Analyzing Statements of Cash Flows I

This reading explains how the statement of cash flows connects with the income statement and balance sheet, and how operating, investing and financing cash flows are prepared. A candidate must be able to compute CFO with both the direct and the indirect method, derive investing and financing flows from balance sheet changes, convert an indirect statement to the direct format, and classify items under IFRS and US GAAP.

LOS 30.a — How the cash flow statement links to the income statement and balance sheet

Why a separate cash flow statement?

The income statement is prepared on the accrual basis, so net income differs from the cash a firm generates. The statement of cash flows reports the actual cash receipts and cash payments of the period and sorts them into three activities:

The terms cash flow from operations, cash flow from operating activities and operating cash flow mean the same thing.

The classification depends on what a transaction means for the company reporting it. When a machinery maker sells a press to a printing firm, the maker reports an operating inflow, because selling presses is its business. The printing firm reports an investing outflow, because it is buying a long-term asset.

The statement reconciles the opening and closing cash balances. Each section is a signed net amount, so a net outflow enters as a negative number:

The income statement is also a flow statement (sometimes called a dynamic statement): like the statement of cash flows, it covers the period between two balance sheet dates, and net income reaches the closing balance sheet through retained earnings (see the figure below). Because of accrual accounting, net income is not the cash the firm generated, and many investing and financing cash flows, such as buying equipment or borrowing, do not touch the income statement when they occur.

Analysts use the statement of cash flows to judge liquidity, solvency and financial flexibility, meaning whether operations can fund the business, repay maturing debt, absorb shocks and take up opportunities without new financing. It also shows the quality of earnings. Earnings are of higher quality when CFO is close to, or above, net income; earnings that persistently exceed CFO are not backed by cash.

Timing differences show up on the balance sheet

When revenue or expense recognition and the cash flow happen in different periods, a balance sheet account absorbs the difference:

Every such account can be written as a roll-forward, e.g. for receivables:

so that cash collected = sales − increase in AR (or + decrease in AR). Knowing any three items gives the fourth.

Revenue recognition rules decide when a sale reaches the income statement, not when the customer pays. Cash received in advance, for instance for a multi-year service contract, is reported in the statement of cash flows when it arrives, while the revenue is recognized gradually as the contract runs. Tracing each account this way also helps an analyst detect aggressive accounting, since reported revenue or expenses that do not fit the related cash and balance sheet changes stand out.

LOS 30.b — Preparing CFO with the direct method

Sources and uses of cash

CFO can be presented with the direct method or the indirect method. The presentation differs but the CFO total is the same, and CFI and CFF are presented the same way whichever method is chosen. Sources of cash are shown as positive numbers (inflows) and uses of cash as negative numbers (outflows).

The direct method

The direct method lists the operating cash receipts and payments themselves. Typical lines are cash collected from customers (usually the largest component), cash paid to suppliers (cash inputs), cash paid for operating expenses such as wages, cash paid for interest and cash paid for taxes. It gives the analyst more detail than the indirect method, which helps with forecasting.

Steps: begin with the first line of the income statement; for each revenue or expense line (treat expenses as negative numbers), find the related operating asset or liability, apply the source/use rules to its change, and move to the next line. Noncash items such as depreciation and gains and losses on asset disposals are ignored because they are not operating cash flows. Sum the adjusted lines to get CFO. Net income never appears in a direct-method CFO section.

Key formulas. Each formula starts from the income statement amount and corrects it for the part that was not received or paid in cash this period, using the change in the related balance sheet account.

If purchases are given directly, no further inventory adjustment is made, because the inventory change is already built into purchases. The same identities can be run backwards: expense $=$ cash paid $-$ increase in the related prepaid asset, or $=$ cash paid $+$ increase in the related payable.

LOS 30.b — Preparing CFO with the indirect method

Starting point: net income

The indirect method starts with net income and reconciles it to CFO. Net income already contains noncash items and nonoperating gains and losses, so these are unwound, and then the changes in operating working capital are applied:

where NCC are noncash charges and WC${}_{\text{INV}}$ is the investment in working capital (the net increase in operating assets less operating liabilities).

Step 1–2: noncash charges, gains and losses

Noncash components of revenue are subtracted in the same way. Although these items are called noncash "charges", they can raise or lower net income.

An inventory write-down reduces both net income and the inventory balance, so it must be counted only once; the two consistent ways to handle it are set out under LOS 30.c.

A gain on the sale of equipment is removed because the whole cash proceeds from the sale belong in CFI. The gain is the part of those proceeds above carrying value, and it also sits in net income. Leaving it in would count it twice and misclassify investing cash as operating cash. A loss reduced net income without any operating cash outflow, so it is added back.

