The Cash Flow Statement

Statement of Cash Flows

When you examine a set of financial statements, you will invariably find a Balance Sheet, Income Statement, and Retained Earnings Statement. Chapter 18 discusses a fourth statement, the Statement of Cash Flows. Unlike the other statements, which are based on accrual accounting, the Cash Flow Statement shows the sources and uses of cash during the accounting period. As you might assume, cash comes in and cash goes out. Cash coming in is traditionally referred to as a "source" and cash going out is considered a "use".

When an investor reads a financial statement, a question that they might ask is, "how did the company acquire cash and what did they use the cash for?" In other words, what were the sources and uses of cash? This question is answered by the cash flow statement.

Three Types of Cash Flows

A cash flow statement is divided into three sections:

  1. Cash Flows from Operations
    The term Operations implies making a net income or net loss. This is the most important source of cash for a successful corporation. We would expect that the bulk of the cash coming in to the company is from revenue earned, and that the cash going out would be for expenses.

  2. Cash flows from Investing
    In the context of a cash flow statement, we consider investing to consist of purchasing productive assets such as buildings or equipment, or selling buildings or equipment. The purchases would in most cases involve spending cash, and the sale of such assets would be a source of cash.

  3. Cash flows from Financing
    Financing activities would include issuing stocks or bonds, issuing long term notes payable, or paying dividends to stockholders. If a company pays off a bond, or redeems stock, those transactions would also be considered financing transactions.

Every cash flow (in or out) can be categorized as an operating, investing or financing transaction.

Methods Used to Derive the Cash Flows

There are two methods for deriving the Cash Flow Statement -- the Indirect Method and the Direct Method. We will focus on the indirect method for two reasons.  First, the indirect method is often the one required in finance courses; and second, the indirect method is the overwhelming choice of most companies.  You should learn the indirect method.

But, in order to understand the indirect method, it is very helpful to analyze a set of cash transactions. By studying about ten types of transactions, you will gain an appreciation as to why the indirect method works. Also, as a side benefit, we will take one more look at corporation journal entries.

As you look at the transactions, they will tell a story. The corporation is started, it operates for a period, a dividend is paid to the stockholders. Our task is to look at how the accounts changed during the period and derive a cash flow statement containing the three sections. You will also see that the net cash flow for the period reconciles with the cash account.

Cash Flow Example 1--The Basics

We start with the following set of transactions:

1. Johnson Corporation issued 100,000 shares of $1 par common stock and received cash of $100,000.

2. Johnson Corporation purchased equipment for $20,000, paying cash.

3. Johnson earned revenue of $30,000; $10,000 was received in cash, $20,000 was on account (receivable).

4. Johnson incurred expenses of $20,000, paying $5,000 in cash; $15,000 on account (payable).

5. Depreciation was $1,000 on the equipment.

6. The accounts were closed (you can move the net income to Retained Earnings).

7. Johnson declared and paid a dividend of $3000 in cash to stockholders.

These seven transactions are journalized and posted below:

Example 1

Cash Flow Statement Using Cash T-Account

Here's a question I ask my students: if you were preparing a cash flow statement, and you could look at only one account, which one would you want to look at? The cash account, of course. The cash T-account from the picture above appears below:

Cash T acct

I placed the letter O for operating, I for investing and F for financing next to each debit and credit made to the Cash account. The operating transactions consist of $10,000 of revenue collected, and $5,000 of expenses paid out, for total cash received from operations of $5,000. There was one investing transaction, the purchase of the equipment, in the amount of $20,000--a negative cash flow. Finally, under the financing classification, we issued $100,000 of common stock and paid out $3,000 of dividends, so the net financing was a positive $97,000.

As shown in the picture above, we can summarize these 3 totals to create the cash flow statement:

CF Statement 1

Note that the net cash flows in the cash flow statement amount to $82,000. We add this figure to the beginning balance of cash ($0) and arrive at $82,000. This is also the ending balance of cash in the Cash T-account. These two figures must reconcile.

Using the Cash ledger account is one way to prepare the cash flow statement. And it works nicely for an example with 10 transactions. However, it would be an impractical approach if you had 100 or 1,000 transactions. If you consider the number of revenue and expense transactions, the cash flow from operations would be very challenging and time consuming to prepare. In the next sections, we will explore a more efficient way to arrive at cash flow from operations.

Indirect Method: Focus on Changes in the Accounts

Using the indirect method, we focus on the changes in the accounts from the beginning to the end of the accounting period. Here is a table that shows the beginning and ending balance for Example 1:

Account Beg. Balance Ending Balance Comment
Cash 0 $82,000 Cash increased by $82,000
Accounts Receivable 0 $20,000 Accounts Receivable increased by $20,000
Equipment 0 $20,000 Equipment increased by $20,000
Accum. Depreciation Eq. 0 $1,000 cr Accum. Depreciation increased by $1,000
Accounts Payable 0 $15,000 cr Accounts Payable increased by $15,000
Common Stock 0 $100,000 cr Common Stock increased by $100,000
Retained Earnings 0 $6,000 cr Retained Earnings increased by $9,000-$3,000=$6,000

We will use some of the increases and decreases noted in the Comment column above, along with a few facts we already know. We already know, for example, that the net income was $9,000, the depreciation expense was $1,000 and dividends paid in cash were $3,000. Note too, that in the table above, the Ending Balance column nets out to zero--the total debits balances = the total credit balances.

