The cash flow statement classifies a company’s cash flow into three categories: operating, investing, and financing. It can be used to help an analyst evaluate the company’s liquidity, solvency, and financial flexibility. It can be presented in either of two formats: direct or indirect.
Cash Flow from Operating Activities
The cash flow statement begins with the operating activities section. Operating activities reflect cash generated and/or paid as a result of the firm’s core business functions. This part of the cash flow statement is the cash counterpart to income from operations as reported on the income statement. As such, it provides a useful comparison and contrast to the accrual accounting measures on the income statement, potentially highlighting effects of accrual accounting assumptions. Under U.S. GAAP, this category incorporates the cash received from customers, paid to suppliers, paid for operating costs, paid for income taxes, received from interest or dividends, and paid for periodic interest costs.
While cash payments for interest are included in the operating activities section, under U.S. GAAP, dividends paid out to equity capital holders are reported in the financing section. Therefore, interest payments and dividend payments appear in different sections of the cash flow statement under U.S. GAAP. IFRS handles this issue differently, allowing the reporting company the option of including both interest and/or dividends in either operating or financing activities.
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.
Cash Flow from Investing Activities
Cash flows from investing activities are those involving noncurrent capital assets used in the firm’s operations, such as property, plant, equipment (PP&E) and intangible assets. When a company invests in new long-term capacity by acquiring either PP&E or another company, the investment is a cash outflow from investing activities. Disposals of these types of assets for cash generate inflows. Accounting standards differ somewhat as to which activities can be classified as investing. For example, under IFRS, some research and development expenditures can be capitalized on the balance sheet and would thus be considered investing activities. Under U.S. GAAP, research and development costs must all be expensed immediately on the income statement and appear as operating cash outflows regardless of whether the research will result in long-term benefits to the firm.
Note that the investing activities section does not necessarily provide a complete listing of all capital asset activity because only acquisitions or disposals involving cash appear here. Noncash acquisitions, such as acquisition of a building using a mortgage, are disclosed in supplemental information to the cash flow statement. Under both U.S. GAAP and IFRS, a specific provision is made for these types of noncash financing and investing transactions. They are typically simultaneous, arising from an acquisition of a capital asset funded solely by incurring debt, such as the mortgage used to acquire property. Conceptually, it can be argued that a company receives cash from incurring the debt and then spends the cash on the acquisition. Nevertheless, if cash does not actually change hands, both sets of standards treat these as noncash transactions that must be disclosed separately from cash transactions. The disclosure could appear either at the end of the cash flow statement or in the notes to the statements. Another common noncash financing transaction, which is disclosed in the same manner, is the conversion of convertible debt or preferred stock into common equity.
Cash Flow from Financing Activities
Cash flows from financing activities are those that take place between a firm and its investors. These include both the equity investments of stockholders (owners) and the loans from bondholders and other creditors. When the company issues new shares or debt in exchange for cash it records a cash inflow from financing, and when it repurchases shares, pays dividends (with some exceptions under IFRS) or pays off debt it records a cash outflow. This section of the cash flow statement is typically related to activities in the non-current liabilities and owners’ equity section of the balance sheet. Under IFRS, cash interest payments may also be included here.