The Statement of Cash Flows (SCF) explains, in an organized way, the changes that took place between two balance sheets, focusing on how all of the changes ultimately affected the cash account. As such, it can be a very powerful tool for understanding both the kinds of financing decisions an organization's managers have made during an accounting period, as well as how they have managed the organization's assets.
We begin our discussion of the SCF by examining the distinction between financial performance as measured by accrual accounting and by cash flows. In so doing, we discuss the three activities that give rise to the receipt or use of cash: operating, investing, and financing. We then discuss the purpose of the SCF and the two methods that can be used to prepare it: direct and indirect. Finally, we look at some of the ways the SCF might be used to assist in the analysis of an organization's financial management activities. Learning objectives are contained in Exhibit 1,
Exhibit 1. LEARNING OBJECTIVES
Upon completing this note, you should know about:
- Why a positive net income amount does not necessarily result in a positive inflow of cash.
- The three activities that effect cash inflows and outflows for an organization: operations, investing, and financing
- The nature of the statement of cash flows (SCF) and how it is prepared using the direct method and the indirect method
- How to use the SCF to assess the way an organization has managed its cash during a given accounting period
THE CASH VERSUS ACCRUAL DILEMMA
Because of the accrual nature of accounting, it is possible for an organization to be operating very profitably and yet experiencing significant decreases in the cash it has on hand. Similarly, it is possible for an organization that is operating with a loss to have increases in its cash balance. These two somewhat counter intuitive phenomena can happen because of management's decisions and activities in the areas of operations, investing, and financing.
An organization uses cash during normal operations to purchase inventory, pay wages, and pay other operating expenses (e.g., rent, cleaning, utilities). While an organization can delay some payments to vendors by charging purchases (i.e. by using accounts payable), eventually it must make these payments in cash. At the same time, although the organization is earning revenue, much if not all of it is entered initially into accounts receivable, and is actually collected in cash sometime later.
Because of the timing differences among these various activities, it is possible that an organization will show a profit on its income statement, but be paying out more cash for its inventory and operating expenses than it’s collecting from its accounts receivable. In this case, the organization’s cash will decrease even though the income statement shows a profit. Similarly, if an organization is selling off finished goods inventory that it manufactured some time ago, it could be realizing cash inflows with minimal or no cash outflows. If the goods are being sold at a discount, it is possible that the organization has a loss on is income statement, and yet is increasing its cash balance.
In addition to operations, organizations frequently are investing in long-lived (fixed) assets. A factory and the equipment in it are good examples of fixed assets, as are the furniture and fixtures, computers, and buildings in other organizations.
When an organization invests in fixed assets it has an immediate cash outflow. It expects that the assets will be used in the future to generate revenues, but ordinarily the revenues and expenses associated with a particular set of fixed assets result in an annual profit that is much smaller than the initial cost of the assets themselves. Thus, several years of profits (and collection of the associated accounts receivable) are needed to recover the cash outflows that occurred when the assets were purchased initially.
It is possible, of course, to be dis-investing; that is, to be selling fixed assets. This happens when a company upgrades its equipment, or if a particular line of business is discontinued, resulting in a need to dispose of the fixed assets associated with that line of business. In general, however, investing activities use up an organization's cash rather than generate it.