Introduction to the Statement of Cash Flows - Online Tutor, Practice Problems & Exam Prep

The statement of cash flows is crucial for understanding a company's cash management, detailing the transition from beginning to ending cash balances. It comprises three sections: operating activities, which focus on cash generated from core business operations; investing activities, related to the purchase and sale of long-term assets; and financing activities, which involve cash flows from investors and creditors. This statement aids in evaluating management's effectiveness, predicting future cash flows, and analyzing the relationship between net income and cash flow, highlighting the importance of liquidity and financial health.

Introduction to the Statement of Cash Flows

Alright. Now we're going to discuss the statement of cash flows. This is one of the tougher units in the course, so make sure to pay close attention. Let's start with an introduction. So, the statement of cash flows. Remember, we have our 4 main financial statements. We've dealt a lot with the balance sheet and the income statement. The statement of retained earnings or the statement of stockholders' equity tells us the changes in stockholders' equity or retained earnings, right? And that's where we deal with dividends. Here, the statement of cash flows helps us get from our beginning cash balance to our ending cash balance, right? We start with some cash balance and then we're going to have all sorts of additions to cash and subtractions to cash throughout the period that gets us to the ending cash balance, right? So the statement of cash flows focuses on these additions and subtractions. What got us from the beginning cash to the ending cash? A lot of things happen in the cash account, and we want to summarize them here with the cash flow statement. Okay?

So why do we use the statement of cash flows? Well, first, it has predictive values. A lot of investors are interested in the cash flows of the company from a financial perspective; they are definitely focused on cash flows, so a lot of investors focus on cash flows and the statement of cash flows is a great place for that information. It gives predictive value of future cash flows based on the past cash flows. How's the company doing now? Well, that gives us predictive value of what it's going to be doing in the future. It helps us evaluate management, right, because we can evaluate how management uses cash flows, the cash that it brings into the business and how it uses it in the business. It determines the company's ability to pay, right? When we have to pay interest or pay dividends, well, we need cash to do those transactions, so the statement of cash flows is a good place to get information about that. And it, lastly, it gives us a little more information between the relationship of net income and cash flow. Remember that net income by itself is not a cash amount. Right? Net income deals with revenues and expenses that are not always cash-based. Sometimes, we'll have a revenue that we don't receive the cash for yet, right? We'll have an account receivable for the future. Well, we want to make comparisons between that net income and cash flow. Maybe we have huge income but not much cash flow coming in, right? That could signify a problem. Okay? So that's the main reasons why the statement of cash flow is important.

Now let's start discussing a little more details about the statement of cash flows itself. It's going to be organized into 3 main sections. Okay? We're going to see 3 sections that we're going to become very familiar with throughout this chapter. So the first section is the operating activities. Operating activities, this is where we deal with operations, right? The core business of the company, we want to see the cash flows that are generated through operations. So these operating activities, they create revenues, expenses, the gains, and losses, right, they deal with net income that comes from the income statement. Right? So we want to see this net income and the relationship it has to cash flow that comes from these operating activities. So, like I said, it represents the core business and it's obvious that a successful business should be generating cash flows from operations, right? We're in business to do this core business of ours, and if we can't generate positive cash flows, well, that's a red flag that we might go bankrupt in the future. So, we must be generating positive cash flows to be a successful business. Maybe we'll have a period where we don't have operating cash flows, but in general, we want to be seeing positive operating cash flows or it's just not going to work. Okay? So when we talk about operating activities, we're going to be focused on current assets and liabilities, okay? When you think about our operations, we're generally dealing with our current assets and our current liabilities on our day-to-day basis, right? And we're talking about specifically operating current assets and liabilities, right? When we think about operating current assets and liabilities, that's things like current assets or, excuse me, like accounts receivable, inventory. Right? Prepaid expenses. Things that we use in our day-to-day operations or accounts payable and our accrued expenses. Right? These types of operating assets and liabilities, well these are the things that we deal with in our day-to-day operations. So our operating activities generally deal with that relationship between net income and operating cash flows. Cool?

