Interpreting the Cash Flow Statement
In this lesson, you’re expected to learn about:
– operating, investing, and financing activities
– using a cash flow statement
The cash flow statement describes the movement of cash into a company (inflows) and out of a company (outflows), and the reasons why these cash flows occur.
To create a cash flow statement, companies divide cash flows into three separate categories based on the type of business activity that caused the transaction to take place:
– Operating Activities
– Investing Activities
– Financing Activities
Each cash flow statement starts with a section on operating activities that lists the transactions that increase cash flow, followed by the transactions that decrease cash flow.
The end of each section lists the net cash flow as positive or negative. So if a company makes revenues from its primary operations, it would have a positive net cash flow.
Together, the three sections of the cash flow statement determine how a company’s different financial operations influence its total cash flows. Management can then use this information to better manage its cash and identify any potential problems that may result from having a lack of cash.
Though a company may have a lot of assets, unless it can turn those assets into cash, it can still have cash flow and liquidity problems.
Operating Activities Cash Flows
These cash flows include any increases or decreases in cash that result from the primary functions of the company. In this section, the most commonly seen changes in cash are:
1) Cash received from customers: when a customer pays in cash, you count that transaction as a cash increase.
2) Cash paid to suppliers and employees: this cash counts as cash flow but it doesn’t include cash paid for direct labor only.
3) Income taxes paid: these are considered a part of operations because they’re the taxes that result from selling goods at a profit.
Net cash flow from operating activities
The total amount of cash gained or lost by operations.
To calculate it, add up the positive values from the list above and subtract the negative values.
Investing Activities Cash Flows
Whenever a company purchases or sells any form of investment, including long-term assets, the cash flows result in a gain or loss in cash from the total cash and cash equivalents.
Any of these cash flow changes that result from the purchase or sale of investment assets belong in the investing activities portion of the cash flow statement.
Some of the most common transactions in this section are:
1) Purchases of investments: when a company buys an investment with cash, the price of that purchase decreases the amount of cash available to the company. No matter what type of investment it is, the impact on cash influences the cash flows from investing activities.
2) Proceeds from sale of investments: when a company sells the investments it already owns for cash, whatever cash increase the sale generates is considered proceeds from investing activities.
3) Purchase of fixed assets: since companies often make fixed asset purchases on credit, the impact on cash usually happens a little at a time over several periods.
4) Interest received: savings accounts and certain types of short-term money-market investments generate interest. This interest comes in the form of cash and so contributes to a positive net cash flow.
5) Interest paid: a number of transactions related to operations influence a company’s cash balance, including interest financing for the purchase of equipment and stock or other short-term loans.
Net cash flow from investing activities
When you add up all the positive values from investing activities and subtract the negative values, the resulting figure is the total amount of change in cash the company has had as a result of its investing activities.
Financing Activities Cash Flows
Financing refers to the process of acquiring capital to fund a new company, an expansion, and basic operations for which a company needs the extra funds.
Most of the time changes in liabilities and shareholders’ fundsimpact cash, regardless of whether the company is acquiring or repaying the cash.
The following types of financing activities show up in the cash flow statement:
1) Sale of shares: when a company sells another company’s shares, the sale is considered an investing activity but when it sells its own shares, the sale is considered a financing activity.
2) Dividend payments: a company that makes money has to give it back to shareholders at some point. It may hold on to that money in the P&L account reserves (or retained earnings) to reinvest that money back into the business. Alternatively, it might pay out the cash held now in the form of dividends to the shareholders.
3) Purchase of treasury shares: a company purchases its own shares.
4) Loans received: companies often accept loans as a way of financing operations or expansion.
5) Loans paid: companies need to pay back the loans they accept, which is typically done by using cash.
Net cash flows from financing activities
When you add up the positive values of the items in the preceding list and subtract the negative ones, you get the net cash flows from financing activities.
When you add up all the net cash provided by the three types of company operations, you get the total amount of change to the company’s cash and cash equivalents as follows:
– Positive net change: the company increased its total amount of cash.
– Negative net change: the company decreased its total amount of cash.
A reduction in cash isn’t necessarily a bad thing, as long as the operations are positively contributing to the company’s overall value. If a company is experiencing negative cash flows consistently, management has to ensure that it manages the company’s cash and other assets carefully so that the firm can continue to pay its bills.
The cash flow statement is useful for lenders who are considering whether or not to lend money to a company. Even if a firm is making money, lenders still want to make sure that it will have cash available to make payments on its loans.
So lenders commonly use the cash flow statement to assess a company’s financial health, particularly its ability to maintain consistent positive cash flows to the degree required to pay off any potential new loans.
– to measure a company’s liquidity.
– to measure the strength of a company’s profitability.
– to evaluate how efficiently a company is using its assets.
– to evaluate a company’s financial management regarding its costs of capital.