Understanding Cash Flow Statements: Principles and Classifications | CFA Level I FSA

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

We move on to the third important required financial statement – the statement of cash flows. The cash flow statement provides information about a company’s cash receipts and cash payments during an accounting period. This allows an analyst to determine if the company generates sufficient cash to finance its operations, pay off debt, and distribute cash to shareholders.

In this first part, we shall briefly look at the fundamental principles in the preparation of cash flow statements. We shall also learn what are operating, investing, and financing cash flows, and how the various activities are classified into each of these categories. We shall end this lesson with a quick discussion on non-cash transactions. This will help us understand the differences between the income statement and the cash flow statement.

Principles of Cash Flow Statements

Since the income statement is based on the accrual method, net income may not represent cash generated from operations. You are likely to find that the change in the amount of cash for the period does not tally with the net income for the period.

The statement of cash flow provides a reconciliation of the beginning and ending cash on the balance sheet. It accounts for the cash generated and cash used during the accounting period.

Classification of Cash Flows

Cash flows are usually segregated into 3 categories: operating, investing, and financing cash flows.

Operating Activities (CFO)

Operating activities include the company’s day-to-day activities that create revenues, such as selling inventory and providing services, and other activities not classified as investing or financing. Cash inflows result from cash sales and from the collection of accounts receivable.

To generate revenue, companies undertake activities, such as manufacturing or purchasing inventory from suppliers and paying employee salaries.

Cash outflows result from:

• Cash payments for inventory and accounts payable.
• Payments for salaries.
• Other operating-related expenses.

Operating activities can also include receipts and payments related to trading securities.

Investing Activities (CFI)

Investing activities include purchasing and selling long-term assets and other investments. These long-term assets and other investments include property, plant, and equipment, and intangible assets. Cash inflows include cash receipts from the sale of such assets. Cash outflows include payments for the purchase of these assets.

Investments in the equity and debt issued by other companies are also considered investing activities. Note that investments in liquid securities like cash equivalents and securities held for trading purposes are not considered investing activities. Instead, they should be classified as operating activities.

The cash proceeds from the sale of investment assets and cash outflows from the purchase of investment assets are recorded under cash from investing.

Financing Activities (CFF)

Financing activities include obtaining or repaying capital. The two primary ways of obtaining capital are to issue shares to shareholders and debt or bonds to creditors.

Cash inflows in this category include:

• Cash receipts from issuing stock.
• Cash receipts from issuing bondsor through borrowing.

Cash outflows include:

• Cash payments to repurchase stock.
• Cash payments to repay bonds and other borrowings.

The activities we have gone through so far are straightforward and consistent between IFRS and US GAAP.

Classification of Interim Income, Dividends, and Taxes Paid

The classification for interim income like dividends and interest, and taxes paid are a bit more tricky.

Under US GAAP:

• Interest or dividends received and interest paid are reported as operating activities.
• Dividends paid are always reported as financing activities.
• Taxes paid are always reported as operating activities.

In contrast, IFRS provide companies with choices:

• Interest or dividends received may be classified either as an operating activity or as an investing activity.
• Interest or dividend paid may be classified as either an operating activity or a financing activity. Companies must use a consistent classification from year to year. They must also disclose interest and dividends separately, not as a single item.
• Taxes are generally reported as operating activities, unless the tax expense can be specifically identified with an investing or financing activity.

Non-cash Transactions

Companies may also engage in non-cash investing and financing transactions.

A non-cash transaction is any transaction that does not involve an inflow or outflow of cash.

For example, if a company exchanges one non-monetary asset for another non-monetary asset, no cash is involved. Similarly, no cash is involved when a company distributes stock dividends.

Another common non-cash transaction is when convertible bonds or convertible preferred stock are exchanged for common stock.

Because no cash is involved in non-cash transactions, these transactions are not incorporated in the cash flow statement.

However, because such transactions may affect a company’s capital or asset structures, any significant non-cash transaction is required to be disclosed. This can either be in a separate note or a supplementary schedule to the cash flow statement.

That wraps up this quick introduction lesson on the statement of cash flows. In the next lesson, we shall move on to the linkages of the cash flow statement with the income statement and balance sheet, and the steps in the preparation of the cash flow statement.