Cash Flow Statement Basics Explained

Today we will talk about the

cash

flow

statement

. It is one of the three main financial

statement

s, but it is often overlooked. Sure, the income statement provides information about revenue and profits over a given period of time, and the balance sheet offers a snapshot of financial health at a given point in time. But it's in the

cash

flow

statement that you can find out how effective a company is in managing its cash and what it spends it on. And in the end, cash is the lifeblood of any business. If you can no longer pay your employees, your suppliers or your taxes, it's game over. (computerized electronic music) So let's get started. (upbeat music) In a previous video we talked about the difference between cash and accrual accounting.

We said it's important to understand that profits and cash can be two different things. Profit is defined as income minus expenses. And in accrual accounting, we report revenues when they are generated and expenses when they are incurred. But earning income doesn't always increase cash immediately. And incurring expenses doesn't always reduce cash immediately. Remember this important difference from cash accounting. If you want to know how much cash a company has, you can look at the balance sheet. There you will be able to see if the cash position has gone up or down. But this way you won't see how the cash came into the business and, perhaps even more importantly, what it was spent on.

Therefore, to get a complete picture of the business, we must also look at its cash flow statement. Think of this as a report showing how cash was coming in or going out of the business. If you see a positive figure, it means cash came into the business and a negative figure means cash left the business. A cash flow statement looks like this. It consists of three main parts. The first is cash flow from operations. This is the most important part, because it shows you how much cash is generated from the actual operations of the business, that is, from the sale of the company's products and services.

Next, we have the cash flow from investing activities. As the name suggests, this is cash spent on investments or cash received from sales of investments. In other words, it is outside the core business activities of selling products and services. In this section we can see if the company purchased assets such as machinery and equipment, or perhaps even acquired another business. The last one is the cash flow from financing activities. This section summarizes the cash transactions that involved obtaining, borrowing, and repaying capital. For example, here we can see if the company issued new shares, if dividends were paid, if a bank loan was obtained, or if the debt principal was paid.

At the bottom of the account statement you can see the reconciliation with the balance sheet. It shows you the starting point of the cash from the last period and the ending balance of the current balance. The difference between the two is the net cash change which should equal the sum of the three cash flow sections above. In other words, the beginning cash balance, plus cash flows from operations, investing, and financing, must equal the ending balance of the current balance sheet. Let's look at the three main sections in a little more detail. First, cash flow from operations.

To calculate cash flow from operations, two different methods are used. One is the indirect method that takes the net income from the income statement as a starting point. But we already know that income does not equal cash. So to arrive at a cash flow, many adjustment lines must be added. Therefore, it is not the most intuitive method to understand. The other is the direct method that does not start with a net income, but instead lists different types of transactions that produce cash amounts received and paid. For example, you will have lines such as cash received from customers, cash paid to suppliers, to employees, or interest and taxes paid.

GAAP and IFRS allow both methods and both will give you the same result. While the direct method is easier to read and provides better insight, it is time-consuming to prepare. The indirect method, on the other hand, is linked to profit and loss and the balance sheet. It's less intuitive, but much easier to prepare, which is why most companies use this method. So we'll skip the direct method and just focus on the indirect method in this video. As we said, we start with net income, which is taken directly from the income statement. We then adjust net income to account for multiple effects to arrive at cash flow.

Let's look at the most common ones. Depreciation and amortization are expenses on the income statement that have no impact on cash. We call this cashless transaction. Think about it, when we take into account wear and tear on an asset, no cash leaves the business. This is how we allocate expenses over the useful life of the asset. The only time cash is affected is when we actually purchase the asset. But depreciation and amortization reduce net income. And since net income is the starting point here, we need to add this expense back. The same applies to the gain or loss on the disposal of non-current assets.

Let's say the company is selling a forklift that it purchased for $10,000 two years ago, but now no longer needs it. And let's see that the current asset value of the forklift is 5,000 because the company has been using it for two years, in its warehouse. The company can sell it for $8,000. What we will see on the income statement is a gain on the sale of the forklift of $3,000. But in the cash flow statement we want to see the total cash impact, not the profit from the sale. Therefore, we must remove the 3,000 included in the net income above and show the full $8,000 in cash.

But since the sale of equipment is not part of the ongoing operations of this business, we are not going to show $8,000 in cash here, but below in the cash flow from investing activities section. Next is the adjustment for changes in working capital, which simply consists of inventory, accounts receivable, and accounts payable. To understand why we need to adjust these balance sheet items, it is necessary to think about how these positions influence the amount of money the company has in the bank. First, inventory. Let's say that at the end of last year, your inventory value on the balance sheet was 100 and now it is 150.

It increased by 50, which means you keep more inventory in stock. And this increased inventory had to be paid for, so there was more cash in the business. Is this increase reflected in the starting point here, the net income? Not well? Net income only includes expenses for the cost of goods sold, but not if you buy more inventory than you sell. That's why we need to adapt here. Higher inventory means cash is decreasing, lower inventory would increase it. Next, accounts receivable. These work the same way. Let's say you are selling products to someone for 100, but on credit.

You haven't received the cash yet. On the income statement under the accrual method, we would show the income earned, which increases our net income. And our starting point would include the 100. However, no cash was received, right? We are still waiting for the cash. So if accounts receivable increases, we adjust with a negative number. If they are lower, we adjust with a positive figure. Then, accounts payable. They work the other way around, due to passives. If we increased this position, we would pay our suppliers less. We're working with your money, which is good for our cash balance.

Therefore, a higher figure for accounts payable is a positive increase in cash instead. However, if they decrease, it is negative for the cash balance, because we use more cash to pay suppliers. Now, all that's left to do is add these adjustments by adding net income to arrive at cash flow from operations. Obviously, Microsoft's cash flow is huge, but even if you look at a smaller company, you'll want to see a positive number here. Otherwise, the company will not generate cash, with its core business, which should raise all kinds of red flags. Another important aspect to highlight here is the crucial role that working capital plays for most businesses.

If you carry a large inventory, give long payment terms to your customers, or have a lot of overdue accounts receivable, you are using a lot of cash to finance it. Cash, to which you do not then have to add capacity, expand into new markets or invest in marketing. Now speaking of investing, let's talk about the next section of the cash flow statement. Cash flow from investing activities. Remember when we used to adjust depreciation and gains or losses on the sale of assets? The reason was that these were cashless transactions. They do not affect your cash balance.

However, what does affect it is the inflow or outflow of cash when the company buys or sells these assets. And that's exactly what we see here. When a company purchases new property or equipment, we will look at the full cash outflow in this section. Likewise, if you acquire a company or other investments, we will see that they are also here. The last part is the cash flow from financing activities. This section summarizes cash transactions that involve obtaining, borrowing, and repaying capital. So to make this clear, let's look at an example and how it affects this section of cash flow.

When a company borrows money from a bank or issues bonds or stocks, it receives cash. This cash will be reported as a positive amount in cash flow from financing activities. A positive amount informs the reader that cash was received, which increased the company's cash balance. On the other hand, when a company repays the principal portion of its loans, buys its own shares, or pays dividends to its owners, the amount of cash used will be reported here as a negative amount. The negative amount informs the reader that cash was used, which reduced the company's cash balance. Alright, these are the three sections of the cash flow statement.

It is important to be able to distinguish between these elements, as it will give you a good idea of ​​where the company earns and spends its money. And as we saw at the beginning of this lecture, the sum of these three types of cash flow gives us the change in net cash of the company for the period. Net cash flow is the difference between the amount of cash the company had at the beginning of the period and the amount of cash it had at the end of the period. I hope this video was helpful in better understanding the cash flow statement.

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