FSA 4 Analyzing Statements of Cash Flows I

The statement of cash flows records the cash a company takes in and pays out over a reporting period, and it reconciles the cash balance on one balance sheet date to the cash balance on the next. The income statement measures performance for the same period, but it does so on an accrual basis, so it does not track when cash actually moves. Because investors are ultimately paid in cash, the size and timing of cash flows matter for valuation and for judging a company’s liquidity, solvency, and financial flexibility.

Four primary statements describe an entity, and they interlock:

• Balance sheet: the financial position at a single point in time, reporting the balances of stock accounts (assets and how they are financed).
• Income statement: financial performance between two balance sheet dates. It is a flow statement built from revenue, expense, gain, and loss accounts, prepared on an accrual basis under IFRS or US GAAP.
• Statement of cash flows: the change in cash, cash equivalents, and restricted cash between two balance sheet dates, with each inflow and outflow classified as operating, investing, or financing. It is also a flow statement.
• Statement of shareholders equity: how equity moved between two balance sheet dates, showing components such as common stock and retained earnings and the events (share issuance, net income or loss, dividends) that changed them.

The income statement, the cash flow statement, and the statement of shareholders equity each carry the balance sheet forward across successive reporting dates. In the simplest terms, the cash flow statement reconciles the two cash balances:

Similarly, the statement of shareholders equity ties the opening retained earnings on one balance sheet to the closing figure on the next, adding net income from the income statement and subtracting any dividends, which also appear on the cash flow statement when paid in cash.

Linkages between current assets and current liabilities

Accrual accounting and cash accounting recognize operating activity at different moments, and the gap between them lands in a current asset or current liability. When accrual revenue exceeds cash collected, accounts receivable rises. When accrual expense is below the cash paid, accounts payable or another accrued liability falls. When a company is paid before it delivers, it books the cash as an asset and records a deferred revenue liability for the obligation still owed; that liability is removed once the performance obligation is satisfied and revenue is recognized.

These links let an analyst solve for a missing figure. Given the opening receivable, revenue, and cash collected, the closing receivable follows:

Tracing these relationships is useful for gauging financial health and for spotting irregularities. A company that keeps booking sales on credit with little regard for collection can show strong reported income while almost no cash arrives, a classic signature of improper revenue recognition.

The first step in building a cash flow statement is the operating section, which may be shown two ways. The direct method reports gross operating receipts and payments grouped by category (cash from customers, cash to suppliers, and the like). The indirect method instead reconciles net income to operating cash flow. Investing and financing activities are presented the same way under either choice.

Companies most often disclose only the indirect version, but if you understand how the pieces fit, you can take an indirect statement apart and rebuild an approximate direct statement. The worked figures below use Acme Corporation, a fictitious retailer, whose income statement and comparative balance sheets follow.

In 2018 Acme acquired new equipment costing USD1,300 in total, and only net income and dividends moved retained earnings.

Cash received from customers

Start from revenue and adjust for the change in receivables. A rise in receivables means accrual revenue ran ahead of cash collections, so it is subtracted; a fall is added.

Acme’s receivables rose by USD55, so cash from customers was USD23,598 − USD55 = USD23,543. Acme had no deferred revenue; if it did, a change in that balance would need a further adjustment.

Cash paid to suppliers

This takes two moves. First convert cost of goods sold into purchases by adjusting for the inventory change; a rise in inventory means purchases exceeded cost of goods sold.

Then convert purchases into cash paid by adjusting for the change in accounts payable; a rise in payables means the firm bought more on credit than it settled in cash.

Cash paid to employees, other expenses, interest, and taxes

Each remaining line takes the accrual expense and shifts it by the related working capital account. Salary expense of USD4,123 less the USD10 rise in salary and wages payable gives cash paid to employees of USD4,113. Other operating expenses of USD3,577 less the USD23 fall in prepaid expenses and the USD22 rise in other accrued liabilities gives USD3,532. Interest expense of USD246 plus the USD12 fall in interest payable gives cash paid for interest of USD258. Income tax expense of USD1,139 less the USD5 rise in income tax payable gives cash paid for taxes of USD1,134.

