Notes

Cash flow statement patterns are used to determine a business's financial efficiency. Learn more about cash flow statements, including the components of the statement and how to analyze different activities using the provided example.
Cash Flow Statements
Mr. I. M. Rich runs a successful coffee shop, The Aroma Café. Business has been growing steadily over the past few years and profit has been increasing. He recently purchased a large amount of inventory as one of his suppliers was having a huge sale, as well as a new state-of-the art brewing system to allow him to attract more customers by offering exotic coffee blends. The problem is that Mr. I. M. Rich never seems to have any cash to pay employees and suppliers. He's even had to approach the bank for a short-term loan to cover his most recent payroll. He'd like to know more about where he is getting his cash and where it's being spent. Analyzing his cash flow might help Mr. I. M. Rich solve this problem.

Statement Components
While a balance sheet conveys the cash balance at a point in time, it does not show the source of the changes between last year's cash balance and this year's cash balance. A balance sheet is a financial statement that shows a company's assets, items that it owns; liabilities, items that it owes; and equity, the owner's investment in the business. A cash flow statement identifies sources and uses of cash as a result of three activities:

Operating activities
Investing activities
Financing activities
Operating activities represent the main source of cash for a company and arise out of regular business operations. For example, operating activities include collections from customers, payments to suppliers and employees and payments of interest and income tax to the government.

Investing activities relate to increases and decreases in long-term assets, which are used by the company over a period of time to generate revenue. Examples of investing activities include the purchase and sale of capital assets such as machinery and equipment, as well as collections of loans made to others. Next to operating activities, investing activities represent the most important source and use of cash.

Financing activities relate to activities that impact the long-term liabilities, items that a company owes, and shareholders' equity. Shareholders' equity is the difference between the company's assets, items it owns, and liabilities, items it owes. Examples of financing activities include issuing shares, paying dividends to shareholders, and borrowing money from a bank and paying it back.

Dividends represent a distribution of profit to the owners of a company; for example, its shareholders.

Example
The Aroma Café's cash balance last year was $75,000, and this year-end it was $10,000. Other than determining that his cash balance is $65,000 lower this year-end versus last year, Mr. I. M. Rich is unable to explain where his money has been spent. A summary of cash provided by and used in each activity for the current year is provided below.

Cash Flow Statement - 1
Analyzing Operating Activities
A company that has cash provided by operating activities is in a good position to purchase long-term assets and/or pay down its long-term loans. If a company also has cash provided by investing and financing activities, this situation could indicate that the company is stock-piling cash for a potential acquisition.

A company that has cash used in operating activities could indicate that it is being inefficient in collecting outstanding amounts from its customers, it has recently purchased a large amount of inventory that it intends to resell to its customers, or it has paid a significant amount that was outstanding to its suppliers and its employees. In the case of the Aroma Café, the large purchase of inventory would decrease the amount of cash available from operating activities.

Analyzing Investing Activities
A company that has cash provided by investing activities could have recently sold some of its long-term assets, such as equipment or machinery, to generate cash. A company that has used cash for investing activities has recently purchased long-term assets that it will use to generate revenue for the business. The Aroma Café's recent purchase of coffee equipment would represent a use of cash, or cash used in investing activities. This use of cash is consistent with a business that is in expansion mode.

Analyzing Financing Activities
A company that has cash provided by financing activities has recently borrowed money from the bank or raised money from shareholders by issuing shares to expand the business or finance a potential acquisition. A company that uses cash for financing activities is paying down its long-term debts or paying the owners of the company. Since the Aroma Café is expanding and obtained money from its bank, it makes sense that its cash flow indicates that cash has been provided by financing activities. The inflow of cash was used to fund the purchase of its new coffee maker. It's important to recognize that borrowed money must be repaid at a future date, and will be a use of cash when repayments begin.

Overall Analysis
If Mr. I. M. Rich's business is efficient, he'll sell the purchased inventory at a higher price than he paid to generate profit and improve his cash flow from operations. His investment in the brewing machine could also increase sales, leading to a greater cash flow. Mr. I. M. Rich should see an improvement in his cash flow from operations in the next twelve to eighteen months.

Lesson Summary
The cash flow statement helps a business determine the causes of a change in its cash balance from one period to the next. By analyzing cash flow in operating, investing and financing activities, one can determine how efficient a business is in collecting money from its customers, if it's stockpiling cash for a potential acquisition, or whether it is expanding and acquiring a large amount of long-term assets that it will use to produce revenue. It can also communicate if a business is expanding too rapidly by taking on too much debt before its cash flow from operating activities is firmly established.