In today’s business environment, it is not enough simply to monitor earnings

| June 13, 2018

THE STATEMENT OF CASH FLOWSAssociate Professor PhD Cernusca Lucian University „Aurel Vlaicu” of Arad,luciancernusca_ro@yahoo.comProfessor PhD Mates Dorel, West University of TimisoaraAbstract: In today’s business environment, it is not enough simply to monitor earnings andearning per share measurements. An entity’s financial position and especially its inflows andoutflows of cash are also critical to its financial success. The statement of cash flows alertsfinancial statement readers to increases and decreases in cash as well as to the reasons and trendsfor the changes. This brief article is going to present a historical perspective on this financialstatement, the statement of cash flows’ purpose and, finally, the way of systematizing and reportingthe financial information on it.A Historical Perspective on the Statement of Cash FlowsThe statement of cash flows is a relatively new financial statement. In 1987, the FinancialAccounting Standards Board (FASB) issued an accounting standard, FASB Statement no. 95,requiring that the statement of cash flows be presented as one of the three primary financialstatements. Previously, companies had been required to present a statement of changes in financialposition, often called the funds statement. In 1971, APC Opinion no. 19 made the funds statement arequired financial statement although many companies had begun reporting funds flow informationseveral years earlier.The funds statement provided useful information, but it had several limitations. First, APBOpinion no. 19 allowed considerable flexibility in how funds could be defined and how they werereported on the statement. As a result, many companies reported on a working-capital basis (currentassets minus current liabilities), whereas other reported on a cash basis or some other basis. Further,in each case, the individual company selected its own format. The inconsistency across companiesmade comparisons difficult. Second, the funds statement, even when prepared on a cash basis, didnot provide a complete and clear picture of a company’s ability to generate positive cash flows. Onereason is that APB Opinion no. 19 required that all investing and financial activities be reported inthe statement, even those that did not affect cash or wo rking capital. Another problem was that thefunds statement usually included two sections: sources (inflows) and uses (outflows) of funds. Thus,the amount of working capital or cash provided or used by each major type of activity (operating,investing and financing) was not identified. The limitations of the funds statement often made itdifficult to assess a company’s ability to generate sufficient cash. Some companies were able toreport favorable earnings in the income statement, even while experiencing serious cash flowsproblems that were not readily apparent from the information reported in the funds statement.The Purpose of the Statement of Cash FlowsThe statement of cash flows, as its name implies, summarizes a company’s cash flows for aperiod of time. The statement of cash flows explains how a company’s cash was generated duringthe period and how that cash was used. Even if the statement of cash flows seems to be areplacement for the income statement, the two statements have two different objectives.The income statement measures the results of operations for a period of time. Net income isthe accountant’s best estimate at reflecting a company’s economic performance for a period. Theincome statement provides details as to how the retained earnings account changes during a periodand ties together, in part, the owner’s equity section of comparative balance sheets. The statement1of cash flows provides details as to how the cash account changed during a period. The statement ofcash flows reports the period’s transactions and events in terms of their impact on cash. Also, thisfinancial statement provides important information from a cash-basis perspective that complementsthe income statement and balance sheet, thus providing a more complete picture of a company’soperations and financial position. It is important to note that the statement of cash flows does notinclude any transactions or accounts that are not already reflected in the balance sheet or the incomestatement. Rather, the statement of cash flows simply provides information relating to the cash floweffects of those transactions.Users of financial statements, particularly investors and creditors, need information about acompany’s cash flows in order to evaluate the company’s ability to generate positive net cash flowsin the future to meet its obligations and to pay dividends. In some cases, careful analysis of cashflows can provide early warning of impending financial problems.Information Reported in the Statement of Cash FlowsAccounting standards include specific requirements for the reporting of cash flows. Theinflows and outflows of cash must be divided in three main categories, namely operating activities,investing activities and financing activities. Further, the statement of cash flows is presented in amanner that reconciles the beginning and ending balances of cash and cash equivalents. Cashequivalents are short-term, highly liquid investments that can easily be converted into cash.Generally, only investments with maturities of three months or less qualify as cash equivalents,such as: Treasury bills, money market funds or commercial paper. The general format for thestatement of cash flows is presented in the exhibit below (Exhibit 1):Cash provided by (used in):Operating activitiesInvesting activitiesFinancing activitiesNet increase (decrease) in cash and cash equivalentsCash and cash equivalents at beginning of yearCash and cash equivalents at end of yearExhibit 1: General Format for a Statement of Cash FlowsThe three categories of activities (operating activities, investing activities and financingactivities) generating inflows and