Step 3: working capital changes

Only operating working capital counts. Cash and short-term investments are ignored, except trading securities, whose flows are CFO. Short-term interest-bearing debt and dividends payable are financing items and are also ignored.

The definition of working capital depends on the context. For ratio analysis it is total current assets minus total current liabilities. For cash flow work, and in corporate finance, it means operating assets minus operating liabilities, often called noncash working capital. The working capital changes can be applied line by line or as one net figure: the increase in noncash working capital is subtracted.

Some items never enter CFO under the indirect method because they are not in net income or are not operating: issuing or repaying bonds, issuing or buying back stock, dividends paid (CFF under US GAAP), and purchases of PP&E or land (CFI). They matter for CFO only through any gain or loss they create.

Example

Net income $64,000; depreciation $15,000; gain on sale of a delivery van $3,000; AR up $7,000; inventory down $4,000; prepaid rent up $1,000; AP up $6,000; wages payable down $2,000; dividends paid $10,000.

The $10,000 dividend is a financing outflow and is not deducted. When there are no disposals, the increase in accumulated depreciation equals the period's depreciation, which is the add-back seen from the balance sheet.

Direct vs. indirect presentation

The CFO totals agree because both methods start from the same income statement and use the same working capital changes. The direct method converts each revenue and expense line to cash and leaves out noncash items. The indirect method takes net income, in which those lines are already netted, and unwinds the noncash items and gains instead.

Most firms present CFO with the indirect method. What each framework requires of the choice is compared under LOS 30.d.

LOS 30.b — Cash flow from investing and financing activities

Investing activities (CFI)

Cash flow from investing activities covers buying and selling long-term assets and investments: purchases and sales of PP&E and intangibles, purchases and sales of investments in bonds and shares (trading securities excepted), and loans the firm makes to others and later collects. Only the cash paid or received counts. For an asset sale the cash is the disposal proceeds:

When the proceeds must be backed out of the balance sheet:

Carrying value sold = gross cost − accumulated depreciation removed; then add the gain or subtract the loss. The three steps can be combined:

Land is not depreciated, so its carrying value is its cost. With no land purchases, the carrying value of land sold is the fall in the land balance.

Financing activities (CFF)

Cash flow from financing activities covers transactions with the providers of capital:

Dividends paid often have to be derived:

The Level I convention assumes bonds are issued at par and shares are repurchased at their issue price, so the changes in bonds payable and in contributed capital (common stock at par plus additional paid-in capital) give the principal and equity flows. For a bond issued at a discount or premium, the amortization is noncash: interest expense = coupon + discount amortized − premium amortized, and the carrying value of the bond changes without any financing cash flow. When buybacks occur at a price different from the issue price, the difference goes through retained earnings. The total of CFO, CFI and CFF must equal the change in the cash balance, which serves as a check figure.

Noncash investing and financing activities

Transactions with no cash, such as buying an asset in exchange for bonds or stock or converting bonds into preferred or common stock, do not appear in CFI or CFF. They are disclosed in a footnote or supplementary schedule. If an asset is bought partly for cash, only the cash portion is an investing outflow.

US GAAP classification summary

LOS 30.c — Converting an indirect statement to the direct method

Only the CFO section differs between the two formats, so the conversion uses the income statement plus the working capital changes from the indirect statement:

1. Total the revenues and gains, and separately total the expenses and losses.
2. Remove all noncash items (depreciation, amortization, gains and losses, inventory writedowns, deferred tax changes) and break the rest into individual lines.
3. Convert each line from accrual to cash using the related working capital change.

An inventory writedown (lower of cost or market / net realizable value) raises COGS but involves no cash, so it is taken out of COGS when computing cash paid to suppliers. A decrease in inventory means some goods sold came out of existing stock and were not bought this period, so it also reduces the cash paid.

The writedown also lowers the ending inventory balance, so it must not be counted twice. There are two consistent routes:

1. Subtract the writedown from COGS and use the inventory change before the writedown (purchases less cost of units sold), or
2. Keep COGS including the writedown and use the raw balance sheet inventory change (after the writedown), with no separate writedown adjustment.

LOS 30.d — IFRS versus US GAAP

Under these IAS 7 choices, interest and dividends received are never financing and interest and dividends paid are never investing, and every US GAAP classification of the four items is also allowed under IFRS. Exam convention: the IAS 7 choices in the table above. Current practice: IFRS 18, effective for annual periods beginning on or after 1 January 2027, amends IAS 7 and removes most of this choice for companies whose main business is not investing or financing (interest and dividends received go to CFI; interest and dividends paid go to CFF).