Financial Statements: Cash Flow Statement
The purpose of the cash flow statement is to provide detailed information about a company's cash receipts (inflows) and cash payments (outflows) over the course of the fiscal period. More specifically, the cash flow statement reports the net change in cash (in grade 11 we called this the Bank or Cash account) and cash equivalents (highly liquid, short-term investments with maturities under three months such as government treasury bills, corporate commercial paper and money market mutual funds) due to the operating, investing and financing activities of the firm during the period. The format of the cash flow statement reconciles (or explains the difference between) the balance in the Cash account at the beginning and at the end of the fiscal period under study.

There are four general steps involved in the completion of the cash flow statement:

Step 1) Determine the net increase or decrease in cash over the course of the period
Step 2) Determine the net cash provided (in) or used (out) by operating activities
Step 3) Determine the net cash provided (in) or used (out) by investing activities
Step 4) Determine the net cash provided (in) or used (out) by financing activities

Step 1) The net increase or decrease in cash over the course of the period can easily be calculated by comparing the beginning and ending cash balances on a comparative balance sheet. The cash flow statement will essentially be used to explain the increase or decrease in the cash figure over the course of the period.

Step 2) In order to calculate the net cash provided (in) or used (out) by operating activities, the normal operating activities of the business must be converted from the accrual basis of accounting (which records economic events when they occur regardless of payment) to the cash basis of accounting (which records economic events only when payment is delivered). The conversion is necessary, of course, as the income statement and balance sheet have most certainly been completed using the accrual basis of accounting which, inter alia, records revenues and expenses when they are incurred in keeping with GAAP and IFRS (revenue recognition and matching principles). This conversion may be completed using either the direct method (which is not very common in North America) or the indirect method (which is much more common in North America). Please note that both methods ultimately arrive at the same figure for "Net cash provided/used by operating activities." As such, the two methods differ only in terms of the specific items used to calculate the final figure. In this course, we will focus on the indirect method due to its relative ease of preparation and overwhelming popularity within North America. See pages 839-840 in the textbook for an example of a cash flow statement prepared using the indirect method.

Generally speaking, normal operating activities refer to the cash effects of transactions involving revenues and expenses that impact net income. These transactions tend to affect revenues, expenses, non-cash current assets and current liabilities. In order to calculate net cash provided/used by operating activities, accountants require the current year's income statement, the most recent comparative balance sheet and selected additional information.

Typical cash inflows (increases in net cash) from normal operating activities include: cash sales of goods and services, receipts from debtor customers, interest received on bonds/notes, and dividends received on shares.

Typical cash outflows (decreases in net cash) from normal operating activities include payments: to suppliers for inventory or supplies or other expenses, to employees for wages, to governments for taxes, and to lenders for interest.

Step 3) Generally speaking, investing activities involve the purchase or sale of long-term investments and capital (productive and long-lived) assets, as well as the lending out and subsequent collection of cash. These transactions tend to affect fixed assets and long-term investments. In order to calculate net cash provided/used by investing activities, accountants require the comparative balance sheet and selected additional information.

Typical cash inflows (increases in net cash) from investing activities include: sale of capital (fixed) assets, sale of bonds/notes or shares of other entities, and the collection of principal only on loans to other entities.

Typical cash outflows (decreases in net cash) from investing activities include: purchase of capital (fixed) assets, purchase of bonds/notes or shares of other entities, and loans to other entities.

Step 4) Generally speaking, financing activities involve obtaining cash from the issue (sale) of bonds or notes (debt financing) and subsequent repayment of principal, as well as obtaining cash from the sale of shares (equity financing) and subsequent payment of dividends. These transactions tend to affect long-term liabilities and equity. In order to calculate net cash provided/used by financing activities, accountants require the comparative balance sheet and selected additional information.

Typical cash inflows (increases in net cash) from financing activities include: sale of company's own shares, sale of company's own bonds, and issue of company's own notes.

Typical cash outflows (decreases in net cash) from financing activities include: payments of dividends to company's own shareholders, redemption (repurchase) of company's own shares, and repayment of principal on company's own bonds or notes.


