Imagine that you run a retail store, you find your long-term loyal customers are short of money due to
recession and job cuts, you let them order the groceries ‘on the credit. You
are therefore creating turnover, but there is no money inflow stemming from
this soon.
This means that no funds
are flowing in for the purchase of new goods, payment of employees’ salaries
and utility bills. While this problem does not appear on the income statement (groceries
‘on the credit are considered income), or only with a substantial delay, it
becomes directly visible in the cash flow statement, as the net profit shown on
the income statement is adjusted for transactions in which the company has not
(yet) received an inflow of money.
How to calculate Statement of Cash
Flows
The cash flow statement is
the central element of any financial statement analysis. Since the income
statement is not adjusted for non-cash items, only the cash flow statement
shows the true cash flows to and from the company during the year.
We have two methods:
The direct method: reports gross cash inflows and gross outflows from operating
activities but is not as widely used as the indirect
method as it is more complex to implement.
The indirect method: uses a
format that differs from the direct method only in the section where net cash
provided or used by operating activities is calculated.
The investing and financing
sections of the statement of cash flows are exactly the same under either
method.
What do we need?
Information used to prepare this statement is obtained from the income
statement for the year and comparative balance sheets for the last 2 years. Net
income is adjusted in order to convert the accrual basis income statement to
cash flows.
As discussed earlier, the
statement which follows is divided into operating, investing, and financing
activities. When we use the indirect method to determine cash flows, we start
with the net income figure from the income statement and adjust the net income
amount to determine the net amount of cash provided or used in operating
activities.
Let us use the accounting equation and modify it slightly by splitting cash from assets.
1) Cash + Non-Cash Assets = Liabilities + Equity
If we solve for Cash, we have:
2) Cash = Liabilities + Equity − Non-Cash Assets
We use the symbol Δ(delta) to define “change in” and apply it to the revised accounting.
3) ΔCash = ΔLiabilities + ΔEquity − ΔNon-Cash Assets
If we split now:
Non-Cash
Assets = Fixed Assets (FA) + Accounts Receivable (AR) + Inventory (INV)
(FA) = CAPital EXpenditure (CAPEX) − Depreciation (Dep)
Liabilities = Long-Term Debt (LTD) + Short-Term Debt (STD) + Accounts Payable
(AP)
D = Debt = LTD + STD
Equity = Share Capital (SC) + Retained Earnings (RE) = Net Income (NI) − Dividends
(Div)
Retained Earnings (RE) = Net Income (NI) − Dividends (Div)
This means that by
examining the liabilities, equity, and non-cash asset accounts for changes from
one period to another we can explain the change in the cash account.
we may rewrite the equation 3 as follows:
4) ΔCash = Δ(LTD + STD + AP) + Δ(SC + RE) − Δ(FA + AR + INV)
5) ΔCash = ΔD + ΔAP + ΔSC + Δ(NI − Div) − Δ(CAPEX − Dep) − ΔAR – ΔINV
Then let
me substitute. WCR = Working Capital Requirements = AR + INV – AP
6) ΔCash = ΔD − ΔWCR + ΔSC + ΔNI − ΔDiv – ΔCAPEX + ΔDep
7) ΔCash = (NI + Dep − ΔWCR) − ΔCAPEX + (ΔSC + ΔD − Div)
n Operating Cash Flow = NI + Dep – ΔWCR
n Investing Cash Flow = ΔCAPEX
n Financing Cash Flow = ΔSC + ΔD − Div
8) Ending Cash Balance = Opening Cash Balance + ΔCash
Eq 8 is a mathematical derivation of the cash flow statement under the indirect method.
Statement of Cash Flows is a great tool to reconcile the accrual method of accounting to the cash basis of accounting, and also to examine the changes in current assets and current liabilities.
Reference:
[1] Financial Forecasting, Analysis, and Modelling - A Framework for Long-Term Forecasting
MICHAEL SAMONAS
