Cash Flow Statement Analysis; Financial Statements Analysis
Types of Financial Statements
Three key financial statements summarize the financial activities of a business.
- Cash Flow Statement
- Income Statements
- Balance Sheet
The balance sheet shows what a company owns: assets and what it owes, which are liabilities.
The difference between those two is its equity.
On the income statement, we see a summary of the revenues, expenses, and resulting profit or loss for a period.
Cash Flow Statement
The cash flow statement shows the sources and uses of cash for a business. The cash flow statement is divided into three sections.
The cash flow from operating activities, the cash flow from investing activities, and the cash flow from financing activities.
Cash Flow Statement Format
The cash flow statement organizes cash inflows and outflows into three categories.
- Operating Activities.
- Investing Activities
- Financing Activities.
Cash Flow Statement Operating Activities
This includes items that are found on the income statement, such as revenue and operating expenses. However, it only includes them if the cash payment actually occurred in that period.
For example, it just includes revenue that the company has actually received the cash for, and it just includes expenses that the company has paid out the cash for.
It is similar to the income statement or statement of operations in that it reflects revenues and expenses from the period.
But it is different in that it only reflects them if actual cash movements occurred during the period.
Cash Flow Statement Investing Activities
Investing activities include purchasing property, plant, and equipment or selling those assets, as well as making investments in other businesses or acquiring or divesting entire businesses.
This is where a company records its capital expenditures as well as M &A activity.
If we take the cash flow from operating activities and add the cash flow relating to investing activities, we arrive at the net cash flow before financing activities.
Cash Flow Statement Financing Activities
This is very distinctly different from operating and investing activities. This includes issuing shares, raising new debt, repurchasing shares, or repaying debt and paying dividends.
Finally, suppose we take the cash flow from operating activities, add the cash flow from investing activities, and add the cash flow from financing activities. In that case, we finally arrive at the net cash movement over the period.
This is the total change in a cash position for the company. Profits and cash flow are not the same things
Prepayments and Accrued Expenses.
The accrual concept requires companies to recognize revenues and costs as they incur them, not as it receives or pays the actual cash for them.
This is what drives the reporting on the income statement revenues when they are earned and expenses when they are incurred.
Now let us compare that to what happens on the cash flow statement.
The statement of cash flows only records transactions when cash is received, or cash is paid
We will look at how this actually works in practice to illustrate the concept of the matching principle over time. Imagine a five-day transit pass that costs $40 and is paid in cash on a Monday.
In this scenario, how much is the cost of daily travel on Thursday?
First, answer that question on a cash flow basis and then answer that question on a matching or a cruel basis.
When you have answered the question, consider which method better reflects the cost of an individual journey and which one better helps you plan your personal cash flow.
Let us look at the answers now.
The daily cost of travel on Thursday on a cash flow basis is Zero because the cash expense was already paid on Monday; however, on a matching principle basis, we took the $40 total cost divided by five days and determined that the daily cost of travel is $8. Both of these approaches provide valuable information to the user.
The matching principle basis is better for planning the daily cost. However, the cash flow basis is better for planning on actual cash inflows and outflows.
Depreciation of Assets
How property, plant, and equipment as well as depreciation work.
Let us imagine that ABC Inc buys a truck for 45,000 in cash. It will use it in the business for five years.
That is to say, it has a useful life of five years, and at the end of that five years’ time, it has a salvaged value of 15,000.
Based on those assumptions, the questions we have are:
What will the company’s show on the cash flow statement, the income statement, and the balance sheet in Year one?
Assumptions to make: (i)the company uses straight-line depreciation, meaning it allocates an equal amount of depreciation to each year. (ii) please assume that the company charges a full year of depreciation expense when it makes the purchase.
Let us look at how these transactions will flow through each of the three financial statements.
In year one, ABC Co. Would have a cash outflow of $45,000 under investing activities on the cash flow statement; this would be a form of capital expenditure.
On the income statement, ABC Co. would have a depreciation expense of 6000.
This is calculated by taking the purchase price of 45,000, deducting the salvage value, and then dividing by the number of years it has a useful life for recall.
