Introduction to the Cash Flow Statement

Hey there! In this video, we’re going to dive into the world of the Cash Flow Statement. It’s one of the three major financial statements, along with the Income Statement and Balance Sheet. The Cash Flow Statement summarizes a business’s cash inflows and outflows over a specific period of time, providing crucial insights into how cash is moving in and out of the business. There are two main methods for preparing the statement: the direct method, which mirrors the cash accounting method, and the indirect method, which starts with the net profit or loss from the Income Statement. The Cash Flow Statement has three main sections: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. Positive numbers represent cash inflows, while negative numbers represent cash outflows. The indirect method is more commonly used because it’s easier to work out using information from the Income Statement and Balance Sheet. Throughout the video, an example of a Cash Flow Statement using the indirect method is provided, using an Income Statement and Balance Sheet for Tumble, a fictional dating app. By the end, you’ll have a good understanding of how to create a Cash Flow Statement and its importance in financial planning.

What is the Cash Flow Statement?

The Cash Flow Statement is an essential financial statement that provides a summary of a business’s cash inflows and outflows over a specific period of time. Alongside the Income Statement and Balance Sheet, it is one of the three major financial statements used to assess a company’s financial health and performance. The Cash Flow Statement is crucial for understanding how cash is moving in and out of the business, providing insights into a company’s liquidity, operational efficiency, and ability to generate future cash flows.

Methods of Preparing the Cash Flow Statement

Direct Method

One method for preparing the Cash Flow Statement is the direct method. The direct method mirrors the cash method of accounting, which recognizes revenue when cash is received and records expenses when cash is paid out. With the direct method, cash receipts from customers, cash paid to suppliers and employees, interest paid, and taxes paid are all directly recorded in the Cash Flow Statement. This method provides a more straightforward presentation of the cash flows, making it easier for non-accountants to understand.

Indirect Method

The indirect method is another commonly used method for preparing the Cash Flow Statement. Unlike the direct method, the indirect method starts with the net profit or loss from the Income Statement and makes adjustments for non-cash expenses and changes in working capital. Non-cash expenses, such as depreciation and amortization, are added back to the net profit or loss, while changes in working capital, such as receivables and payables, are adjusted for in the Cash Flow Statement. The indirect method is more widely used because it is easier to calculate using information from the Income Statement and Balance Sheet.

Comparison between direct and indirect methods

Both the direct and indirect methods provide the same information in the Cash Flow Statement, but they differ in their approach. The direct method presents the actual cash inflows and outflows, while the indirect method starts with the net profit or loss and makes adjustments for non-cash expenses and changes in working capital. The direct method provides a more intuitive presentation of cash flows, but it requires more detailed tracking and record-keeping. On the other hand, the indirect method is easier to calculate and understand but provides less visibility into the specific cash inflows and outflows.

Sections of the Cash Flow Statement

The Cash Flow Statement consists of three main sections:

Cash Flow from Operating Activities

Cash flow from operating activities represents the cash inflows and outflows related to a company’s core revenue-generating activities. It includes cash received from customers, cash paid to suppliers and employees, interest received or paid, and taxes paid. Operating activities are essential for assessing a company’s ability to generate cash flow from its primary business operations.

Cash Flow from Investing Activities

Cash flow from investing activities reports the cash inflows and outflows resulting from a company’s investments in long-term assets or the sale of investments. It includes cash spent on the purchase of property, plant, and equipment, as well as cash received from the sale of these assets. Investing activities provide insights into a company’s investment decisions and capital expenditure.

Cash Flow from Financing Activities

Cash flow from financing activities reflects the cash inflows and outflows related to a company’s financing activities, such as borrowing or raising capital. It includes cash received from issuing debt or equity, as well as cash paid for the repayment of debt or distribution of dividends to shareholders. Financing activities give an overview of how a company raises funds to support its operations.

Understanding Positive and Negative Numbers

In the Cash Flow Statement, positive numbers represent cash inflows, while negative numbers represent cash outflows. Cash inflows are funds coming into the business, visible when a company receives cash from customers, earns interest, or raises capital. On the other hand, cash outflows are funds leaving the business, seen when a company pays suppliers, employees, taxes, or dividends. Understanding the representation of positive and negative numbers is crucial in accurately assessing a company’s cash flow position.

Advantages of the Indirect Method

The indirect method has several advantages over the direct method when preparing the Cash Flow Statement:

Ease of use with information from other statements

The indirect method is easier to use because it utilizes information from the Income Statement and Balance Sheet. It starts with the net profit or loss from the Income Statement and makes adjustments based on non-cash expenses and changes in working capital. This approach provides a more straightforward calculation process and requires less detailed tracking of cash inflows and outflows.

Reconciliation of net increase or decrease in cash

The indirect method helps reconcile the net increase or decrease in cash with the movement in the Balance Sheet. By adjusting for non-cash expenses and changes in working capital, the indirect method ensures that the reported cash flows accurately reflect the changes in cash during the specified period. This reconciliation is crucial for effectively analyzing a company’s financial performance and identifying any discrepancies or inconsistencies.

Example of a Cash Flow Statement using the Indirect Method

To illustrate the process of preparing a Cash Flow Statement using the indirect method, let’s consider an example for a fictional company called Tumble. We’ll go through the steps involved in constructing the Cash Flow Statement.

