Managing Your Cash Flow

Overview

The statement of cash flow reports the movement of cash into and out of your business in a given year. Cash is the lifeblood of your company. Cash includes currency, checks on hand, and deposits in banks. Cash equivalents are short-term, temporary investments such as treasury bills, certificates of deposit, or commercial paper that can be quickly and easily converted to cash.

Your business will use cash to pay bills, repay loans, and make investments, allowing you to provide goods and services to your customers. Your company will use cash to generate even more cash as a result of higher profits. The cash flow statement reports your businessí sources and uses of cash and the beginning and ending values for cash and cash equivalents each year. It also includes the combined total change in cash and cash equivalents from all sources and uses of cash.

It is imperative that you, the business owner, be able to successfully prepare a statement of cash flow. This discussion provides a detailed look into the various sections of a cash flow statement. It also describes two methods used to calculate cash flow from operating activities, indirect and direct with examples that will give you an edge when it comes time to prepare a cash flow statement of your own.

Outline:

  1. Background on a Statement of Cash Flow
  2. Major Classifications of Cash Flow
  3. Operating Activities
  4. Investing Activities
  5. Financing Activities
  6. General Format For a Statement of Cash Flow (interactive tables are available for your use)
  7. Indirect Method
  8. Sample Indirect Method Statement of Cash Flows
  9. Notes on Indirect Method Statement of Cash Flow
  10. Direct Method
  11. Sample Direct Method Worksheet
  12. Errors
  13. Resources

I. Background on a Cash Flow Statement

Before getting into the nuts and bolts of a statement of cash flow, letís take a brief look at how this document has evolved over the years.

Originally, businesses were required to file a statement of changes in financial position, or funds statement. The funds statement went through several years of development before it was widely used. In 1961, Accounting Research Study No. 2, sponsored by the American Institute of Certified Public Accountants (AICPA), recommended that a funds statement be included with the income statement and balance sheet in annual reports to shareholders.

Two years later, Accounting Principles Board (APB) Opinion No. 3 was issued and provided funds statement preparation guidelines. Although Opinion No. 3 did not go so far as to make the funds statement mandatory, most businesses, aware of the statementís value, included it in their annual reports anyway. Finally in 1971, APB Opinion No. 19 officially made the funds statement one of the three primary financial documents required in annual reports to shareholders. The APB also said a funds statement must be covered by the auditorís report. Because Opinion No. 19 didnít specify a particular format for the funds statement, businesses still enjoyed considerable flexibility in how they chose to report their funds flow information.

That flexibility came to an end in late 1987, with the Financial Accounting Standards Boardís (FASB) issuance of Statement No. 95, which called for a statement of cash flows to replace the more general funds statement. Additionally, the FASB, in an effort to help investors and creditors better predict future cash flow, specified a universal statement format that highlighted cash flow from operating, investing, and financing activities. This format is still used today.

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II. Major Classifications of Cash Flow

Cash Flow Statements are broken down into three sections:

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III. Operating Activities

Operating activities (all transactions and events that normally enter into the determination of operating income) include cash receipts from selling goods or providing services, as well as income from items such as interest and dividends. Operating activities also include your cash payments such as inventory, payroll, taxes, interest, utilities, and rent. The net amount of cash provided (or used) by operating activities is the key figure on a statement of cash flows.

Cash receipts include:

Sale of goods or services

Interest revenue

Dividend revenue

Cash payments include:

Inventory purchases

Payroll

Taxes Interest expense

Other (utilities, rent, etc.)

Note: While cash inflows from interest or dividends could be considered investing or financing activities, the FASB classifies them as operating activities (which means you should too!).

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IV. Investing Activities

Investing activities include transactions and events involving the purchase and sale of securities (excluding cash equivalents), land, buildings, equipment, and other assets not generally held for resale. It also covers the making and collecting of loans. Investing activities are not classified as operating activities because they have an indirect relationship to the central, ongoing operation of your business (usually the sale of goods or services).

Cash receipts include:

Sale of plant assets

Sale of a business segment

Sale of investments in equity securities of other entities or debt securities (other than cash equivalents)

Collection of principal on loans made to other entities

Cash payments include:

Purchase of plant assets

Purchase of equity securities of other entities or debt securities (other than cash equivalents)

Loans to other entities

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V. Financing Activities

All financing activities deal with the flow of cash to or from the business owners (equity financing) and creditors (debt financing). For example, cash proceeds from issuing capital stock or bonds would be classified under financing activities. Likewise, payments to repurchase stock (treasury stock) or to retire bonds and the payment of dividends are financing activities as well.

Cash receipts include:

Issuance of own stock

Borrowing (bonds, notes, mortgages, etc.)

Cash payments include:

Dividends to stockholders

Repaying principal amounts borrowed

Repurchasing business' own stock (treasury stock)

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VI. General Format For a Statement of Cash Flows

The Investing and Financing Activities sections of the statement of cash flows are straightforward. The Operating Activities section, however, is more complex. It requires analysis of operating accounts that converts figures from an accrual to a cash format.

The following is the general format for a statement of cash flows:

Cash provided (or used) by:
        Operating activities $XXX
        Investing activities $XXX
        Financing activities $XXX
Net increase (decrease) in cash and cash equivalents $XXX
Cash and cash equivalents at beginning of year $XXX
Cash and cash equivalents at end of year $XXX

There are two methods that are used in calculating and reporting the amount of net cash flow from operating activities: the indirect method and the direct method. Although both produce identical results, the indirect method is used more often because it reconciles the difference between net income and the net cash flow provided by operations.

