Part 1, Lesson 5

What is a cash flow statement?


Previously, we described the income statement as a bridge between the beginning balance sheet and ending balance sheet.  Similarly, the cash flow statement can also be viewed as bridge that explains the changes in a company’s cash balance from the beginning of the period to the end of the period.

The cash flow statement is split into three sections: 1) Cash Flow from Operating Activities, 2) Cash Flow from Investing Activities, and 3) Cash Flow from Financing Activities.  The total of these three sections will provide a bridge from the starting cash balance to the ending cash balance.

When making adjustments in the cash flow statement, we will follow the below framework:

  • Increase in Asset = Decrease in Cash
  • Decrease in Asset = Increase in Cash
  • Increase in Liability = Increase in Cash
  • Decrease in Liability = Decrease in Cash
  • Increase in Equity = Increase in Cash
  • Decrease in Equity = Decrease in Cash


Cash Flow from Operating Activities


The cash flow items in this section relate to activity that is associated with the daily operations of the business.  This section incorporates all the revenues and expenses shown in the income statement, but it adjusts for whether cash was actually exchanged for each of the individual line items in the income statement.

The operating activities section will begin with net income as the starting point.  From here, all non-cash expenses will be added to net income and any cash usage not reflected in the income statement is then subtracted out.

For example, depreciation is added back to net income as it is a non-cash expense.  If we refer back to the income statement in Part 1, Lesson 4, the John’s Pizzeria income statement shows a $4,000 salary expense for January.  However, if only $2,000 of the $4,000 expense was paid out in January, then, the January cash flow statement will show a $2,000 cash inflow since the January net income includes a $4,000 expense but $2,000 of that has not gone out in cash yet.

Since $2,000 in salary has not been paid yet, John’s Pizzeria would record a salary payable line item on the balance sheet of $2,000.  Following the above framework, an increase in a liability is shown as an increase in cash in the cash flow statement.  Therefore, the increase of $2,000 in salary payable on the balance sheet is reflected as $2,000 inflow of cash in the operating activities section.


Cash Flow from Investing Activities


The cash flow items in this section relate to the purchase or sale of fixed assets.  The purchase of a fixed asset is referred to as “capital expenditures.”  Investors refer to this section of the cash flow statement to identify a company’s capital expenditure outlays.

Individuals new to accounting may wonder why certain expenditures appear as expenses in the income statement vs. capital expenditures in the cash flow statement.  The general rule of thumb is that an expense is shown in the income statement when it is associated with the current generation of revenue or operation of the business.  In a simplistic sense, expenses are items that are “used up” in the current period.

However, capital expenditures show up in the cash flow statement when it is associated with the purchase of a fixed asset that will be used in the future.  Ultimately, as the fixed asset is “used up,” this capital expenditure will appear in the income statement as depreciation expense.  For example, if John’s Pizzeria were to purchase a table for $1,000, the initial outlay is considered a capital expenditure since this table will provide future benefit for many years.  If the table has a useful life of 10 years, then, every year, the business will recognize a depreciation expense of $100 in the income statement, until the value of the table reaches $0 in 10 years.

Other examples of capital expenditures include the purchase of a building, purchase of building improvements (such as a new roof), purchase of a vehicle, purchase of aircraft, purchase of IT equipment, purchase of furniture, etc.

When a company makes a capital expenditure, it is recorded as an increase in property, plant, and equipment on the balance sheet.  Following our framework, an increase in an asset (PP&E) is shown as a decrease in cash in the cash flow statement.  Intuitively, it makes sense that capital expenditures are shown as a decrease of cash in the cash flow statement.


Cash Flow from Financing Activities


The cash flow items in this section refer to the increase or decrease of capital for the business.  This includes the issuance of new debt or the paydown of existing debt.  It also includes the issuance of new equity, paydown of existing equity, and payment of dividends to equity holders.

Financing activities can be a source of cash when new debt or equity is issued, or it can be a use of cash when existing debt is paid down, equity is re-purchased, or dividends on equity are paid.

One nuance to remember – interest expense on debt is shown as an expense in the income statement, so it is implicitly incorporated into Cash Flow from Operating Activities.  However, dividends on equity capital is not considered an expense because dividends are considered the return that the owner of the business earns after all other expenses are paid.

Dividends (when paid) are shown as a decrease in cash in the Cash Flow from Financing Activities section.


John’s Pizzeria – First cash flow statement


Now that we have our initial balance sheet and January income statement, let’s put together the January cash flow statement for John’s Pizzeria.

As a recap, below is the December 31st balance sheet and January income statement for John’s Pizzeria.

