Unit 10: Cash Flow Preparation and Use
Now, let's explore how companies manage cash flow. Most companies use the revenues they generated yesterday to pay today's and tomorrow's expenses. For example, some companies manage their cash and maintain enough reserves to pay their expenses when they are due. Others must obtain capital loans to pay their bills, because they have highly seasonal sales or experience rapid growth and do not have enough savings to pay for the upfront costs to fund their expansion. While the company's income statement and balance sheet help monitor performance and their current financial condition, neither statement provides information about cash activity during a given time period.
Companies must manage their cash wisely to accommodate this lag time between revenues and expenses, so they can pay their bills in a timely manner. In this unit, we focus on how to prepare a statement of cash flows, which will provide important information about performance measures, cash-on-hand, and cash needed.
Completing this unit should take you approximately 7 hours.
Upon successful completion of this unit, you will be able to:
- define the purpose of the statement of cash flows;
- describe the three categories of cash flows;
- describe the four steps used to prepare the statement of cash flows;
- prepare a statement of cash flows using the indirect method;
- analyze cash flow information; and
- prepare a statement of cash flows using the direct method.
10.1: Purpose of the Statement of Cash Flows
The statement of cash flow provides cash receipt and cash payment information and reconciles the change in cash for a period of time. Cash receipts and cash payments are summarized and categorized as operating, investing, or financing activities. Simply put, the statement of cash flows indicates where cash came from and where cash went for a given period of time. Time is the important point of a cash flow, as in life, in business timing is everything. Without adequate cash flow suppliers could well refuse to deliver essential inputs and choke of your production and revenue stream. Once you have learned some of the basics of cash flow you will look at a typical case. The CEO of Home Store wants to know “where has the money gone”? Home Store is profitable but there is no money in the bank. You will soon see why this might be.
In this video, Tony Bell provides a rationale for cash flow statements and introduces basic terms.
10.2: The Types of Cash Flows
Cash flow is essential and because of this it take many forms and can be measured in numerous ways. The following considers the usual methods of describing cash flow.
Operating activities include cash activities related to net income (revenues and expenses are included in net income).
Investing includes cash activities related to noncurrent assets. Noncurrent assets include (1) long-term investments; (2) property, plant, and equipment; and (3) the principal amount of loans made to other entities.
Financing includes cash activities related to noncurrent liabilities and owners’ equity. Noncurrent liabilities and owners’ equity items include (1) the principal amount of long-term debt, (2) stock sales and repurchases, and (3) dividend payments.
10.3: Preparation of Cash Flow Statements
The statement of cash flows is based on cash only, and when used for accrual accounting based companies, adjustments must be made to convert accrual basis information to a cash basis. In addition to reconciling the three statement activities (the income statement, balance sheet, and statement of owners’ equity), cash flows need to have certain adjustments made to them. One of the main ones is adjusting the statement for ‘non-cash transactions’, the main one being depreciation. There are four steps used to create a cash flow statement.
You can now get to Home Store and the CEO's question: “where’s the money?” The information needed to prepare Home Store’s statement of cash flows includes the balance sheet, income statement, and other selected data.
This video provides a walkthrough of the indirect method of preparing a statement of cash flows.
Investing activities focus on the effect that changes in noncurrent assets have on cash. Noncurrent asset balances found on the balance sheet, coupled with other information (e.g., cash proceeds from sale of equipment) are used to perform this step. The financing activities section focuses on the effect changes in noncurrent liabilities and owners’ equity have on cash. Noncurrent liabilities and owners’ equity balances found on the balance sheet, coupled with other information (e.g., cash dividends paid) are used to perform this step.
Investing activities focus on the effect that changes in noncurrent assets have on cash. Noncurrent asset balances found on the balance sheet, coupled with other information (e.g., cash proceeds from sale of equipment) are used to perform this step. The financing activities section focuses on the effect changes in noncurrent liabilities and owners’ equity have on cash. Noncurrent liabilities and owners’ equity balances found on the balance sheet, coupled with other information (e.g., cash dividends paid) are used to perform this step.
In this video, Tony Bell explains how to prepare the investing and financing sections of a cash flow statement.
The same four steps apply to preparing a statement of cash flows using the direct method as with the indirect method. The only difference is how the operating activities section is presented in step one; all other steps are the same as presented in the chapter. Although presentation of the operating activities section using the direct method differs from the indirect method, the end result is exactly the same.
In this video, Tony Bell uses the direct method to prepare a statement of cash flows for Turner Inc. You will note that this method yields the same results as the indirect method.
10.4: Cash Flow Analysis
There are numerous ways to analyze financial statements. Cash flow has two major ratios, the operating cash flow ratio and the capital expenditure ratio, and a "dollar-number" (the free cash flow) that are used to interpret and communicate information about cash flow within the company and make comparisons among companies.
In this video, Tony Bell finishes his cash flow work on Turner Inc. by doing a rudimentary analysis of Turner Inc.’s cash flow statements.
Unit 10 Conclusion
In this unit, you learned what a cash flow statement is and why it is an important part of the management accounting tool box. Most companies, either because of legal requirements or because of prudence, create a cash flow statement as a part of their normal reporting documentation – Income Statement, Balance Sheet, Statement of Owner’s Equity and Cash Flow. With each accounting period, monthly or quarterly, the Cash Flow is updated to reflect actual sales and other relevant events. Managers need to be continually aware of their companies ‘cash’ position. In the next and last unit you will consider other metrics that managers should be aware of and use to monitor their companies economic health.