The Basic Financial Statements

Statement of Cash Flows

The Statement of Cash Flows is, as the title suggests, a financial statement that shows how an organization receives and uses cash.

It might seem strange to devote an entire financial statement to a specific asset. But cash is not just any asset. Cash is king!

Small organizations, especially small non-profits, can run out of cash. If that happens, nothing about the organization's mission, clients, or impact on society will matter. Its employees, vendors, and creditors will not accept a compelling mission statement as a form of payment. If the organization is out of cash, it is out of business.

To that end, the Statement of Cash Flows is quite useful if we want to answer a few key questions about how a public organization receives and uses cash:

1. Did the organization's core operations generate more cash than they used? If not, why?
   
   
2. Did the organization depend on cash flow from investing or financing activities to support cash flows necessary for basic operations? How predictable are cash flows from investing and financing activities?
   
   
3. How much of the organization's cash results from transactions it cannot directly control (e.g., receivables)?
   
   
4. How much of the organization's cash flow is related to sales of goods and inventory, and how predictable are those sales?

From the cash flow statement, we can learn a lot about how an organization generates and uses cash. The statement breaks cash flows into three categories: operations, investing activities, and financing activities. Euphemistically, we call this "OIF" (pronounced "oy-f"):

1. Cash Flow from Operations summarizes how the organization receives cash and uses cash for its core activities. Negative cash flow from operations indicates that the organization's basic operations use more cash than they produce. It could mean the organization reported profits because of revenue growth – but those revenues remain uncollected and are reported as receivables. It could also be the case that the non-profit did not report a profit but reports positive cash flows from operations due to collecting outstanding receivables. While our discussion is focused on profitability, keep in mind that without positive cash flows from operations, the organization's finances are not sustainable.
   
   
2. Cash Flow from Investing Activities. In this case, investing includes investments in financial instruments or fixed assets like property and equipment. For most non-profits, this section is focused on cash earned from investments. If those investments produced more cash than what was spent to acquire them, they provide positive cash flow. Purchases of buildings and equipment are a cash outflow, and if the organization sells any buildings or equipment, the receipts from those sales also appear here as a cash inflow (though this is rare). In general, we expect positive cash flow from investing activities. It's essential, however, to know the origins of that positive cash flow. If the organization sold a building, that might produce positive cash flow, but at the expense of its ability to deliver services in the future. It might see negative cash flow from investing activities if, for instance, it moves idle cash into short-term investments.
   
   
3. Cash Flow from Financing Activities. Financing activities capture any cash the organization borrows to finance its operations. Most of the activity in this section has to do with borrowed money. For-profit entities use this section of the cash flow statement to show how issuing stock produces a cash inflow. For non-profits and governments, the cash inflow from issuing bonds or taking out a loan will appear here. For non-profits with an endowment or other permanently restricted net assets that produce unrestricted investment income, that cash flow will also appear here.

Like with the balance sheet and income statement, net assets are a key part of most public organizations' cash flow statements, especially cash flows from operating activities. It might seem strange that net assets are the point of departure for a cash statement, but it makes sense if we are willing to make a few assumptions.

Recall that the most common way for net assets to increase is for revenues to exceed expenses. To understand the cash flow statement, take this idea a step further. Assume that a public organization's total cash will increase during a fiscal period if the cash inflows from its main operating revenues exceed the cash it pays out to cover its main operating expenses. The "cash flow from operations" part of the cash flow statement is based on precisely this idea. It starts with the assumption that an organization's change in net assets is a good indicator of its cash flows from operations.

 

Most sizable public organizations follow this concept and report their cash flows from operations indirectly. This method starts with the Change in Net Assets, assuming that change is the result of cash flows from operations. But of course, not all changes in net assets are the result of positive or negative cash flow. Different transactions and accounting procedures can affect revenues or expenses without affecting cash flow. A typical example is depreciation.

Depreciation is when an organization "uses up" some portion of an asset to deliver services. The portion of that asset's value that is used up is recorded as a depreciation expense. Like all expenses, depreciation reduces net assets. But at the same time, there is no cash flow associated with depreciation. You will not find checks written to an entity called "Depreciation." The same is true for changes in the value of an organization's investments. Its stocks, bonds, and other investments can increase in value, but unless it sells those investments, that increase in value will not produce any positive cash flow. Depreciation and changes in the value of investments are both examples of reconciliations. These are transactions that affect net assets but do not involve a cash flow.

In FY 2022, Treehouse produced its Statement of Cash Flows using the indirect method. Treehouse reported a positive change in net assets or surplus at the end of FY 2022 ($5.6 million). Using the Statement of Cash Flows, we want to understand how core operations contributed to the nonprofit's operating position ($5.6 million) and whether that operating position resulted in higher cash balances. Skip down to the row "Net cash flows from operating activities," and you will see that in FY 2022, Treehouse's operating activities resulted in a net cash outflow of $1.8 million. In other words, while the nonprofit reported a large surplus, that surplus did not result in an increase in cash. In fact, core operations resulted in a $1.77 million decrease in cash balances.

