The Cash Flow Statement – also referred to as a statement of cash flows or funds flow statement – is one of the three financial statements commonly used to gauge a company’s performance and overall health. The other two financial statements — Balance Sheet and Income Statement — have been addressed in previous articles.
As the name implies, the Cash Flow Statement provides information about an organization’s cash inflows and outflows over a specified time period. Simply put, it reveals how a company spends its money (cash outflows) and where that money comes from (cash inflows).
This statement is the best resource for testing a company’s liquidity because it shows changes over time, rather than absolute dollar amounts at a specific point in time. It’s also useful in determining the short-term viability of a company.
It’s important to note that the Cash Flow Statement reflects a firm’s liquidity. It does not show profitability – the Income Statement does that.
Cash Flow Statement: Acme Manufacturing
| Cash Flow From Operations | |
| Net Income | $138,100 |
| Additions to Cash | |
| Depreciations | $55,500 |
| Decrease in Accounts Receivable | $13,000 |
| Increase in Accounts Payable | $12,000 |
| Increase in Taxes Payable | $8,000 |
| Subtractions from Cash | |
| Increase in Inventory | ($100,000) |
| Net Cash From Operations | $126,600 |
| Cash Flow From Investing | |
| Equipment | ($73,000) |
| Cash Flow From Financing | |
| Notes Payable | $10,025 |
| CASH FLOW FOR FY ENDED 31 DEC 2020 | $63,625 |
How the Cash Flow Statement is Prepared
There are two methods of preparing the Cash Flow Statement: direct and indirect.
- The direct method utilizes actual cash flow information from the company’s operations. It presents major classes of gross cash receipts and payments. The direct method would most likely be used by small firms doing their accounting on a cash rather than an accrual basis.
- The indirect method derives the data from the Income Statement and from changes on the Balance Sheet from one period to the next. Both the Income Statement and the Balance Sheet are based on accrual accounting.
Note #1: Net Income on the Acme Manufacturing’s 2020 Consolidated Statement of Cash Flows is $138,100. This number was taken from Net Income as listed on the Acme Manufacturing 2020 Consolidated Statements of Income.
The U.S. GAAP (Generally Accepted Accounting Principles) requires that a Cash Flow Statement prepared by the indirect method be included in financial statements, even if it is also prepared by the direct method. Therefore, most companies use the indirect method and the rest of this article refers only to the indirect method using Acme Manufacturing’s 2020 data.
Components of the Cash Flow Statement and What They Tell Us
This statement organizes and reports cash in three categories: operating, investing, and financing.
Operating Activities
This represents the key source of an organization’s cash generation. It’s considered by many to be the most important information on the Cash Flow Statement.
This section of the statement shows how much cash is generated from a company’s core products or services. A strong, positive cash flow from operations (especially over time) is a good sign of a healthy company.
Operating Activities starts with the Net Income number from the Income Statement.
Example #1: Acme Manufacturing’s Net Income numbers on the Income Statement and the Cash Flow Statement are the same.
| 2020 | 2019 | |
| Net Income (Income Statement, line 16) |
$138,100 | $242,400 |
| Net Income (Cash Flow Statement, line 2) |
$138,100 | $242,400 |
If all of a company’s operating revenues and expenses were in cash, then Net Cash Provided by Operating Activities (Cash Flow Statement) would equal Net Income (Income Statement). However, this is rarely the case. Typically, adjusting Net Income on the Cash Flow Statement is based on an increase or decrease in cash calculated from changes on the Balance Sheet from one period to the next.
Example #2: Merchandise Inventories on Acme Manufacturing’s Consolidated Balance Sheet
| 2020 | 2019 | |
| Merchandise Inventories (Balance Sheet) |
158,600 | 58,600 |
| Difference in inventory (2020 over 2019) |
158,600 – 58,600 = 100,000 | |
The increase in merchandise inventories in 2020 results in a negative adjustment of the same amount ( $100,000) on the 2020 Acme Manufacturing Consolidated Statement of Cash Flows.
Most of these adjustment items can either result in an increase or decrease in cash from operating activities. Exceptions would be adjustments for depreciation and amortization, which are always an increase to Net Income on the Cash Flow Statement.
Look for consistent levels of cash flow from Operating Activities over time, indicating the company will probably continue to be able to fund its operations.
Investing Activities
This section records changes in equipment, assets, or investments.
Cash changes from investing are generally considered “cash outflows” because cash is used to purchase equipment, buildings, or short-term assets. When a company divests an asset, the transaction is considered a “cash inflow.” A healthy company generally invests continually in plant, equipment, land and other fixed assets.
Financing Activities
Changes in debt, loans or stock options, long-term borrowings, etc. are accounted for under Financing Activities.
When capital is raised, it is considered “cash in”; when dividends are paid or debt is reduced, “cash out”. The Financing Activities section shows how borrowing affects the company’s cash flow.
“Bottom Line”
The bottom line on the statement is the Net Increase (Decrease) in Cash and Cash Equivalents. It’s determined by calculating the total cash inflows and outflows for each of the three sections in the Cash Flow Statement.
The 2020 Net Increase (Decrease) in Cash and Cash Equivalents on the Cash Flow Statement should equal the difference between the 2020 and 2019 Cash and Cash Equivalents figures on the Balance Sheet.