The next section, so notice we have 3 sections. This is the first section, arguably the most important section because that's our core business. Then we have the investing section. So the investing section relates to the purchase and sale of long-term assets. Okay? So this is when we're buying equipment or selling equipment for cash. Well, that's always going to be an investing activity. We're going to be dealing with our investments in long-term assets as well as in long-term investments. Maybe we buy some, equity or debt investment that we're going to have for a long period of time, well, that would be in the investing section. And remember, we're focused on cash, right? This is the statement of cash flows.

And finally, the third section is our financing activities. So we've got operating activities, investing activities, and financing activities. So notice, we've talked about current assets and liabilities, we've talked about long-term assets, well guess what? The financing activities, they deal with our investors and our creditors, and it's the rest of our balance sheet. So notice we're talking about our balance sheet here, right? The current assets and liabilities from our balance sheet, the long-term assets from our balance sheet, and then the finance activities, they deal with our long-term liabilities and our stockholders' equity. So that's every part of our balance sheet is now being focused on through our cash flow statement. Okay? So now we're taking everything from a cash perspective in our cash flow statement.

So going forward, we're going to deal with each of those cash flows separately. We're going to start with our operating cash flows, then we'll get to the investing cash flows and the financing cash flows. Okay?

So let's start with a little practice problem here, and then I'm going to show you a cash flow statement on the next page.

The purchase of equipment and the sale of equipment would be shown on the Statement of Cash Flows as:

• A. Purchase:Investing Sale:Financing
• B. Purchase:Operating Sale:Financing
• C. Purchase:Investing Sale:Investing
• D. Purchase:Operating Sale:Investing

Statement of Cash Flows

Alright, I want to make one more note before I show you the statement of cash flows and this is the supplemental disclosures. At the bottom of the cash flow statement, we generally show a few extra things. So at the bottom here, at the bottom of the statement, we're going to explicitly tell the cash paid for interest and the cash paid for taxes. Sometimes that information gets a bit muddled inside the statement, and we want to be very explicit. Investors generally want this information, so we tell them explicitly the cash paid for interest and the cash paid for taxes. That's not so important right now. I want to focus on the significant non-cash investing and financing activities. So sometimes we'll have some big purchase that doesn't strictly touch cash. So an example would be if we purchased a building. Oops. We purchased a building but did not put any cash down and instead, we sign a note payable. Notice, this is a pretty significant transaction, right? We buy a building, let's say, for 5000000 dollars and we sign a 5000000 dollar note payable. Well, there's no cash in this transaction and it wouldn't show up on the statement of cash flows. However, this is probably pretty important information to the investor, so we would make a supplemental disclosure at the bottom. We would say, hey, there was a purchase of a building in exchange for a note payable and there might be extra information about that transaction in the footnotes to the statements after we show the statements. Okay? So we'll talk more about significant non-cash investing and financing activities in a separate lesson, but for now, let's take a peek at an example of a cash flow statement. A statement of cash flow is here. So the first thing I want to note is here at the top, it says for the year ended December 31, 2012. So remember, this is for a period of time. It's not a snapshot. Which statement shows us a snapshot in time? The balance sheet, right? The balance sheet shows us at this moment, how much cash is there? How much inventory is there, how much accounts payable, how much retained earnings, right? It's at a point in time. But all the other statements, our income statement, our statement of stockholders' equity, our retained earnings, and our statement of cash flows, they all show a period of time, and that's exactly what we're dealing with. Right? So notice how it starts here. It starts with our three sections. It shows us our operating section right here, so operating activities, do it in a different color, green for cash. Okay. So the cash flow from operating activities and it shows we'll get into the details of how we calculate this, but it goes through the calculation and notice it deals with net income here because it's an operating activity and we go through our calculation and get to a net cash flow from operating activities of 50000 dollars in this example and then it goes on to the next section, investing activities. Right? Investing activities and it shows different transactions from investments and then it shows us our net cash flows from investing activities. And notice it's negative in this case, right? That's okay. It's allowed to be negative. It's allowed to be positive. Well, we're just showing what happened, right? This means that we had an outflow of cash, a net outflow of cash from our investing activities. And, finally, we have our financing activities. So, financing activities here and it shows us our net cash flows from financing activities were again a negative amount, that means we had outflows from financing activities. This doesn't necessarily mean a good thing or a bad thing in any case, it's just showing you the information. So after we do our operating, investing, and financing activities, we get a subtotal here. So this is the net increase or decrease in cash which is the total of those three numbers. Right? This right here is the total of this, this, and this over here. Right? So, it's a total of those three numbers that gets us to 14000 and that's the change in cash during the period. And we take that change in cash and add it to the beginning amount of cash. So the 14000 change in cash plus the beginning amount of cash. So this is the beginning of the period. This is the change in cash and this is the end of the period, right? If we take the beginning plus the change, well, that gets us to the ending balance. And this ending balance will be shown on the balance sheet. The balance sheet is going noto show us, actually, both of these. It's going to show us the beginning balance as last year's balance, right? Because when we show a balance sheet, we don't generally just show one year. We show last year as well, right? So it would show us the beginning balance as last year's balance and then it would show us the ending balance as this year's balance. So the cash flow statement shows us the change from that beginning balance to the ending balance. And now notice here at the bottom, we've got a note where it's showing the non-cash activities. So it says we purchased equipment by issuing a note payable in the amount of 20000 so it's giving you that extra information about a non-cash activity. Cool? Alright. So this is how a statement of cash flows is set up. You might want to go back and check this out after we've discussed each section in detail. Okay? So let's go ahead and start with the operating section in the next video.

