The cash flow statement provides important information about a company's cash receipts and cash payments during an accounting period as well as information about a company's operating, investing and financing activities. Although the income statement provides a measure of a company's success, cash and cash flow are also vital to a company's long-term success. Information on the sources and uses of cash helps creditors, investors, and other statement users evaluate the company's liquidity, solvency, and financial flexibility.
Cash receipts and cash payments during a period are classified in the statement of cash flows into three different activities:
These involve the cash effects of transactions that enter into the determination of net income and changes in the working capital accounts (accounts receivable, inventory, and accounts payable). Cash flows from operating activities (CFOs) reflect the company's ability to generate sufficient cash from its continuing operations. CFOs are derived by converting the income statement from an accrual basis to a cash basis. For most companies, positive operating cash flows are essential for long-run survival.
The major operating cash flows are (1) cash received from customers, (2) cash paid to suppliers and employees, (3) interest and dividends received, (4) interest paid, and (5) income taxes paid.
Special items to note:
- Interest and dividend revenue, and interest expenses, are considered operating activities, but dividends paid are considered financing activities. Note that interest expense is reported on the income statement while dividends flow through the retained earnings statement.
Remember that an interest/dividend item is an operating activity if it appears on the income statement. For example, payments of dividends do not appear on the income statement, and thus are not classified as operating activities.
- All income taxes are considered operating activities, even if some arise from financing or investing.
- Indirect borrowing using accounts payable is not considered a financing activity - such borrowing would be classified as an operating activity.
These include making and collecting loans and acquiring and disposing of investments (both debt and equity) and property, plants, and equipment. In general, these items relate to the long-term asset items on the balance sheet. Investing cash flows reflect how a company plans its expansions.
- Sale or purchase of property, plant and equipment.
- Investments in joint ventures and affiliates and long-term investments in securities.
- Loans to other entities or collection of loans from other entities.
These involve liability and owner's equity items, and include:
- Obtaining capital from owners and providing them with a return on (and a return of) their investments.
- Borrowing money from creditors and repaying the amounts borrowed.
In general, the items in this section relate to the debt and the equity items on the balance sheet. Financing cash flows reflect how the company plans to finance its expansion and reward its owners.
- Dividends paid to stockholders (not interest paid to creditors!). Note that the cash outflow caused by dividends is determined by dividends paid, not dividends declared. Dividends paid are not reflected in the retained earnings account. The amount is provided in the supplementary information.
- Issue or repurchase of the company's stocks.
- Issue or retirement of long-term debt (including the current portion of long-term debt).
Purchase of debt and equity securities from other entities (sale of debt or equity securities of other entities) and loans to other entities (collection of loans to other entities) are considered investing activities. However, issuance of debt (bonds and notes) and equity securities is a financing cash inflow, and payment of dividend, redemption of debt, and reacquisition of capital stock are financing cash outflows.
Some investing and financing activities do not flow through the statement of cash flows because they don't require the use of cash:
- Retiring debt securities by issuing equity securities to the lender.
- Converting preferred stock to common stock.
- Acquiring assets through a capital lease.
- Obtaining long-term assets by issuing notes payable to the seller.
- Exchanging one non-cash asset for another non-cash asset.
- The purchase of non-cash assets by issuing equity or debt securities.
For example, if a company purchases $200,000 of land by issuing a long-term bond, this transaction is a non-cash one, as it does not involve direct outlays of cash. Therefore, it is excluded from the statement of cash flows. These types of transactions should be disclosed in a separate schedule as part of the statement of cash flows or in the footnotes to the financial statements.
Differences between IFRS and U.S. GAAP
The above discussions are based on the U.S. GAAP. Under IFRS there is some flexibility in reporting some items of cash flow, particularly interest and dividends.
- Interest and dividends received:
- Under U.S. GAAP, interest income and dividends received from investment in other companies are classified as CFO.
- Under IFRS, interest and dividends received may be classified as either CFO or CFI.
- Interest paid:
- Under U.S. GAAP, interest paid is classified as CFO.
- Under IFRS, interest paid may be classified as either CFO or CFF.
- Dividends paid:
- Under U.S. GAAP, dividends paid are classified as CFF.
- Under IFRS, dividends paid may be classified as either CFO or CFF.