The Cash Flow Recipe--Indirect Method

Using the indirect method, we follow a formula, or recipe to calculate cash flows from operating, investing and financing activities. Here is a summary of the recipe that will handle 90% of the cash flow statements you will ever create:

Cash Flows from Operations    
Net Income XXX  
+ Depreciation Expense XXX  
- Increase in Accts Receivable (or + Decrease in A/R) XXX  
+ Increase in Accts Payable (or - Decrease in A/P) XXX  
- Gain on Sale of Assets (or + Loss on Sale of Assets) XXX  
Net Cash Flows from Operations   XXX
     
Cash Flows from Investing    
- Cash Purchases of LT Assets (or + Cash Sales of LT Assets) XXX  
Net Cash Flows from Investing   XXX
     
Cash Flows from Financing    
+ Issuance of Stock or LT Debt (or - Redemption of Stock or Debt) XXX  
- Payment of Dividends XXX  
Net Cash Flows from Financing   XXX
Net Cash Flows   XXX
+ Beginning Balance of Cash Account   XXX
Ending Balance of Cash Account   XXX

Let us now fill in the table with the increase/decrease data from Example 1. Note: negative cash flows are signified with parentheses.

Cash Flows from Operations    
Net Income $9,000  
+ Depreciation Expense 1,000  
- Increase in Accts Receivable (or + Decrease in A/R) (20,000)  
+ Increase in Accts Payable (or - Decrease in A/P) 15,000  
Net Cash Flows from Operations   $5,000
     
Cash Flows from Investing    
- Cash Purchases of LT Assets (or + Cash Sales of LT Assets) (20,000)  
Net Cash Flows from Investing   ($20,000)
     
Cash Flows from Financing    
+ Issuance of Stock or LT Debt (or - Redemption of Stock or Debt) $100,000  
- Payment of Dividends (3,000)  
Net Cash Flows from Financing   $97,000
Net Cash Flows (from Operating, Investing and Financing)   $82,000
+ Beginning Balance of Cash Account   0
Ending Balance of Cash Account   $82,000

Note that we achieved the same results using the indirect method that we got from using the Cash T-account approach.

Frequently Asked Questions About the Indirect Method

1. Why do we add the Depreciation Expense to the Net Income?

Net Income = Revenues minus Expenses. Depreciation is an expense, but it has no effect on cash. (We debit Depreciation Expense and credit Accumulated Depreciation. We don't credit Cash.) So, to make the net income = to the cash flow, we need to nullify the effect of this noncash expense. In fact, depreciation, depletion and amortization expenses would all need to be added back to the net income to derive the cash flow.

2. Why do we subtract an increase in Accounts Receivable? Accounts Receivable represent revenues that were earned but not collected in cash. If all sales were for cash, there would be no increase in Accounts Receivable. The amount by which Accounts Receivable went up represents the amount of revenues that have not come in yet. If we are trying to derive the net cash flow, we need to subtract the Accounts Receivable increase.

3. Why do we add an increase in Accounts Payable? Accounts Payable increase when expenses are not paid immediately. If some expenses were incurred on account, they reduce net income, but do not decrease Cash. The amount of cash we spent for expenses is equal to the expenses incurred minus the increase in Accounts Payable.

Other Current Assets and Current Liabilities

You should manage current assets in the same way as accounts receivable. So if the supplies account increases, subtract the increase from net income; if inventories decrease, add the decrease to net income.

For current liabilities, if salaries payable increases, add the increase to net income; if taxes payable decreases, subtract the decrease from net income.

The Ending Cash Balance as a Check Figure

How do you know if your cash flow statement is correct? You must arrive at the correct ending balance for cash. In Example 1, the cash flow statement must reconcile with the ending balance of cash, $82,000.

Noncash Investing and Financing Transactions

A special type of transaction must be considered--a transaction that does not involve cash, but must be treated as if it did involve cash. Suppose a company issued $110,000 of long term bonds in exchange for land. At first glance, you might take the viewpoint that this is a transaction that doesn't involve cash at all. In fact, you could imagine that the journal entry might have consisted of a debit to Land and a credit to Bonds Payable. That's probably true; there were no debits or credits to Cash.

This type of transaction is called a Noncash Investing and Financing transaction. The word "and" is literal here--the company is acquiring a plant asset (the investing part) and is using a financial instrument in order to acquire it (the financing part). Such transactions are supposed to be disclosed in a separate paragraph on the Cash Flow Statement.

Cash Flow Example 2--Second Year

Let us take a look at the transactions for the second year.