Example #3: Acme Manufacturing 2020 Balance Sheet Net Decrease in Cash and Cash Equivalents
| 2020 | 2019 | |
|
Statement of Cash Flows Net Cash (Operating Activities) – Net Cash (Investing Activities) + Net Cash (Financing Activities) |
$126,600 (operating) – $73,000 (investing) + $10,025 (financing) |
$226,600 (operating) – $83,500 (investing) + $12,025 (financing) |
| Bottom Line | $63,625 | $155,125 |
Supplemental Information
There is a fourth section, titled “Supplemental Information”, which is often included with the primary three sections of the Cash Flow Statement. It reports the exchange of significant items, such as company stock for company bonds, which did not involve cash.
This section also records the amount of income taxes and interest paid. The Acme Manufacturing Consolidated Statement of Cash Flows does not include Supplemental Information.
Using the Cash Flow Statement to Determine the Financial Health of an Organization
The statement shows how a company raised money (cash) and how it spent those funds during a given period. It’s a tool that measures a company’s ability to cover its expenses in the near term.
Generally, a company is considered to be in “good shape” if it consistently brings in more cash than it spends. Cash flow reflects a company’s financial health, and its ability to pay its bills and other liabilities.
In most cases, the more cash available for business operations, the better. However, a low or negative cash flow in one year could result from a company’s growth strategy – and, therefore, not be a real issue. As with all financial analysis, it’s important to determine the company’s cash flow trend.
“High Quality” Net Income
To determine if a company’s net income is of “high quality”, compare the Net Cash Provided by Operating Activities to the Net Income. Both of these figures are found on the Cash Flow Statement. The Net Cash Provided by Operating Activities should be consistently (over time) greater than the Net Income.
Note #3: On Acme Manufacturing’s Consolidated Statement of Cash Flows, you can see that 2020 Net Cash Provided by Operating Activities is less than Net Income. This is not a good sign. It’s important to understand, however, where the decrease is coming from – so a more thorough analysis over a greater period of time would help.
Cash Flow-based Financial Ratios
The problem with using the Balance Sheet for liquidity analysis is that it only presents data that measures where the organization stands at a particular point in time.
The problem with the Income Statement is that it includes many non-cash allocations, accounting conventions, accruals and reserves that have nothing to do with cash.
Utilizing the Cash Flow Statement for liquidity analysis results in a more dynamic picture of the resources a company has to meet its current financial obligations.
1. Cash Flow to Sales = Operating Cash Flow ÷ Net Sales
This ratio determines how much cash is being generated for each dollar of sales. Obviously, the higher the number, the better.
Example #4: Acme Manufacturing Cash Flow to Sales
| Net Cash Provided by Operating Activities (Cash Flow Statement) |
Net Sales (Income Statement) |
Cash Generated for Each Dollar of Sales | |
| 2020 | $126,600 ÷ | $1,864,000 = | $0.06 or 6% |
| 2019 | $226,600 ÷ | $1,790,200 = | $0.13 or 13% |
Is this good or bad? At first glance, six cents cash generated by each one dollar of sales in 2020 isn’t great, but not bad. What is troubling, however, is that Acme Manufacturing’s Cash Flow to Sales has decreased by seven cents from the previous year, which is a major cause for concern. To make a more accurate assessment, you should compare this performance to industry benchmarks and get to the root of what caused such a decrease.
2. Operation Index = Net Cash from Operations ÷ Net Income after income tax
This measures the relationship between operating cash flows and profit. The higher the percentage, the better.
Example #5: Acme Manufacturing Operation Index
| Net Cash Provided by Operating Activities (Cash Flow Statement) |
Net Income (Income Statement) |
Operation Index | |
| 2020 | $126,600 ÷ | $138,100 = | 91.6% |
| 2019 | $226,600 ÷ | $242,400 = | 93.5% |
3. Operating Cash Flow Ratio = Cash Flow from Operations ÷ Current Liabilities
This ratio is used to assess whether an operation is generating enough cash to cover current liabilities.
If the ratio falls below 1.00, the company isn’t bringing in enough cash and will have to find other sources to finance its operations.
Example #6: Acme Manufacturing Operating Cash Flow (OCF) Ratio
| Net Cash Provided by Operating Activities (Cash Flow Statement) |
Total Current Liabilities (Balance Sheet) |
Operating Cash Flow Ratio | |
| 2020 | $126,600 ÷ | $558,800 = | $0.23 |
| 2019 | $226,600 ÷ | $560,800 = | $0.40 |
Conclusion
Looking at the Balance Sheet and Income Statement in previous articles, Acme Manufacturing has taken on too much inventory in 2020 and is negatively affecting its free cash flow. The overall impression from the Cash Flow Statement raises concern regarding Acme Manufacturing’s ability to pay its short-term liabilities (including payments due creditors).
The Income Statement and Balance Sheet are important tools for evaluating a company’s health. However, the Cash Flow Statement is an important complement to these, and should not be overlooked.
These articles give you a basic understanding and the tools you need. Use them to improve your credit decision-making process by examining all three of these financial statements to get the best idea of how a current or potential customer’s company is doing.
If you enjoyed this article, check out these other credit management articles.
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