Significant Non-cash Activities
Please note that significant investing and financing activities that do not affect cash (e.g., the issue of shares or bonds/notes to purchase assets, exchanges of capital assets, etc.) are not reported in the body of the cash flow statement but instead are reported in the notes to the statement pursuant to the full disclosure principle.


Detailed Steps in the Preparation of Cash Flow Statement using the Indirect Method
Unfortunately, evidence of the transactions that affect net cash inflows and outflows is not always so easy to locate or even comprehend. This is because one must examine the individual accounts of both the income statement and comparative balance sheet (and any additional information provided in the notes to the financial statements) in order to determine which transactions had an impact on cash and cash equivalents over the period. See page 835 in the textbook for an example of a typical income statement and comparative balance sheet (and additional information) used in the preparation of the cash flow statement. And once again, see pages 839-840 in the textbook for an example of a cash flow statement prepared using the indirect method from the information found on pages 835-839.

A) Prepare the heading of the cash flow statement (name of company, name of statement, fiscal period ended)

B) Calculate the net change (increase or decrease) in cash over the course of the most recent period using the ending cash figures for two consecutive years as stated in the most recent comparative balance sheet. These three figures will always appear at or near the bottom of the cash flow statement.

C) Cash flows from operating activities - List the net income found in the most recent income statement at the top of the cash flow statement and then list the changes (increases or decreases) to the following accounts over the course of the most recent period (while not forgetting that the purpose of this section is to convert the net income for the period from the accrual basis to the cash basis):

Additions to net income (including decreases in non-cash current assets and increases in current liabilities over period):
  • decreases in accounts receivable, inventory, prepaid expenses or other current assets (balance sheet current asset)
  • increases in accounts payable, accrued expenses payable or other current liabilities (balance sheet current liability)
  • amortization or depreciation of capital asset (income statement expense)
  • loss on sale of company asset in extraordinary transaction (income statement expense)

Deductions to net income (including increases in non-cash current assets and decreases in current liabilities over period):
  • increases in accounts receivable, inventory, prepaid expenses or other current assets (balance sheet current asset)
  • decreases in accounts payable, accrued expenses payable or other current liabilities (balance sheet current liability)
  • gain on sale of company asset in extraordinary transaction (income statement revenue)
  • dividend or interest income on shares or bonds of other entities (income statement revenue)

Please note that when using the direct method, calculating net cash flows from operating activities involves the simple measurement of cash inflows (cash sales of goods and services, receipts from debtor customers, interest received on bonds/notes, dividends received on shares) and cash outflows (payments to suppliers for inventory or supplies or other expenses, payments to employees for wages, payments to governments for taxes, and payments to lenders for interest.) Please see pages 848 and 852 for examples of a cash flow statement using the direct method.

D) Cash flows from investing activities - List the changes (increases or decreases) to the following accounts over the course of the most recent period:

Cash inflows:
  • decreases in capital (fixed) assets due to cash sale (balance sheet fixed asset)
  • decreases in long-term debt or equity investments due to cash sale (balance sheet investment)
  • decreases in long-term loans to outside entities (balance sheet investment)

Cash outflows:
  • increases in capital (fixed) assets due to cash purchase (balance sheet fixed asset)
  • increases in long-term debt or equity investments due to cash purchase (balance sheet investment)
  • increases to long-term loans to outside entities (balance sheet investment)

E) Cash flows from financing activities - List the changes (increases or decreases) to the following accounts over the course of the most recent period:

Cash inflows:
  • increases in share capital (balance sheet equity)
  • increases in bonds payable/notes payable (balance sheet long-term liability)

Cash outflows:
  • decreases in retained earnings due to cash payments of dividends on company shares (balance sheet equity)
  • decreases in bonds payable/notes payable due to cash repayments (balance sheet long-term liability)

F) Summary - When examining the cash flow statement then, one must ensure that net income, once reconciled (adjusted) for net cash provided/used by operating activities, is then adjusted for net cash provided/used by investing and financing activities.