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VII. Indirect Method

Popular because of its relative simplicity, the indirect method has you start with a figure for net income (from your income statement) and helps you adjust this accrual amount for any items that do not affect cash flows. There are three basic types of adjustments:

Note: When determining the change in current assets do not include the cash and cash equivalent accounts.

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VIII. Sample Indirect Method Statement of Cash Flows

(You can use the interactive table provided to create a cash flow statement for your company. Netscape users must scroll back down to the form after clicking 'submit' for your results.)

XYZ COMPANY
STATEMENT OF CASH FLOW
FOR THE YEAR ENDED DECEMBER 31, 2002

DIRECT METHOD
Cash flow from operating activities..
Cash receipts from customers..
Cash paid for inventory..
Cash paid for operating expenses..
Cash paid for interest expense..
Cash paid for Corporate Income taxes..
Ne cash provided (used)..
By operating activities..
Cash flow from investing activities..
Purchase of equipment..
Proceeds from sale of equipment..
Net cash provided (used)..
By investing activities..
Cash flow from financing activities..
Long term borrowings..
Reduction of long term-debt..
Net cash provided (used)..
By financing activities..
Net increase (decrease) in cash..
Cash at beginning of year..
Cash at end of year..

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IX. Notes on Indirect Method Statement of Cash Flow

  1. Take net income directly from your statement of income. In this example, the financial statements are on the accrual basis.

  2. Depreciation expense also comes directly from the statement of income.

  3. Gain from sale of equipment in this example, the company sold equipment during 1997 and recognized a gain from the sale. The profit from the gain is removed from the operating activities section of the cash flow statement and recorded later in the investing activities section.

  4. Increase in current assets do not include cash or cash equivalents when determining this item. Instead use this formula:

    Current Assets 12/31/00 $ 75,500
    Current Assets 12/31/99 $70,000
    Increase $5,500

  5. Note: Since current assets increased, $5,500 is reported as a negative amount. Cash was spent or converted into current assets, therefore reducing the cash balance.

  6. Increase in current liabilities an increase in liabilities allows for more cash. Therefore, the increase is presented as a positive amount increasing the cash flow.
    Note: Do not include any change in short-term debt from loans or mortgages. Changes in short-term debt are reported under the financing activities (see notes 8 and 9 below).
  7. Purchase of equipment don't worry whether the company used its own cash or borrowed funds to buy equipment. If a check was written, cash decreased.

  8. Proceeds from sale of equipment cash received from the sale of equipment.

  9. Reduction in long term debt cash spent on reducing the companyís long-term debt.

  10. Long-term borrowings indicates what the company borrowed in the form of long-term debt, while number 8 reported what was repaid on the new and old long-term debt. If the company had short-term debt, numbers 8 and 9 should be repeated.
Note: The change in short-term debt is not part of number 5.

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X. Direct Method

The direct method, although less popular, is favored by many financial managers because it reports the source of cash inflows and outflows directly, without the potentially confusing adjustments to net income. Instead of starting with a reported net income, the direct method analyzes the various types of operating activities and calculates the total cash flow created by each one. Before beginning the direct method, all accrual accounts must first be converted to a cash figure.

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XI. Sample Direct Method Worksheet

This worksheet will help explain how the amounts were determined in the direct method cash flow statement (see Statement).

A. Cash receipts from customers:
      Net Sale
      +Beginning Accounts Rec. (1/1/00)
      -Ending Accounts Rec. (12/31/00)
      Cash Receipts from Customers


B. Cash payments for inventory:
      +Ending Inventory (12/31/00)
      -Beginning Inventory (1/1/00)
      +Beginning A/P (1/1/00)
      -Ending A/P (12/31/00)
      Cash paid for inventory


C. Cash paid for operating expenses:
      Operating expenses
      -Depreciation expense
      +Ending prepaid expense
      -Beginning prepaid expense
      +Beginning expense payable
      -Ending expense payable
      Cash paid for operating expenses


D. Cash paid for interest expense:
      Interest expense per P&l
      +Beginning interest payable
      -Ending interest payable
      Cash paid for interest expense


E. Cash paid for corporate income taxes
      Income taxes expense per P&L
      +Beginning taxes payable
      -Ending taxes payable
      Cash paid for corporate taxes

DIRECT METHOD
XYZ COMPANY
STATEMENT OF CASH FLOW
FOR THE YEAR ENDED DECEMBER 31, 2002

CASH FLOWS FROM OPERATING ACTIVITIES
Cash receipts from customers..
Cash payments for inventory..
Cash paid for operating expenses..
Cash paid for interest expense..
Cash paid for corporate income taxes..
Net cash provided (used) by operating activities..

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XII. Errors

Common problems encountered in preparing a cash flow statement stem from trade-ins on equipment or from the preparerís failure to adjust net income by the gain or loss from the sale of equipment.

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XIII. Resources

Statement of Financial Accounting Standard No. 95 "Statements of cash flows"

Books

Fred Skousen et al., "Intermediate Accounting" (south-Western Pub., 2000)

Magazines

Journal of Accountancy

The Practical Accountant

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