The statement of cash flow

In the previous lesson, we discussed the accrual or deferral of revenue. In a statement of cash flow we strip all accounts of their accrual and deferral effects and we act like only cash went through the business.

Cash flow statement is divided according to the intention of the business in obtaining or spending cash. There are 3 main purposes a business obtains or spends cash namely:

1. Operations
2. Investing
3. Financing

Operations

This is cash received from or used in the business main operations. A well run business main source of cash will be from operations.

Cash flow from operations is an adjustment of the profit and loss statement for cash only transactions. When a business obtains cash from customers or pays cash to vendors, the purpose of the cash flow is for operations.

In other words, cash flow from operations is case paid or received to run the business. It’s like a profit and loss statement with only cash transactions. Cash flow from operation tells users if the business has enough cash to run the business or if it must borrow cash to meet its obligations.

If a business is trying to temporarily boost revenue, you will see the effect in the cash flow from operation section. For instance a sales manager trying to meet his quota books a lot of sales just before the books closed. On the profit and loss statement you will see a huge revenue gain but in the cash flow statement those transactions will be stripped out because no cash was received. So you will be able to see a large order was made with no cash received. There are many reasons this may happen but at least the CEO has a basis for investigation.

Examples of accounts that will run through the cash flow from operation account are:

• Inflow from customers
• Inflow from interest revenue
• Outflow for inventory purchases
• Outflow for operating expenses

 

Investments

Cash flow to or from investments is mainly used to ensure that the required assets needed to support efficient operation are acquired and maintained. Investments are made to increase a business’s competitiveness in the market place. When a business decides an asset no longer places it in a competitive position it may decide to sell that asset. The cash flow from the sale of a business asset is a cash inflow from investing activity. The cash for the acquisition of capital assets are cash outflows.

Moreover, if a business has excessive cash it could decide to invest by purchasing securities or acquiring other businesses. The cash outflow from purchasing securities are cash flow from investing activities. However, according to US GAAP, the dividends received from investments flows through the income statement as other income and is cash flow from operations.

Examples of accounts that will run through cash flow from investing are:

• Cash outflow to purchase investment securities
• Cash inflow from the sale of business assets
• Cash outflow to purchase business equipment

 

Financing

Businesses often use debt or money from other investors to purchase business assets. Companies can finance operations by issuing stock, borrowing money, etc. These activities are to finance the business operations and are classified as income from financing activities on the cash flow statement.

In addition, dividends paid to shareholders are income from financing. Dividends paid is paid from retained earnings (past income) and does not show up on the income statement as an expense. Dividends paid can be found as a reduction of equity and a reduction of income from financing.

Examples of accounts that will run through cash flow from financing are:

• Cash inflow from issuing common stock
• Cash outflow to pay dividends
• Cash outflow to reduce bonds payable

 

Exercise

Create a cash flow statement from the following transactions:

• Joe the sole shareholder of Joe Inc. engaged in the following transactions in 2014:
• Received $5000 from Mr. Best Customer in exchange for consulting services
• Paid $200 to Supplies and Co. for office supplies
• Borrowed $10,000 from Bank Co. for buying inventory
• Borrowed $15,000 from Bank Co. for buying fixed assets
• Paid $15,000 to Equip Co. for new equipment
• Paid $500 dividend to Joe the single shareholder

If beginning cash balance was 0, construct a statement of cash flow for Joe Co.

Joe Co.

Statement of Cash Flows

For the Year ended December 31, 2014