Under US GAAP, cash paid for interest sits in operating activities; under IFRS it may be classified as operating or financing. Collecting the six lines, Acme’s net cash provided by operating activities is USD23,543 − USD11,900 − USD4,113 − USD3,532 − USD258 − USD1,134 = USD2,606.

The indirect method reaches the same operating cash flow from a different starting point: net income. Three kinds of adjustment are needed. Remove non-operating items, add back non-cash charges, and adjust for changes in operating working capital.

For Acme, the only non-operating item on the income statement is the USD205 gain on the sale of equipment; it is stripped out here because the full cash effect belongs in investing. The only non-cash charge is depreciation of USD1,052, which is added back because it reduced net income without moving cash.

Working capital adjustments follow a consistent sign rule. For current operating assets, an increase is subtracted and a decrease is added. For current operating liabilities, an increase is added and a decrease is subtracted. The logic mirrors the direct method: a larger receivable, for example, means reported revenue outran cash collected, so it must come back out of income.

Applying the rule to Acme: subtract the USD55 rise in receivables and the USD707 rise in inventory; add the USD23 fall in prepaid expenses; add each current-liability increase, namely USD263 for accounts payable, USD10 for salary and wage payable, USD5 for income tax payable, and USD22 for other accrued liabilities; then subtract the USD12 fall in interest payable. The full statement follows, with investing and financing sections that are identical to the direct-method version.

Analysts often want the direct view to watch trends in cash receipts and payments even when only the indirect statement is published. A three-step conversion, accurate enough for most analytical work, gets there using data in the financial reports.

1. Aggregate. Split net income into total revenues and total expenses.
2. Strip out non-cash and non-operating items. Remove them from the aggregated revenues and expenses, then break the remainder into its component lines.
3. Convert accrual to cash. Adjust each revenue and expense line for the related working capital change; the results are the direct-method lines.

For Acme, Step 1 gives total revenues of USD23,803 and total expenses of USD21,593, which net to income of USD2,210. In Step 2, the USD205 non-operating gain is removed from revenue (USD23,803 − USD205 = USD23,598) and the USD1,052 of non-cash depreciation is removed from expenses (USD21,593 − USD1,052 = USD20,541). Step 3 applies the working capital adjustments already computed to produce the direct-method operating section.

Investing and financing sections look the same regardless of how operating cash flow is presented. For Acme, land and buildings did not move, so the only investing activity was equipment. The informational note says Acme spent USD1,300 on new equipment, yet the equipment balance rose by only USD243 (from USD8,555 to USD8,798). Acme must therefore have sold some equipment, and the cash from that sale has to be reconstructed.

Work from the accounts. The historical cost of the equipment sold is the beginning balance plus purchases less the ending balance:

The accumulated depreciation removed with that asset is the beginning balance plus the year’s depreciation expense less the ending balance:

Book value is therefore USD1,057 − USD500 = USD557. Adding the reported gain gives the cash proceeds:

Investing activities net to a USD538 outflow: USD762 received from the sale less USD1,300 paid for new equipment.

Financing activity is read from the changes in the debt and equity accounts. Acme’s long-term debt fell by USD500, which, absent other information, means USD500 of debt was retired, a cash outflow. Common stock fell by USD600, indicating a USD600 repurchase of shares, also an outflow.

Dividends are not always stated directly, but they can be recovered from retained earnings:

Rearranging for Acme: USD2,876 + USD2,210 − USD3,966 = USD1,120 of dividends paid. The three financing lines net to a USD2,220 outflow (USD500 + USD600 + USD1,120). Adding the operating inflow of USD2,606 and the investing outflow of USD538 gives a net decrease in cash of USD152, exactly the drop from USD1,163 to USD1,011.

The two frameworks agree on the shape of the statement but differ on where certain items are classified. IFRS allow more choice, mainly for interest and dividends received or paid and for the treatment of income taxes.

US GAAP fix interest and dividends received in operating activities, whereas IFRS let a company place them in operating or investing. US GAAP treat interest paid as operating even though the underlying principal is financing; IFRS allow interest paid to be operating or financing. Dividends paid are financing under US GAAP but may be operating or financing under IFRS. Both frameworks treat income taxes as operating, except that IFRS permit a portion to be allocated to investing or financing when it can be specifically identified with such an activity. Both require taxes on income to be disclosed separately.