was acquired for	289	Investing
Accounts receivable decreased by	701	Operating
Cost of goods sold	3603	Operating
Debt (including current portion) was reduced	56	Financing
Depreciation & Amortization expenses were	229	Operating
Dividends paid for both common and preferred were	219	Financing
Effect of exchange rate changes was to increase cash by	25	Separate line item
Interest expense	85	Operating
Inventories increased	56	Operating
Net stock repurchased and stock option issuance was	415	Financing
Other assets and short-term investments were purchased for	455	Investing
Payables and other current liabilities increased	140	Operating
Prepaid and other current assets increased	102	Operating
Selling and administrative expenses	1044	Operating
There were additions to property, plant and equipment of	702	Investing

Additional info: This table helps students practice the classification of cash flows, a key skill in financial accounting.

Summary Table of Cash Flow

The Summary Table is a tool for analyzing the statement of cash flows by common-sizing the data. It shows cash inflows and outflows as percentages of total inflows and outflows, respectively. The table typically aggregates cash from operations and provides details for investing and financing activities.

• Highlights the importance of internal cash generation from operations.

• Shows the implications for investing and financing when operational cash generation is insufficient.

Analysis of the Statement of Cash Flows

Cash Flow from Operating Activities

• Ongoing business success depends on generating cash from operations.

• Early-stage companies may use more cash than they generate, while mature companies should generate significant cash from operations.

Analysis of Cash Inflows and Outflows

• Excess cash from operations is preferred for financing capital expenditures, debt repayment, and dividends.

• When analyzing outflows, consider their necessity and how they are financed (short-term assets with short-term debt, long-term assets with long-term debt or equity).

Practice and Application

• Students are encouraged to practice with real company data and summary tables to reinforce their understanding of cash flow analysis.

• Excel activities and interactive simulations can help develop practical skills in preparing and analyzing statements of cash flows.