Ch. 1 Types of Business and Financial Statements
1.7 Financial Statements: Direct Statement of Cash Flows
Learning Objectives
After finishing this section, students will be able to:
- Create a direct Statement of Cash Flows
In a business environment, it is possible to have net income on the income statement but not have cash available to pay necessary expenses. It is important to always look at the cash position of a company. You do not want to invest in or work for a company that does not have cash available to pay their bills and obligations.
In your personal life, looking at how you use your cash is also important. Are you spending money on general household operating expense or investing? Or are you living on credit cards and financing your personal life? If you know where your cash is going, you will sleep better at night.
Statement of Cash Flows
The fourth and final financial statement prepared is the statement of cash flows, which is a statement that lists the cash inflows and cash outflows for the business for a period of time. At first glance, this may seem like a redundant financial statement. We know that the income statement also reports the inflows and outflows for the business for a period of time. In addition, the statement of owner’s equity and the balance sheet show the other activities, such as investments by and distributions to owners that are not included in the income statement. To understand why the statement of cash flows is necessary, we must first understand the two bases of accounting used to prepare the financial statements. The changes in cash within this statement are often referred to as sources and uses of cash. For example, is cash being generated from sales to customers, or is the cash a result of an advance in a large loan. Use of cash looks at what cash is being used for. Is cash being used to make an interest payment on a loan, or is cash being used to purchase a large piece of machinery that will expand business capacity?
Operating Activities
Cash flows from operating activities arise from the activities a business uses to produce net income. For example, operating cash flows include cash sources from sales and cash used to purchase inventory and to pay for operating expenses, such as salaries and utilities. Operating cash flows also include cash flows from interest and dividend revenue, interest expense, and income tax.
Investing Activities
Cash flows from investing activities are cash business transactions related to a business’ investments in long-term assets. They can usually be identified from changes in the Fixed Assets section of the long-term assets section of the balance sheet. Some examples of investing cash flows are payments for the purchase of land, buildings, equipment, and other investment assets and cash receipts from the sale of land, buildings, equipment, and other investment assets.
Financing Activities
Cash flows from financing activities are cash transactions related to the business raising money from debt or stock, or repaying that debt. They can be identified from changes in long-term liabilities and equity. Examples of financing cash flows include cash proceeds from issuance of debt instruments such as notes or bonds payable, cash proceeds from issuance of capital stock, cash payments for dividend distributions, principal repayment or redemption of notes or bonds payable, or purchase of treasury stock. Cash flows related to changes in equity can be identified on the Statement of Stockholder’s Equity, and cash flows related to long-term liabilities can be identified by changes in long-term liabilities on the balance sheet.
Cash Reconciliation
At the bottom of each cash flow statement, you add the three activity sections together (operating, investing, and financing), then reconcile the beginning cash balance to the ending cash balance. This is a step often forgotten by students but is the only way to know if the cash flow statement has been done correctly.
Horizontal Model
The far right column of the horizontal model has been set up to help prepare the Statement of Cash Flows. First, if there is a number in the first green column, you should enter the same number in the second green column. Using the “=” sign in Excel is the simplest way to do this quickly and efficiently.
Second, using your knowledge of operating (OA), investing (IA), and financing (FA) activities, enter the appropriate designation. It is easier to do this as you process each transaction. For ease of learning, I have made a separate step.
Transaction I is a bit tricky. When stock was issued, the company was financed by shareholders. Dividends are paid to shareholders for the use of their money. Dividends paid are a financing activity.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||||||||
| Cash | + | Equipment | = | Accounts Payable | + | Wages Payable | + | Income Tax Payable | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA | Description | |
| A | 12,500 | + | = | + | + | 12,500 | + | 12,500 | + | – | = | 12,500 | FA | Stock | |||||||
| B | 85,000 | + | = | + | + | + | + | 85,000 | 85,000 | – | = | 85,000 | 85,000 | OA | Revenue | ||||||
| C | -76,800 | + | = | + | + | + | + | -76,800 | – | 76,800 | = | -76,800 | -76,800 | OA | COGS | ||||||
| D | -300 | + | = | + | + | + | + | -300 | – | 300 | = | -300 | -300 | OA | Advertising | ||||||
| E | + | = | + | 1,200 | + | + | + | -1,200 | – | 1,200 | = | -1,200 | 0 | – | Wages | ||||||
| F | -12,500 | + | 12,500 | = | + | + | + | + | – | = | -12,500 | IA | Equipment | ||||||||
| G | -250 | + | = | 650 | + | + | + | + | -900 | – | 900 | = | -900 | -250 | OA | Misc. | |||||
| H | + | = | + | + | 1,218 | + | + | -1,218 | – | 1,218 | = | -1,218 | 0 | – | Income Tax | ||||||
| I | -1,450 | + | = | + | + | + | + | -1,450 | – | = | -1,450 | FA | Dividends | ||||||||
| 6,200 | + | 12,500 | = | 650 | + | 1,200 | + | 1,218 | + | 12,500 | + | 3,132 | 85,000 | – | 80,418 | = | 4,582 | 6,200 | |||
With the transactions identified on the horizontal model as operating, investing, and financing activities, we can now create the Statement of Cash Flow. As we bring the numbers into the Statement of Cash Flow, DO NOT change the signs in the cash column.
| Cheesy Chuck’s Classic Corn | ||
| Statement of Cash Flows | ||
| For the Month Ended June 30, 20X8 | ||
| Cash flows from operating activities | – | – |
|---|---|---|
| Received revenue from customers | $85,000 | – |
| Paid for popcorn supplies | -76,800 | – |
| Paid for advertising expenses | -300 | – |
| Paid for miscellaneous expenses | -250 | – |
| Net cash flows from operating activities | – | $7,650 |
| Cash flows from investing activities | – | – |
| Purchased Equipment | -12,500 | – |
| Net cash flows from investing activities | – | -12,500 |
| Cash flows from financing activities | – | – |
| Issued Common Stock | 12,500 | – |
| Paid cash dividends | -1,450 | – |
| Net cash flows from financing activities | – | 11,050 |
| Net cash flow | – | 6,200 |
| Beginning cash balance | – | 0 |
| Ending cash balance | – | $6,200 |
Let’s analyze the cash reconciliation at the bottom of the statement. When we add net cash flows from operating activities ($7,650), net cash flows from investing activities (-$12,500), and net cash flows from financing activities ($11,050) together, a net cash flow of $6,200 came in during the month of June 30, 20X8. We then find our starting cash balance ($0) and add it to net cash flow ($6,200) for an ending cash balance of $6,200. Looking at the cash amount on the balance sheet, we can see that the cash on the balance sheet and the ending cash on the statement of cash flow equal each other. This lets us know that the cash flow statement has been done correctly. If these numbers do not equal each other, you have done something incorrectly.
The most common error on this statement comes from changing the sign in the cash column on the horizontal model when it is placed on the Statement of Cash Flow.
1.7a Example
Watch video from 25:50 to end
Instructions:
- Using the Horizontal Model from 1.6 Example, prepare a Statement of Cash Flows for Year 1, 2 and 3.
1.7a Homework
Instructions:
- Using the Horizontal Model from 1.6 Homework, prepare a Statement of Cash Flows as of January 31, 20X8.
Licensing and Attribution:
Content on this page is adapted from the following openly licensed resource(s):
Principles of Accounting, Volume 1: Financial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License
