What is the Cash Flow Statement?
The Cash Flow Statement (CFS) tracks the actual inflows and outflows of cash from operating, investing, and financing activities over a specified period of time.
- What is the cash flow statement?
- Why is the cash flow statement required?
- How is the cash flow statement linked to the other two financial statements?
- If you have a balance sheet and had to pick between the income statement or cash flow statement, which would you choose?
Table of Contents
Cash Flow Statement Definition
The cash flow statement (CFS), along with the income statement (I/S) and balance sheet (B/S), represent the three core financial statements.
The importance of the cash flow statement is tied to the reporting standards under accrual accounting.
- Revenue is recognized once the product/service is delivered to the customer (and “earned”), as opposed to when a cash payment is received (i.e. the revenue recognition principle).
- Expenses are incurred in the same period as the coinciding revenue to match the timing with the benefit (i.e. the matching principle).
- Depreciation is an expense on the income statement, yet the real cash outflow occurred in the initial year of the capital expenditure (CapEx).
The net income as shown on the income statement – i.e. the accrual-based “bottom line” – might not be an accurate depiction of what is actually occurring to the company’s cash.
Therefore, the cash flow statement is necessary to reconcile net income to adjust for factors such as:
- Non-Cash Expenses – e.g. Depreciation & Amortization (D&A), Stock-Based Compensation
- Changes in Working Capital – e.g. Accounts Receivable (A/R), Inventory, Prepaid Expenses, Accounts Payable (A/P), Deferred Revenue, Accrued Expenses
In effect, the real movement of cash during the period in question is captured on the cash flow statement – which brings attention to operational weaknesses and investments/financing activities that do not appear on the accrual-based income statement.
The impact of non-cash add-backs is relatively straightforward, as these have a net positive impact on cash flows (e.g. tax savings).
However, for changes in net working capital, the following rules apply:
- Increase in NWC Asset and/or Decrease in NWC Liability ➝ Decrease in Cash Flow
- Increase in NWC Liability and/or Decrease in NWC Asset ➝ Increase in Cash Flow
Focusing on net income without looking at the real cash inflows and outflows can be misleading because accrual-basis profits are easier to manipulate than cash-basis profits. In fact, a company with consistent net profits could potentially even go bankrupt.
CFS Linkages to I/S and B/S
Assuming the beginning and end of period balance sheets are available, the cash flow statement could be put together (even if not explicitly provided) as long as the income statement is also available.
Net income from the income statement flows in as the starting line item on the cash flow statement, and the year-over-year changes in the balance sheet accounts are tracked on the cash flow statement.
Indirect vs Direct Method
There are two methods by which cash flow statements can be presented:
- Indirect Method – In the U.S., the indirect method is far more common, whereby the starting line item is net income, which is adjusted for non-cash items (e.g. depreciation & amortization) and changes in working capital to arrive at cash flow from operations.
- Direct Method – Net income is not the starting point for this method, but rather, the direct method explicitly lists out the cash received and paid out to third parties during the period (e.g. cash from customers, cash to suppliers).
Cash Flow Statement Sections
Under the indirect method, the cash flow statement is broken out into three distinct sections:
- Cash from Operations – The section’s top-line item is net income, which is adjusted by adding back non-cash expenses, such as D&A and stock-based compensation, and then adjusted for changes in working capital line items.
- Cash from Investing – In the next section, investments are accounted for, with purchases of PP&E (i.e. capital expenditures, as the major recurring outflow), followed by business acquisitions and divestitures.
- Cash from Financing – In the final section, the net cash impact of raising capital from issuing equity or debt from outside investors, share repurchases (i.e. buybacks), repayments of financial obligations, and issuances of dividends are taken into account.
If the three sections are added together, we arrive at the “Net Change in Cash” for the period.
Net Change in Cash = Cash from Operations + Cash from Investing + Cash from Financing
Subsequently, the net change in cash amount will then be added to the beginning-of-period cash balance to calculate the end-of-period cash balance.
Ending Cash Balance = Beginning Cash Balance + Net Change in Cash
The shortcomings regarding the income statement (and accrual accounting) are addressed here by the CFS, which identifies the cash inflows and outflows over a certain time span while utilizing cash accounting – i.e. tracking the cash coming in and out of the company’s operations.
Cash Flow Statement Excel Template
Now that we’ve described the purpose and structure of the cash flow statement, we can complete an example modeling exercise in Excel. Fill out the form below to access the file:
Cash Flow Statement Example Model
To begin, we are provided with the three financial statements of a company, including two years of financial data for the balance sheet, as shown below in the completed model.
Income Statement (I/S)
In Year 1, the income statement consists of the following assumptions.
- Revenue: $100m
- (–) COGS: $40m
- Gross Profit: $60m
- (–) OpEx: $20m
- (–) D&A: $10m
- EBIT: $30m
- (–) Interest Expense (6% Interest Rate) = $5m
- Pre-Tax Income = $25m
- (–) Taxes @ 30% = $8m
- Net Income = $18m
Cash Flow Statement (CFS)
The net income of $18m is the starting line item of the cash flow statement.
In the “Cash from Operations” section, the two adjustments are the:
- (+) D&A: $10m
- (–) Increase in NWC: $20m
Next, the only line item in the “Cash from Investing” section is capital expenditures, which in Year 1 is assumed to be:
- (–) CapEx: $40m
- (–) Mandatory Debt Amortization: $5m
The beginning cash balance, which we get from the Year 0 balance sheet, is equal to $25m, and we add the net change in cash in Year 1 to calculate the ending cash balance.
- Cash from Operations: $48m
- (+) Cash from Investing: -$40m
- (+) Cash from Financing: -$5m
- Net Change in Cash: $3m
Upon adding the $3m net change in cash to the beginning balance of $25m, we calculate $28m as the ending cash.
- Beginning Cash: $25m
- (+) Net Change in Cash: $3m
- Ending Cash: $28m
Balance Sheet (B/S)
On the Year 1 balance sheet, the $28m in ending cash that we just calculated on the CFS flows into the current period cash balance account.
- Accounts Receivable: $50m to $45m
- Accounts Payable: $65m to $80m
Operating assets declined by $5m while operating liabilities increased by $15m, so the net change in working capital is an increase of $20m – which our CFS calculated and factored into the cash balance calculation.
For our long-term assets, PP&E was $100m in Year 0, so the Year 1 value is calculated by adding CapEx to the amount to the prior period PP&E and then subtracting depreciation.
- PP&E – Year 1: $100m + $40m – $10m = $110m
Next, our company’s long-term debt balance was assumed to be $80m, which is decreased by the mandatory debt amortization of $5m.
- Long-Term Debt – Year 1: $80m – $5m = $75m
With the assets and liabilities side of the balance sheet complete, all that remains is the shareholders’ equity side.
The common stock and additional paid-in capital (APIC) line items are not impacted by anything on the CFS, so we just extend the Year 0 amount of $20m to Year 1.
- Common Stock & APIC – Year 1: $20m
But for Year 1, the retained earnings balance is equal to the prior year balance plus net income.
- Retained Earnings – Year 1: $30m + 18m = $48m
Note that if there were any dividends issued to shareholders, the amount paid out would come out of retained earnings.
In our final step, we can confirm our model is built correctly by checking that both sides of our balance sheet in Year 0 and Year 1 are in balance (i.e. Assets = Liabilities + Equity).