John’s Pizzeria – Balance Sheet
As of December 31, 2018

Assets Liabilities
Cash $150,000 Short-Term Debt $50,000
Inventory $10,000 Accounts Payable $5,000
Supplies $5,000    
Total Short-Term Assets $165,000 Total Short-Term Liabilities $55,000
Furniture, Fixtures & Equipment (“FF&E”) $60,000 Long-Term Debt $70,000
Total Long-Term Assets $60,000 Total Long-Term Liabilities $70,000
 
Total Short and Long-Term Liabilities $125,000
Shareholders’ Equity
John’s Equity $100,000
Total Assets $225,000 Total Liabilities and Equity $225,000

 

John’s Pizzeria – Income Statement
For the Period Ending January 31, 2019

Revenue $16,000
– Cost of Goods Sold ($8,000)
= Gross Profit $8,000
– Salary Expense ($4,000)
– Rent Expense ($1,000)
– Electric Utility Expense ($500)
– Supplies Expense ($250)
– Depreciation Expense ($500)
= Operating Profit $1,750
– Interest Expense ($1,000)
= Earnings Before Taxes $750
– Income Tax Expense at 40% ($300)
= Net Income $450

Below is a recap of the January income statement activity from Lesson 3, but we have added in additional detail in red text showing the cash related activity:

  1. Sold 800 pizzas for $20 each – received $15,000 in cash and is owed $1,000 from a customer
  2. Hired one employee on January 1st at a salary rate of $4,000 per month – paid $2,000 in January and the remaining $2,000 was paid on February 1st
  3. Signed a lease on January 1st at a rate of $1,000 per month – paid January and February lease payments on January 1st
  4. Incurred a $500 electric bill – has not paid this bill yet
  5. Consumed $250 worth of supplies in January – supplies were already purchased, so this is a non-cash expense
  6. Depreciated FF&E based on a 10-year useful life – FF&E has already been purchased (depreciation is always a non-cash expense)
  7. Agreed to pay 10% yearly interest on both the short-term and long-term debt he has incurred – first year interest paid upfront on January 1st
  8. Owed federal and state taxes at an assumed rate of 40% of pre-tax profits – has not paid taxes yet
  9. Purchased furniture for $500
  10. Paid a dividend to equity owners of $50

Let’s now build the January cash flow statement for John’s Pizzeria:

1. Sold 800 pizzas for $20 each – received $15,000 in cash and is owed $1,000 from a customer

John’s Pizzeria – Statement of Cash Flows
For the Period Ending January 31, 2019

Cash Flows from Operating Activities
Net Income $450
Decrease in Inventory $8,000
Increase in Accounts Receivable ($1,000)

When we build the cash flow statement, the first line of the operating cash flow section is typically the net income line from the income statement.  From the net income line, it is then our job to add in uses of cash or sources of cash over the course of the month.

Remember- when an asset account increases, it is a use of cash, and when a liability account decreases, it is a use of cash.  Think of it this way, if John were to purchase inventory (increase asset), this would be a use of cash.  Likewise, if John were to pay down accounts payable (decrease liability), this would also be a use of cash.  Therefore, the converse must also be true – a decrease in an asset is a source of cash and an increase in a liability is a source of cash.

Following the net income, the next line we will adjust for is inventory.  We know from the income statement, that we have sold $8,000 worth of goods from John’s inventory (Cost of Goods Sold).  This decrease in inventory from $10,000 to $2,000 represents a source of cash of $8,000.  It may seem confusing at first that the decrease in inventory is a source of cash, but remember, John’s Pizzeria has already incurred a cash outflow to purchase inventory.  The Cost of Goods Sold shows an $8,000 expense, which is being deducted to arrive at the $450 net income, but this is not a cash expense in January since the inventory has purchased prior to January.  Therefore, we will add the $8,000 back as an increase in cash.

The next item we will adjust for is the $1,000 of revenue that is still owed from a customer.  Whenever, we have money owed from a customer, we increase the accounts receivable on the balance sheet to show that we expect payment on this revenue in the future.  The increase in an asset account, accounts receivable, to $1,000 is a $1,000 use of cash.

You will notice that we are simply moving down the income statement when adding in adjustments in the cash flow statement.  After net income, we incorporated the non-cash portion of revenue and the change in inventory (Cost of Goods Sold).

