The Statement of Cash Flows (also referred to as the cash flow statement) is one of the three key financial statements that report the cash generated and spent during a specific period of time (e.g., a month, quarter, or year). The statement of cash flows acts as a bridge between the income statement and balance sheet by showing how money moved in and out of the business.
Three Sections of the Statement of Cash Flows:
Operating Activities: The principal revenue-generating activities of an organization and other activities that are not investing or financing; any cash flows from current assets and current liabilities.
Investing Activities: Any cash flows from the acquisition and disposal of long-term assets and other investments not included in cash equivalents
Financing Activities: Any cash flows that result in changes in the size and composition of the contributed equity capital or borrowings of the entity (i.e., bonds, stock, dividends)
Cash Balance: Cash on hand and demand deposits (cash balance on the balance sheet)
Cash Equivalents: Cash equivalents include cash held as bank deposits, short-term investments, and any very easily cash-convertible assets – includes overdrafts and cash equivalents with short-term maturities (less than three months).
Cash Flow Classifications
1. Operating Cash Flow
Operating activities are the principal revenue-producing activities of the entity. Cash Flow from Operations typically includes the cash flows associated with sales, purchases, and other expenses.
The company’s chief financial officer (CFO) chooses between the direct and indirect presentation of operating cash flow:
Direct Presentation: Operating cash flows are presented as a list of cash flows; cash in from sales, cash out for capital expenditures, etc. This is a simple but rarely used method, as the indirect presentation is more common.
Indirect Presentation: Operating cash flows are presented as a reconciliation from profit to cash flow:
Change in working capital
Change in provisions
Operating cash flow
The items in the cash flow statement are not all actual cash flows, but “reasons why cash flow is different from profit.”
Depreciation expense reduces profit but does not impact cash flow (it is a non-cash expense). Hence, it is added back. Similarly, if the starting point profit is above interest and tax in the income statement, then interest and tax cash flows will need to be deducted if they are to be treated as operating cash flows.
There is no specific guidance on which profit amount should be used in the reconciliation. Different companies use operating profit, profit before tax, profit after tax, or net income. Clearly, the exact starting point for the reconciliation will determine the exact adjustments made to get down to an operating cash flow number.
2. Investing Cash Flow
Cash flow from investing activities includes the acquisition and disposal of non-current assets and other investments not included in cash equivalents. Investing cash flows typically include the cash flows associated with buying or selling property, plant, and equipment (PP&E), other non-current assets, and other financial assets.
Cash spent on purchasing PP&E is called capital expenditures (CapEx).
3. Financing Cash Flow
Cash flow from financing activities are activities that result in changes in the size and composition of the equity capital or borrowings of the entity. Financing cash flows typically include cash flows associated with borrowing and repaying bank loans, and issuing and buying back shares. The payment of a dividend is also treated as a financing cash flow.
Below is an example from Amazon’s 2017 annual report, which breaks down the cash flow generated from operations, investing, and financing activities. Learn how to analyze Amazon’s consolidated statement of cash flows in CFI’s Amazon Advanced Financial Modeling Course.
Under IFRS, there are two allowable ways of presenting interest expense in the cash flow statement. Many companies present both the interest received and interest paid as operating cash flows. Others treat interest received as investing cash flow and interest paid as a financing cash flow. The method used is the choice of the finance director.
Under U.S. GAAP, interest paid and received are always treated as operating cash flows.
Free Cash Flow
Investment bankers and finance professionals use different cash flow measures for different purposes. Free cash flow is a common measure used typically for DCF valuation. However, free cash flow has no definitive definition and can be calculated and used in different ways.
The operating section of the statement of cash flows can be shown through either the direct method or the indirect method. With either method, the investing and financing sections are identical; the only difference is in the operating section. The direct method shows the major classes of gross cash receipts and gross cash payments.
The indirect method, on the other hand, starts with the net income and adjusts the profit/loss by the effects of the transactions. In the end, cash flows from the operating section will give the same result whether under the direct or indirect approach, however, the presentation will differ.
The International Accounting Standards Board (IASB) favors the direct method of reporting because it provides more useful information than the indirect method. However, it is believed that greater than 90% of public companies use the indirect method.
Direct Method vs Indirect Method of Presentation
There are two methods of producing a statement of cash flows, the direct method, and the indirect method.
In the direct method, all individual instances of cash that are received or paid out are tallied up and the total is the resulting cash flow.
In the indirect method, the accounting line items such as net income, depreciation, etc. are used to arrive at cash flow. In financial modeling, the cash flow statement is always produced via the indirect method.
Below is a comparison of the direct method vs the indirect method.
What Can the Statement of Cash Flows Tell Us?
Cash from operating activities can be compared to the company’s net income to determine the quality of earnings. If cash from operating activities is higher than net income, earnings are said to be of “high quality.”
This statement is useful to investors because, under the notion that cash is king, it allows investors to get an overall sense of the company’s cash inflows and outflows and obtain a general understanding of its overall performance.
If a company is funding losses from operations or financing investments by raising money (debt or equity) it will quickly become clear on the statement of cash flows