Here’s what students ask on this topic:

What is the purpose of the statement of cash flows?

The statement of cash flows serves several key purposes. It helps investors and analysts understand how a company manages its cash, detailing the transition from the beginning to the ending cash balances. This statement is divided into three sections: operating activities, investing activities, and financing activities. It provides predictive value for future cash flows based on past performance, evaluates management's effectiveness in using cash, and determines the company's ability to pay obligations like interest and dividends. Additionally, it highlights the relationship between net income and cash flow, which is crucial for assessing a company's liquidity and financial health.

What are the three main sections of the statement of cash flows?

The statement of cash flows is divided into three main sections: operating activities, investing activities, and financing activities. Operating activities focus on cash generated from the core business operations, such as revenues and expenses. Investing activities relate to the purchase and sale of long-term assets, like equipment and investments. Financing activities involve cash flows from investors and creditors, including transactions related to long-term liabilities and stockholders' equity. Each section provides insights into different aspects of a company's cash management and financial health.

How does the statement of cash flows help in evaluating management's effectiveness?

The statement of cash flows helps evaluate management's effectiveness by showing how well they manage the company's cash. It reveals how cash is generated and used in operating, investing, and financing activities. By analyzing these sections, investors can assess whether management is efficiently using cash to support the company's core operations, invest in long-term assets, and manage debt and equity. Consistent positive cash flows from operations, prudent investments, and effective financing strategies indicate strong management performance.

Why is the relationship between net income and cash flow important?

The relationship between net income and cash flow is crucial because net income alone does not provide a complete picture of a company's financial health. Net income includes non-cash items like depreciation and accounts receivable, which do not immediately affect cash flow. The statement of cash flows adjusts net income to reflect actual cash generated or used, offering a clearer view of liquidity. A company may report high net income but struggle with cash flow issues, signaling potential financial problems. Understanding this relationship helps in assessing the company's true financial stability and operational efficiency.

What are operating activities in the statement of cash flows?

Operating activities in the statement of cash flows refer to the cash flows generated from a company's core business operations. This section includes cash receipts from sales of goods and services, cash payments to suppliers and employees, and other cash transactions related to operating expenses. It focuses on current assets and liabilities, such as accounts receivable, inventory, and accounts payable. Positive cash flow from operating activities indicates that the company is generating sufficient cash to sustain its day-to-day operations, which is essential for long-term viability.