outflows of cash are very suggestively presented in the exhibitfrom below (Exhibit 2):Cash received fromoperating activitiesCash received frominvesting activitiesCash received fromfinancing activitiesINFLOWSCash and cashequivalentsOUTFLOWSCash paidfor operating activitiesCash paidfor investing activit iesExhibit 2: The Flow of Cash2Cash paidfor financing activitiesOperating activities include those transactions and events that enter into the determination ofnet income. Cash receipts from the sale of goods or services are the major cash inflows f r mostobusinesses. Other inflows are cash receipts for interest revenue, dividend revenue and similar items.Major outflows of cash are for the purchase of inventory and for the payment of wages, taxes,interest, utilities, rent and similar expenses.Transactions and events that involve the purchase and sale of securities, property, buildings,equipment and other assets not generally held for resale and the making and collecting of loans areclassified as investing activities. These activities occur regularly and result in cash inflows andoutflows. They are not classified under operating activities because they relate only indirectly to theentity’s central, ongoing operations, which usually involve the sale of goods and services. Theanalysis of investing activities involves identifying those accounts on the balance sheet relating toinvestments (typically long-term asset accounts) and then explaining how those accounts changedand how those changes affected the cash flows for the period.Financing activities include transactions and events whereby resources are obtained from orpaid to owners (equity financing) and creditors (debt financing). Dividend payments, for example,fit this definition. The receipt of dividends and interest and the payment of interest are classifiedunder operating activities simply because they are reported as a part of income on the incomestatement. The receipt or payment of the principal amount borrowed or repaid (but not the interest)is considered a financing activity.Operating ActivitiesCash receipts from:Sales of goods and servicesInterest revenueDividend revenueSale of investments in trading securitiesCash payments to:Suppliers for inventory purchasesEmployees for servicesGovernments for taxesLenders for interest expenseBrokers for purchase of trading securitiesOthers for other expenses (utilities, rent)Investing ActivitiesCash receipts from:Sale of property, plant and equipmentSale of a business segmentSale of investments in securities other than trading securitiesCollection of principal on loans made to other entitiesCash payments to:Purchase property, plant and equipmentPurchase debt or equity securities of other entitiesMake loans to other entitiesFinancing ActivitiesCash receipts from:Issuance of own stockBorrowing (bonds, notes, mortgages)Cash payments to:Stockholders as dividendsRepay principal amounts borrowedRepurchase an entity’s own stock (treasury stock)Exhibit 3: Major Classifications of Cash Flows3The major classifications of cash flows, taking into consideration the three types of activities,are presented in the exhibit above (Exhibit 3).Analyzing the cash flow effects of financing activities involves identifying those accountsrelating to financing (typically long-term debt and common stock) and explaining how changes inthose accounts affected the company’s cash flows. Some investing and financing activities do notaffect cash. For example, equipment may be purchased with a note payable or land may be acquiredby issuing stock. These non cash transactions are not reported in the statement of cash flows.However, if a company has significant non cash financing and investing activities, they should bedisclosed in a separate schedule or in a narrative explanation. The disclosures may be presentedbelow the statement of cash flows or in the notes to the financial statements.The Process of the Statement of Cash Flows’ ElaborationTaking into consideration, the information presented in the balance sheet and in the incomestatement, there is a six-step process in preparing the statement of cash flows. These steps consist of:1. Compute the change in the cash and cash equivalent accounts for the period of thestatement. Seldom is one handed a check figure in real life, but such is the case when preparing astatement of cash flows. The statement of cash flows is not complete until it is explained the changefrom the beginning balance in the cash account to the balance at year-end.2. Convert the income statement from an accrual-basis to a cash-basis summary ofoperations. This is done in three steps, namely: eliminate from the income statement those expensesthat don’ t involve cash (such non cash items would include depreciation expense that does notinvolve an outflow of cash in the current period even though income was reduced); eliminate fromthe income statement the effects of non operating activity items (such items include gains and lossesassociated with the retirement of debt); identify those current assets and current liability accountsassociated with the income statement accounts and adjust those income statement accounts for thechanges in the associated current assets and current liabilities. For example, sales will be adjustedfor the change between the beginning and ending balance in accounts receivable to derive the cashcollections for the period. The final result will be cash flows from operating activities.3. Analyze the long-term assets to identify the cash flow effects of investing activities.Changes in property, plant and equipment and in long-term investments may indicate that cash haseither been spent or been received.4. Analyze the long-term debt and stockholders’ equity accounts to determine the cash floweffects of any financing transactions. These transactions could be borrowing or repaying debt,issuing or buying back stock or paying dividends.5. Prepare a formal statement of cash flows by classifying all cash inflows and outflowsaccording to