1. Johnson Company issued $50,000 of 6% bonds at par, with interest to be paid annually over 10 years.

2. Johnson purchased a piece of Land for $15,000, issuing a Note Payable for the entire amount. (This is a Noncash Investing and Financing transaction).

3. Johnson earned revenue of $50,000, receiving $30,000 in cash; $20,000 is on account (receivable).

4. Johnson incurred expenses of $25,000, and all of it was paid in cash.

5. Johnson paid off Accounts Payable of $4,000 in cash.

6. Johnson paid interest on the bonds for the year, $3,000 in cash.

7. Depreciation Expense on the Equipment for year 2 is $1,000.

8. Johnson sold 1/5 of the Land for $5,000 cash, making a $2,000 gain on the sale.

9. The accounts were closed and the net income transferred to Retained Earnings.

10. Johnson paid a $4,000 dividend in cash.

Presented below are the journal entries and postings for these 10 transactions.

CF Example 2

Example 2 Transactions--Discussion

The company issued $50,000 of 6% bonds--this is a financing transaction. The interest expense will be recorded at the end of the year.

In transaction 2, the company purchased Land for $15,000 entirely financed using a note payable. This is an example of a Noncash Investing and Financing transaction, which, at first glance, did not require the use of cash. The Land came in and a Note Payable was signed--no cash. However, according to the FASB, this type of transaction must be disclosed on the cash flow statement. A good way to do this is with a footnote.

The revenue and expense transactions are similar to those in Example 1. Note also that the company paid off Accounts Payable in the amount of $4,000--an operating transaction.

Transactions 6 and 7 are for one year's Interest Expense on the Bonds, and the Depreciation for year 2, respectively.

Transaction 8 is worthy of study. The company sold off 1/5 of the Land that they purchased for a total of $15,000. One third of the Land would have a cost basis of $3,000, but they sold it for $5,000, making a gain on the sale of $2,000. This gain goes to the income statement, where you will find a credit to the Gain on Sale of Land credited for $2,000. A gain increases the net income.

But--if you look at the effect on Cash T-account, the full $5,000 is debited to Cash. Our treatment will be to consider the $5,000 to be an Investing transaction, not an operating transaction, because investing transactions involve the acquisition or sale of long term assets. If we are to include the $5,000 in the investing section of the cash flow statement, we must take out the $2,000 gain from the operating section. Otherwise, the $2,000 amount will appear in both the operating and investing sections, overstating the cash flow amount from this transaction. Looking at the cash flow recipe, shown earlier, you will note that Gains from sales of long term assets are subtracted from net income in the operating section.

I showed the closing entries for Example 2 as journal entries; I did not post them, other than the final net income of $23,000 ending up in Retained Earnings.

Look at the Cash account postings:

Cash T2

If we combine the I's, O's and F's as before, we end up with this cash flow statement:

CF Statement 2

Note that we ended up with a negative cash flow from operations--not a good sign for a company. The investing total was solely from the sale of Land. In the financing area, the company issued bonds and paid a dividend.

Can you create the cash flow statement using the indirect method?

We know that the net income in year 2 was $23,000, the cash dividend was $4,000, and depreciation expense was $1,000.

Additionally, the changes in the accounts were as follows:

Account Beg. Balance Ending Balance Comment
Cash 82,000 $131,000 Increase of $49,000
Accounts Receivable 20,000 $40,000 Accounts Receivable increased by $20,000
Equipment 20,000 $20,000 No change
Accum. Depreciation Eq. 1,000 cr $2,000 cr Increase of $1,000
Land 0 12,000 Increase of $12,000
Accounts Payable 15,000 cr $11,000 cr Decrease of $4,000
LT Note Payable 0 $15,000 cr Increase of $15,000
Bonds Payable 0 $50,000 cr Increase of $50,000
Common Stock 100,000 cr $100,000 cr No change
Retained Earnings 6,000 cr $25,000 cr Increase of 23,000-4,000= 19,000 cr

It is good to check that the debits=credits in both the beginning and ending balance columns.

Taking all the clues into account, here is the cash flow statement for Year 2 using the indirect method.

Cash Flows from Operations    
Net Income $23,000  
+ Depreciation Expense 1,000  
- Increase in Accts Receivable (20,000)  
- Decrease in Accounts Payable (4,000)  
- Gain on Sale of Equipment (2,000)  
Net Cash Flows from Operations   ($2,000)
     
Cash Flows from Investing    
Cash Sales of LT Assets--Land $5,000  
Net Cash Flows from Investing   $5,000
     
Cash Flows from Financing    
+ Issuance of LT Bonds Payable $50,000  
- Payment of Dividends (4,000)  
Net Cash Flows from Financing   $46,000
Net Cash Flows (from Operating, Investing and Financing)   $49,000
+ Beginning Balance of Cash Account   82,000
Ending Balance of Cash Account   $131,000
Footnote 1: The company purchased land in the amount of $15,000 and signed a note payable in that amount. This transaction is considered a Noncash Investing and Financing Transaction.

Note that, as before, the ending balance in the Cash T-account reconciles with the ending figure on the cash flow statement.