8 September 2001 C:\WINDOWS\Desktop\Acctng\Cashflow in a nutshell.wpd

CASH FLOW IN A NUTSHELL

Cash flow statements may be created directly from a cash account by simply pulling out the variousreceipts and disbursements found in that account and arranging them in three categories: operations,investments, and financing. The result is a so-called direct cash flow statement.

Financing involves cash flows related to borrowing money in the form of loans or raising capital frominvestors. It also includes dividends paid by the company.

Investing involves cash flows related to the buying and selling of long-term assets such as property,plant and equipment but also long-term investments in stocks and bonds.

Operations involves cash flows related to the buying and selling of goods and services. If thedisbursement or receipt is associated with an expense or a revenue in the income statement then it isalmost certainly an operating item.

Few companies produce direct cash flow statements. Most produce them in an indirect fashion byadding back to income a number of non-cash adjustments. In effect, instead of reporting wages paiddirectly, they report wage expense less the portion that was not paid this year so arriving at wages paidindirectly. The result is the so-called indirect cash flow statement.

A quick glance at the table that follows shows that the investing and financing section of the direct andindirect cash flow statements are identical in format as well as in totals. The operating section adds upto the same amount for both but the format is different. As already noted, the one gives us the receipt orexpenditure directly; the other gives it to us indirectly.

There are two “tricks” in creating cash flow statements. One is determining whether an item is a Sourceor a Use of cash and therefore whether one adds it to or subtracts it from the overall cash position.Many times this is obvious. At other times it is easily determined by remembering:

Increases in assets involve the use of funds; decreases in assets are sources of fundsIncreases in equities are sources of funds; decreases in equities requires the use of funds

The other trick is to remember that as a general rule a change in a working capital item is associatedwith operating cash flows; changes in long-term assets are associated with investing cash flows; andchanges in long-term liabilities and capital are associated with financing cash flows. Net income isoperating; dividends are part of financing.

To create an indirect cash flow statement, pick up net income and depreciation from the incomestatement and dividends from the reconciliation of owners’ equity. Difference two balance sheets. Labelthe differences i.e., the changes as Sources or Uses and as Operating, Investing or Financing. Sort into

8 September 2001 C:\WINDOWS\Desktop\Acctng\Cashflow in a nutshell.wpd

the three categories adding and subtracting according to whether they are Sources or Uses. The resultshould be a reconciliation to the change in cash in the balance sheet.

Direct cash flow statement Indirect cash flow statement

Receipts from customers Net income

Payments to suppliers for inventory Depreciation expense from income statement

Expenditures for services received Changes in working capital

Cash from operations Cash from operations

Acquisition of PPE Acquisition of PPE

Disposition of PPE Disposition of PPE

Cash for investing Cash for investing

Receipt/repayment of loans Receipt/repayment of loans

Issuance/repurchase of capital Issuance/repurchase of capital

Cash dividends Cash dividends

Cash from financing Cash from financing

Net change in cash Net change in cash