operating, investing and financing activities. The net cash flows provided by (used in)each of the three main activities of an entity should be highlighted. The net cash flows amount forthe period is then added (subtracted) from the beginning cash balance to report the ending cashbalance.6. Report any significant investing or financing transactions that did not involve cash in anarrative explanation or in a narrative explanation or in a separate schedule to the statement of cashflows. This would include such transactions as the purchase of land by issuing stock or theretirement of bonds by issuing stock.The Statement of Cash Flows and DecisionsAnalysis using cash flow information is often restricted to examining the relationshipsamong the categories in the statement of cash flows. It is not performed vertical or horizontalanalysis because, unlike the balance sheet and income statement, there is no guarantee that aspecific number from the statement of cash flows will consistently serve as the denominator for4scaling purposes. For example, all balance sheet accounts are compared to total assets whenpreparing a vertical analysis of the balance sheet because the total assets are always going to be thebiggest number on the balance sheet. The same is true for the income statement. Revenue is usedbecause it is, in almost every case, the biggest number on the income statement. In the case of thestatement of cash flows, some years the cash flow from operations may be the largest number on thestatement. In subsequent years, that number may be negative. Thus, horizontal and vertical analysesare rarely performed using the statement of cash flows because of scaling problems.Although the statement of cash flows, like the other financial statements, reports informationabout the past and careful analysis of this information can help investors, creditors and others assessthe amounts, timing and uncertainty of future cash flows. Specifically, the statement helps usersanswer questions such as how a company is able to pay dividends when it had a net loss or why acompany is short of cash despite increased earnings. A statement of cash flows may also show thatexternal borrowing or the insurance of capital stock provided the cash from which dividends werepaid even though a net loss was reported for that year. Similarly, a company may be short on cash,even with increased earnings, because of increased inventory purchases, plant expansion or debtretirement.Trends are often more important than absolute numbers for any one period. Accordingly,cash flow statements are usually presented on a comparative basis. This enables users to analyze acompany’s cash flows over time. Because companies are required to highlight cash flows fromoperating, investing and financing activities, a company’s operating cash flows and investing andfinancing policies can be compared with those of other companies. It could be learned much about acompany by examining patterns that appear among the three cash flow categories in the statementof cash flows. Thus, there are more patterns regarding the cash flows from the three types ofactivities. The exhibit from below (Exhibit 4) shows eight possible cash flow patterns and providessome insight into what each cash flow pattern indicates about the company:No.1Cash FlowsfromOperating+Cash FlowsfromInvesting+CashFlows fromFinancing+2+–3++-4+-+5-++6–+General ExplanationCompany is using cash generated fromoperations, from sale of assets and fromfinancing to build up pile of cash (very liquidcompany) possibly looking for acquisition.Company is using cash flows generated fromoperations to buy fixed assets and to paydown debt or pay owners.Company is using cash from operations andfrom sale of fixed assets to pay down debt orpay owners.Company is using cash from operations andfrom borrowing (or from owner investment)to expand.Company’s operation cash flow problems arecovered by sell of fixed assets, by borrowingor by stockholder contributions.Company is growing rapidly, but hasshortfalls in cash flows from operations andfrom purchase of fixed assets financed bylong-term debt or new investment.57-+-8–Company is financing operating cash flowshortages and payments to creditors and/orstockholders via sale of fixed assets.Company is using cash reserves to financeoperation shortfall and pay long-termcreditors and / or investors.-Exhibit 4: Analysis of Cash Flows StatementPositive cash flows from operations are necessary if a company is to succeed over the longterm. The most common pattern is a positive operating activities cash flow and negative cash flowsfrom investing and financing activities. Companies use cash flows from operations to purchasefixed assets or to pay down debt. Growing companies prefer a positive financing activities cashflow and negative cash flows from operating and investing activities. Cash is being borrowed tocover a shortage of cash from operations as well as to purchase fixed assets.In conclusion, conducting financial statement analysis using information from the statementof cash flows is more difficult than analyses using information from the income statement and thebalance sheet. The primary reason is that it is common for cash flows for certain categories to benegative, thereby making interpretation difficult. Nevertheless, an analysis of the relationshipamong the categories on the statement of cash flows can provide insight into a company’sperformance.References1.Walter, T. Harrison jr., Charles, T. Horngren, Financial Accounting Second Edition, New Jersey,Prentice Hall Englewood Cliffs2.Nobes, C.W., Parker, R., 2000, Comparative International Accounting, Editura Prent ic Hall3.Albrecht, S., Stice, J., Stice, E., Skousen, F., Accounting Concepts and Applications Edition 8,South-Western, Thomson Learning4.*** 2005, Consilier Management Financiar, Editura Rentrop & Straton5.*** 2005, Standardele Internationale de Raportare Financiara (IFRS), Editura CECCAR6

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