Step 1: Determining net profit or loss

The first step in preparing the Cash Flow Statement using the indirect method is to determine Tumble’s net profit or loss for the current year. This information can be found in the Income Statement. The net profit or loss represents the company’s revenue minus expenses during the specified period and serves as the starting point for calculating cash flows.

Step 2: Reversing out non-cash expenses

Next, Tumble needs to reverse out any non-cash expenses from the net profit or loss in the Cash Flow Statement. Non-cash expenses are expenses that do not involve actual cash outflows, such as depreciation and amortization. These expenses are added back to the net profit or loss to reflect the cash impact accurately.

Step 3: Adjusting for the movement in working capital

Working capital represents the difference between current assets and current liabilities and reflects a company’s short-term liquidity. Changes in working capital, such as changes in receivables (money owed by customers) and payables (money owed to suppliers), need to be adjusted for in the Cash Flow Statement. Increases in receivables reduce cash flow, while increases in payables increase cash flow.

Step 4: Calculation of net cash inflow from operating activities

After adjusting for non-cash expenses and changes in working capital, Tumble can calculate the net cash inflow from operating activities. This number represents the cash generated from Tumble’s core business operations. It includes cash received from customers, cash paid to suppliers and employees, and any other operating-related inflows or outflows.

Step 5: Cash flow from investing activities

Tumble needs to calculate the cash flow from investing activities, which involves cash inflows and outflows related to investments in long-term assets or the sale of investments. For example, if Tumble purchases computer equipment, it would result in a cash outflow, while selling a long-term asset would result in a cash inflow.

Step 6: Cash flow from financing activities

Next, Tumble needs to determine the cash flow from financing activities, which involves cash inflows and outflows related to funding the business. This includes raising capital through debt or equity, as well as repaying debt or distributing dividends to shareholders. For example, if Tumble borrows money from a bank, it would result in a cash inflow, while paying off debt would result in a cash outflow.

Step 7: Calculation of net increase or decrease in cash

Finally, Tumble can calculate the net increase or decrease in cash by adding the cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. This number represents the overall change in Tumble’s cash position during the specified period.

Step 1: Determining Net Profit or Loss

Determining the net profit or loss is the starting point for creating the Cash Flow Statement. It represents the revenue minus expenses for the specified period and is usually found in the Income Statement. For Tumble, which is a fictional dating app company, the net profit or loss for the year ended December 31st is recorded.

Importance of starting with net profit or loss

Starting with net profit or loss is crucial because it represents the company’s core financial performance. It provides the foundation for calculating the cash flows from operating activities, which captures the cash generated or used by the business’s day-to-day operations.

Using the Income Statement to find net profit or loss

The net profit or loss can typically be found in the Income Statement of a company. It is calculated by deducting expenses, such as cost of goods sold, salaries, rent, utilities, and other operating expenses, from total revenue. The resulting figure reflects whether the company had a profit or a loss during the specified period.

Step 2: Reversing out Non-Cash Expenses

After determining the net profit or loss, Tumble needs to reverse out any non-cash expenses in the Cash Flow Statement. Non-cash expenses are expenses that do not involve actual cash outflows and need to be added back to reflect the cash impact accurately.

Definition and examples of non-cash expenses

Non-cash expenses are expenses that are recorded in the Income Statement but do not involve any cash outflows. Examples of non-cash expenses include depreciation, amortization, and changes in the fair value of financial instruments. These expenses are considered accounting entries that reflect the cost of using assets but do not directly impact the cash flow of the business.

Adjusting for non-cash expenses in the cash flow statement

To adjust for non-cash expenses in the Cash Flow Statement, Tumble needs to add back the value of these expenses to the net profit or loss. This adjustment ensures that the cash flow statement accurately reflects the cash flow generated or consumed by the business, excluding non-cash items.

Step 3: Adjusting for the Movement in Working Capital

Working capital represents the short-term liquidity of a company and is an important indicator of its operational efficiency. As part of preparing the Cash Flow Statement, Tumble needs to adjust for changes in working capital, specifically changes in receivables and payables.

Understanding working capital

Working capital is the difference between a company’s current assets and current liabilities. It represents the funds available to meet short-term obligations and finance day-to-day operations. Positive working capital indicates that a company has enough current assets to cover its current liabilities, while negative working capital suggests a potential liquidity issue.

Adjusting for changes in receivables and payables

Changes in receivables and payables affect a company’s cash flow and need to be adjusted for in the Cash Flow Statement. An increase in receivables represents cash that has not yet been collected, resulting in a reduction in cash flow. Conversely, an increase in payables represents cash that the company owes but has not yet paid, resulting in an increase in cash flow. Tumble needs to consider these changes when calculating the net cash inflow or outflow from operating activities.

Conclusion

The Cash Flow Statement is a crucial financial statement that provides insights into a company’s cash inflows and outflows over a specific period of time. By understanding the components of the statement and applying the indirect method, businesses can gain valuable insights into their liquidity, operational efficiency, and ability to generate future cash flows. The Cash Flow Statement, along with the Income Statement and Balance Sheet, forms a comprehensive picture of a company’s financial health and performance, assisting in decision-making processes and financial planning.