Financial Education

In 1987, the FASB issued Statement 95 requiring the Statement of Cash Flows in its current form. International Accounting Standards mandates a cash flow statement under IAS 7 that is similar in most respects to that provided under U.S. GAAP. While not perfect, the current cash flow statement provides much meaningful information.

The cash flow statement required under U.S. GAAP or IAS presents a detailed display of what has caused the firm’s cash and cash equivalents to change throughout a reporting period. Cash equivalents include investments that are readily convertible to a specified amount of cash (in IAS, “subject to an insignificant risk of changes in value”). Under both standards, the net change in this class of assets over the reporting period is subdivided into three components: cash from operating activities, cash from investing activities, and cash from financing activities. These three components can be seen in the cash flow statement for Distribution Company above.

U.S. GAAP has fairly rigid requirements regarding which area each change in cash (or cash equivalents) falls under. IAS offers some choices for specific items. Under either IAS or U.S. GAAP, the full cash flow statement summarizes the change in cash and cash equivalents, reconciling the cash balance on the ending balance sheet to that on the beginning balance sheet. The net change is the sum of the effects of the three components—operating, investing, and financing.

In a healthy, mature firm, operating activities should support themselves; that is, sales to customers should generate enough cash to pay for inventories sold to those customers and to pay for other operating expenses required to make those sales, such as wages. Investing activities, the acquisition and disposal of the long-term assets needed for operations, could be supported using excess cash from operations. Alternatively, the funds for these investments may be acquired by issuing debt or equity. These debt and equity transactions are the firm’s financing activities.

In general, a mature firm should not need to finance operations by incurring debt or issuing stock (though such firms may still raise financing in order to change the capital structure, expand into new businesses or acquire another company.) In a new or otherwise rapidly growing firm, however, operating activities may not yet generate enough cash to support themselves without borrowing or issuing equity. But for a company to survive over the long run, its operations must support themselves. Consequently, a clear picture of how the firm is managing its cash is important to the overall understanding of a company’s financial position.

For more information, see all articles on: Accounting, Financial Statement Analysis, Fundamental Analysis

See also:

How Non-Cash Investing and Financing Transactions are Treated on the Statement of Cash Flows

The Cash Method of Accounting

Net Change in Cash (Overall Cash Flow)

What is a Balance Sheet?

Computing Free Cash Flow to the Firm from the Statement of Cash Flows