The statement of cash flow
In the previous lesson, we discussed the balance sheet and income statement. Now, we turn out attention to the statement of cash flow. The cash flow statement is interested in cash received and spent in business. It does not care about cousin Lia who used your services and promised to pay you next month when she gets paid. Cash is the lifeblood of any business.
Cash flow statement is not only interested in the cash that flows through a business but also explains the source of the cash. There are 3 main areas a business obtains or spends cash namely:
- Operations
- Investing
- Financing
Operations
This is cash received from or used in the business main operations. It is the major source of cash for most well run businesses. When a business obtains cash from customers or pays cash to vendors, the purpose of the cash flow is for operations.
The main questions to ask to determine if a transaction affects the cash flow from operations is:
- Does this cash flow result from business operations?
- Did or will the transaction affect the income statement?
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. Businesses buy and sell assets to stay competitive. The cash flow from the sale of a business asset is a cash inflow from investing activity. The cash from the purchase of capital assets are cash outflows from investing.
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.
Financing
Businesses often use debt or money from other investors to purchase business assets. Companies can finance operations by issuing stock, using personal funds, borrowing money, etc. These activities are to finance the business operations and are classified as income from financing activities on the cash flow statement.
Now let us construct a cash flow statement using our previous example:
Your cousin Lucy, was downsized from her business and so decided to start a consulting business. She took $2,000 from her savings to buy a computer. After the first month she had one client who paid $1,000. She paid $200 for wages to a high school student who worked with her.
Previously, we constructed the profit and loss and balance sheet statement as follows:
Profit and loss statement
|
Lucy’s Ice Cream Profit and Loss Statement |
|
| Sales Revenue | $1,000 |
| Wage expense | 200 |
| Net Income | 800 |
Balance sheet statement
| Lucy’s Ice Cream Balance Sheet Statement |
|
| Assets | |
| Cash | $ 800 |
| Computer | $2,000 |
| Total Assets | $2,800 |
| Liabilities | None |
| Equity | |
| Capital Contributions | $2,000 |
| Retained Earnings (prior earnings) | $ – |
| Net Income | $ 800 |
| Total Equity | $ 800 |
| Total Liabilities and Equity | $2,800 |
Now using the same information we will construct the cash flow statement.
| Lucy’s Ice Cream Statement of cash flow |
|
| Operating activities | |
| Cash inflow from customers | $ 1,000 |
| Cash outflow for salary | -$ 200 |
| Net cash outflow from operating activities | $ 800* -see note 1 |
| Investing activities | None |
| Cash outflow for computer purchases | – $ 2,000 |
| Net cash outflow from investing activities | – $ 2,000 |
| Financial activities | |
| Cash inflow from capital contributions | $2,000 |
| Net cash outflow from financing activities | $2,000* – see note 2 |
| Net change in cash | $ 800 |
| Plus beginning cash balance | $ – |
| Ending cash balance | $ 800* – see note 3 |
*Note 1 – Since all income and expenses were cash based, the cash flow from operations matches the net profit
*Note 2 – Net change in cash = net cash flow from operating activities + net cash flow from investing activities + net cash flow from financing activities
*Note 3 – Ending cash balance equals the cash account in the balance sheet
Next we will discuss how to identify each element of the financial statement for correct classification.