The assumption is that the company uses the straight-line depreciation method. That means that 6000 will be expensed each year for five years now, moving on to the balance sheet.
At the end of year one, the company will have property, plant, and equipment related to the truck of 39,000. We calculate this value by taking the initial purchase price of 45,000 and deducting year one’s depreciation expense of 6000, so the asset’s depreciated value is 39,000. This value will reduce by 6000 each year for the five years until it reaches its salvage value.
It is important to point out that there are different depreciation methods that a company can use to calculate depreciation expense.
Three of the most common are the
- Straight-Line Depreciation Method,
- The Double Declining Balance Depreciation Method
- The Units of Production Depreciation Method.
Straight-Line Depreciation Method
In the straight-line approach, an equal amount of depreciation is applied every year for its useful life.
The formula is equal to the cost, minus the salvage value divided by the useful life in a number of years.
As you can see in the graph, an equal amount is expensed every year until it reaches the salvage value.
Double Declining Balance Depreciation Method
With the double-declining balance, it is a form of accelerated depreciation, meaning that the depreciation expense is greater in the first few years and smaller in the later years.
The formula for calculating accelerated depreciation using a double declining balance is equal to taking one dividing it by the number of years that the assets life is, and then multiplying that by two to accelerate it. That number is then multiplied by the beginning period book value of the asset.
This depreciation method requires building an actual schedule and is a much more detailed form of calculating depreciation.
It could be useful for a company that wants to lower its tax bill in the early years by having a bigger depreciation expense.
The company lowers its taxable income and pays a smaller tax bill.
Units of Production Depreciation Method.
As you can see in this example, the depreciation expense varies each year. That’s because the depreciation expense is based on the output that the assets produce.
To calculate it, you take the number of units produced in the period and divided by the lifetime number of units that remain to be produced by those assets that will result in a percentage which is then multiplied by the cost of the asset minus its salvage value.
As you can see in this chart, some early years were not a lot of units were produced then, in years five and six, production really ramps up, so there is a large depreciation expense, and in later years it slows down again.
This depreciation method is useful for a company that wants to match the actual output of the business to the depreciation expense that it incurs.
Cash Flow Direct Method
Let us begin by looking at the first section of the Cash Flow statement, which deals with operating cash flows.
The most obvious way of showing an operating cash flow would be to record each individual transaction to show every single inflow of cash and then deduct every single outflow of cash to have a net result being the total operating cash flow.
This method, called the direct approach, is rarely used in practice.
The reason being is that it would be impracticable to keep track of every single cash inflow and every single cash outflow in one consolidated financial statement.
Cash Flow Indirect Method
Now let us look at the indirect method of creating a cash flow statement. This approach takes the net income number from the bottom of the income statement and makes adjustments to it to arrive at cash flow.
If the income statement were prepared entirely on a cash basis, no adjustments would be necessary.
However, we have to adjust for the following items.
- If sales were made on credit to customers, there is going to be an accounts receivable balance.
- Furthermore, that means cash flow does not match revenue.
- If purchases were made on credit, there is going to be an accounts payable balance.
- Furthermore, that means that expenses do not match cash flow if inventory was purchased but not sold in the period. That would also make a difference between the cost of goods sold and the actual cash flow.
- There are non-cash expenses, such as the depreciation of property, plant, equipment, or other items like stock-based compensation for executives or unrealized gains and losses.
These items need to be adjusted to arrive at the actual change in cash from operating activities for the period.
This is the method that virtually all companies used to calculate their cash flow from operations.
Cash Flow indirect Method Example
Now we will walk through an example of the typical process for calculating operating cash flow with an indirect method. We begin by taking the net income of the bottom of the income statement and then adding it back.
Any non-cash items, depreciation, and amortization are the most common examples of noncash items.
However, it could be other things that we mentioned earlier, such as stock-based compensation, unrealized gains or losses, or impairment charges, to name a few.
Then adjustments are made for changes in working capital.
Those changes in working capital include any changes in inventory balance over the period, any change in accounts receivable balance over the period
Finally, any change in accounts payable balance over the period and other working capital accounts and the total at the bottom.
After adding up, all of these items are the net operating cash flow for the period.