Notes

Cash flow statements outline the fluctuation of cash from a company. Follow the six steps in preparing these: Calculating the new cash balance, operating activities, investing activities, financing activities, net cash, and notating disclosures.
The Statement of Cash Flows
Daniel owns a profitable widget business. Even though revenues have doubled since inception, cash volatility occurs frequently, and bills are paid late every month. Daniel calls his new Certified Public Accountant (CPA) and asks him to analyze the company's financials to determine any anomalies. Later the next week, the CPA informs Daniel the former CPA never constructed cash flow statements, so looking into the business's financials would be a little more work than anticipated.

A statement of cash flows provides details on incoming and outgoing cash transactions and explains net increases or decreases in cash. Broadly, it looks at anything which generates cash, including operations, investments, and financing. The CPA shows Daniel an easy, six-step process to prepare a statement of cash flows. There are two methods for preparing these: direct and indirect. We will illustrate the indirect method. Let's take a closer look at these six steps.

Step 1: Calculate the New Cash Balance
A business will start and end the year with a cash surplus or deficit. Subtracting the annual beginning and ending cash in one year provides the beginning balance for the next year. For example, the widget company began the year with $10,000 and ended with $5,000; therefore, net cash is $5,000 ($10,000 - $5,000). The main purpose of the cash flow statement is to explain this reduction in cash. Also, analyzing cash transactions allows for proper planning for the following year.

Step 2: Calculate Operating Activities
The next step is to start with net income and add depreciation back in, since it was a deducted non-cash transaction on the income statement. Now we'll account for incoming and outgoing operating cash activities. Operating activities are the actions the business undertakes as a normal course of doing business. Examples of the widget company's outgoing operational cash activities include: paying suppliers, rent, utilities, and taxes. After this, we can add any incoming operational cash activities, such as customers paying their widget credit accounts.

Step 3: Calculate Investing Activities
The CPA explains the next category is investing. Daniel chuckles and expresses the widget company barely pays its bills, let alone invests in the stock market. The CPA clarifies investing activities include buying and selling securities as well as property, plant, and equipment. For example, let's say you heard behind closed doors the city plans to develop hundreds of acres of land next to the widget business. If you had the money, you could purchase the land at a discount, which constitutes a decrease in cash. If the city purchased your land at a premium six months later, the new profit would be listed in this section as incoming cash due to investment.

Step 4: Calculate Financing Activities
Most businesses at some point take out loans to finance startup costs or buy equipment, buildings, vehicles, trucks, or inventory. Hence, financing activities involve borrowing cash. In the past, the widget business utilized two main types of financing: debt and equity. Debt financing consists of obtaining loans or selling bonds. Both require the borrower, the widget business, to pay regular periodic interest payments and the principal (the amount borrowed at maturity). These transactions are considered outgoing cash activities. Equity financing entails selling stock to the public and in return paying the stockholders dividends - another outgoing cash activity.

Daniels asks the CPA if there are any incoming cash activities in this section. The CPA smiles and answers, yes, when you receive the money you borrowed, either from the bank, bondholders, or stockholders. Daniel laughs and says, 'Oh, yes that's right!' The CPA offers Daniel the following reference card on incoming and outgoing activities by category:

Statement of Cash Flow
Step 5: Calculate Net Cash
Next is simply to calculate the differences between incoming and outgoing cash transactions. As previously noted in step 1, the widget company's net cash is a positive $5,000, which explains their financial health. It's important to note, startup or rebounding companies may have a net negative cash. However, a solid plan should explain steps to reach future positive cash flows. Here is what one looks like; pay attention to the items listed and where they go:

Daniel Widgets Statement of Direct Cash Flows
Cash flows from operations:
Cash receipts from customers $122,500
Cash paid to suppliers ($15,000)
Cash paid to employees ($6,000)
Cash generated from operations $101,500
Interest paid ($15,000)
Taxes paid ($45,000)
Net cash from operating activities $41,500
Cash flows from investing:
Purchase of PPE ($240,000)
Proceeds from sale of old equipment $100,000
Net cash from investing ($140,000)
Cash flows from financing:
Proceeds from issuing stock $100,000
Proceeds from issuing debt $50,000
Payments of lease obligations ($5,000)
Net cash from finance activities: $145,000
Net increase of cash and equivalents $46,500
Beginning of year cash balance $400,000
End of year cash balance $446,500
Step 6: Notate Disclosures
The last step is to notate disclosures such as non-cash activities (for example, which assets were depreciated and added back to operating activities). Daniel thanks the CPA and asks if he could construct the statement of cash flows for the last five years and provide an analysis. The CPA agrees and says he'll send an invoice for the work next week.

Lesson Summary
A statement of cash flows provides details on incoming and outgoing cash transactions and explains net increases or decreases in cash. The first step is to calculate the new cash balance by subtracting beginning cash from ending cash. The difference will become beginning cash for the following year. Steps two through four involve calculating the incoming and outgoing cash for operating, investing, and financing activities. Operating activities are the actions the business undertakes as a normal course of doing business. Investing activities include buying and selling securities as well as property, plant, and equipment. Financing activities involve borrowing cash from a bank, bondholders, or stockholders and repayment or dividends. Step five is to calculate net cash and, finally, in step six, we notate disclosures.