To appreciate these differences, review the reconciliations reported under "Adjustments to reconcile the change in net assets to net cash flows from operating activities." Recall that the figures in this part of the statement are reconciliations, so we interpret them inversely. Any activity that decreases net assets is shown here as a positive value because we are "adding back" those activities to arrive at Net Cash Flows from Operations. Any activity that would increase net assets is shown as a negative value (or in parentheses) because we are "backing out" those activities to arrive at Net Cash Flows from Operations.

Treehouse reported several reconciliations in FY 2022. Treehouse reported $286,275 in depreciation expense. Depreciation expenses decrease net assets. We add back deprecation to the Change in Net Assets to arrive at Net Cash Flows from Operations – i.e., the estimate of the change in cash flows from operating activities.

Treehouse reported an increase in discounts and allowances for uncollectables of $24,422. That increase in discounts and allowances decreases Change in Net Assets. We reconcile this item by backing out the change in allowances.

Treehouse received $336,936 in donated investments and $7.097 million in donated interest in the 2100 building. These transactions increase net assets (or profitability) but do not produce a positive cash flow. We deduct (or back out) contributed property and investments from Changes in Net Assets. The same logic applies to realized and unrealized losses (gains) on investments. Treehouse reported $1,568,107 in investment losses at the end of FY 2022. Since these cash flows are restricted, and all cash flows are reported under investments – not cash – we add (or deduct) back that loss (gain) from Change in Net Assets.

Below the reconciliations, you will see "Change in Operating Assets and Liabilities." The figures listed here are also reconciliations, this time to reconcile changes in assets and liabilities that do involve cash to Changes in Net Assets. The key here is that we are focused on changes in assets and liabilities as a result of cash flows. So, to make sense of the Change in Operating Assets and Liabilities section, first, think about how typical assets and liabilities interact with cash.

Cash balances are lower if assets other than cash are higher. If, for example, receivables are higher this year compared to the previous year, cash balances will be lower – in other words, the payment we should have received for a donated pledge or services provided has yet to be received. Consider contracts and other receivables. In FY 2022, contracts receivable was $3,528,538. In FY 2021, contracts receivable was $1,141,268. The increase in receivables implies that payments were pending, so our cash balances are $2,387,270 lower. The same logic applies to prepaid expenses, which increased from $46,213 at the end of FY 2021 to $364,127 at the end of FY 2022. The same logic applies when assets other than cash and investments increase. For example, balances in contributions receivable in FY 2022 were $195,182 – $386,917 lower than they were in FY 2021 ($582,099). That reduction increased cash. The same logic applies to inventories and unemployment trust deposits.

Cash balances are higher if balances in liability accounts are higher. Given the focus on Net Cash Flows from Operations, we focus here on accounts payable, other liabilities, and accrued salaries and related costs. As we noted earlier, any balance change in any notes payable or loan payable would be reported in Net Cash Flows from Financing Activities. More on this below.

Consider Accounts payable. In FY 2022, accounts payable were $143,584, nearly half the balance reported at the end of FY 2021 ($286,030). This decrease in payables implies payments were made. As such, cash balances are $142,446 lower. Conversely, balances in other liabilities and accrued salaries and related costs were higher in FY 2022. Delayed payments mean the non-profit holds more cash now, so cash balances are higher ($266,444 and $113,227, respectively).

The Cash Flows from Investing Activities and Cash Flows from Financing Activities sections are more intuitive. Like before, an increase in an asset account reported under Investing Activities (e.g., Investments or Property and Equipment) results in a decrease in cash and cash equivalents and vice versa. An increase in a liability account reported under Financing Activities (e.g., Loan Payable) results in an increase in cash.

Returning to Treehouse, we see that in FY 2022, it purchased $286,933 in furniture and equipment and $195,512 in investments. The nonprofit reported selling investments ($1,129,561). The net effect of investing activities was $647,116—in other words, investing activities (including the sale of investments) increased the nonprofit's cash position.

Treehouse did not report any Cash Flows from Financing Activities. It did not report any long-term obligations, did not draw on any line of credit, and did not rely on borrowed funds. This reflects the nonprofit's strong financial position and the choice of the board to use internal resources to manage its cash position.

We can draw two immediate and important conclusions from Treehouse's Statement of Cash Flows. First, the non-profit reported a large surplus ($5,622,029). While account balances changed related to the non-profit's operating activities, those activities did not generate cash. As a result, net cash flows from operating activities are negative ($1,739,671). The nonprofit relied on proceeds from the sale of investments to improve its cash position.

At the end of FY 2022, the nonprofit's cash position had declined from $5,552,763 at the start of the year to $4,430,208 at the end of the year. While the cash position has declined, it's important to contextualize those findings. The nonprofit reported a large surplus because of a significant revenue increase and the value of donations (investments and interest in building). While the nonprofit does not expect to liquidate the donated space, the contracts and other receivables should be collected in the next 12 months, improving the nonprofit's cash position.