2. Hired one employee on January 1st at a salary rate of $4,000 per month – paid $2,000 in January and the remaining $2,000 was paid on February 1st

John’s Pizzeria – Statement of Cash Flows
For the Period Ending January 31, 2019

Cash Flows from Operating Activities  
Net Income $450
Decrease in Inventory $8,000
Increase in Accounts Receivable ($1,000)
Increase in Salaries Payable $2,000

Since $2,000 of the $4,000 salary expense has not yet been paid, we must increase a salaries payable account on the balance sheet to show that John’s Pizzeria owes $2,000 of salaries.  The increase of this liability account represents a source of cash of $2,000.

If this is still confusing, another way to think of this is that the net income for the month already incorporated $4,000 of salary expense, but since only $2,000 went out the door, we are now adding back $2,000 to the cash flow statement since this portion of the salary expense has not been paid yet.

3. Signed a lease on January 1st at a rate of $1,000 per month – paid January and February lease payments on January 1st

John’s Pizzeria – Statement of Cash Flows
For the Period Ending January 31, 2019

Cash Flows from Operating Activities  
Net Income $450
Decrease in Inventory $8,000
Increase in Accounts Receivable ($1,000)
Increase in Salaries Payable $2,000
Increase in Prepaid Rent ($1,000)

The January income of $450 already incorporates $1,000 rent for January, but it does not contemplate the $1,000 rent payment for February.  Since John’s Pizzeria prepaid the February rent payment, we increase an asset account called Prepaid Rent to reflect the $1,000 payment, which represents a use of cash in the cash flow statement.

4. Incurred a $500 electric bill – has not paid this bill yet

John’s Pizzeria – Statement of Cash Flows
For the Period Ending January 31, 2019

Cash Flows from Operating Activities  
Net Income $450
Decrease in Inventory $8,000
Increase in Accounts Receivable ($1,000)
Increase in Salaries Payable $2,000
Increase in Prepaid Rent ($1,000)
Increase in Accounts Payable (electric bill) $500

The January income of $450 already incorporates $500 utility expense, but since John’s Pizzeria has not paid this amount yet, we increase a liability, Accounts Payable by $500.  Remember – an increase in a liability is a source of cash.

5. Consumed $250 worth of supplies in January – supplies were already purchased, so this is a non-cash expense

John’s Pizzeria – Statement of Cash Flows
For the Period Ending January 31, 2019

Cash Flows from Operating Activities  
Net Income $450
Decrease in Inventory $8,000
Increase in Accounts Receivable ($1,000)
Increase in Salaries Payable $2,000
Increase in Prepaid Rent ($1,000)
Increase in Accounts Payable (electric bill) $500
Decrease in Supplies $250

The $250 supply expense represents the usage of supplies that have already been paid for.  A decrease in the supply asset of $250 represents a source of cash in the cash flow statement.

This is similar to our usage of inventory (Cost of Goods Sold).  Since the inventory asset was purchased prior to January, the Cost of Goods Sold expense does not represent a cash outflow in January.  On the same token, since the supply asset was purchased prior to January, the supply expense incurred in January is a non-cash expense.  In both cases, we measure the cash inflow by looking at the decrease in the asset value on the balance sheet.

6. Depreciated FF&E based on a 10-year useful life – FF&E has already been purchased (depreciation is always a non-cash expense)

John’s Pizzeria – Statement of Cash Flows
For the Period Ending January 31, 2019

Cash Flows from Operating Activities  
Net Income $450
Decrease in Inventory $8,000
Increase in Accounts Receivable ($1,000)
Increase in Salaries Payable $2,000
Increase in Prepaid Rent ($1,000)
Increase in Accounts Payable (electric bill) $500
Decrease in Supplies $250
Depreciation and Amortization $500

Depreciation and Amortization always appears as a source of cash on the income statement because D&A is a non-cash expenses that have already been deducted from net income.  D&A represents the theoretical usage of a fixed asset that has already been purchased, therefore, D&A expense is not cash out the door.  Following our framework, D&A leads to a decrease in the FF&E asset.  A decrease in an asset is a source of cash in the cash flow statement.

Typically, Depreciation and Amortization will appear as the second line item in the operating activities section, right after the Net Income line.  Although depreciation is considered a “Decrease in FF&E,” most cash flow statements will simply label this item as “Depreciation and Amortization.”

7. Agreed to pay 10% yearly interest on both the short-term and long-term debt he has incurred – first year interest paid upfront on January 1st

John’s Pizzeria – Statement of Cash Flows
For the Period Ending January 31, 2019

Cash Flows from Operating Activities  
Net Income $450
Decrease in Inventory $8,000
Increase in Accounts Receivable ($1,000)
Increase in Salaries Payable $2,000
Increase in Prepaid Rent ($1,000)
Increase in Accounts Payable (electric bill) $500
Decrease in Supplies $250
Depreciation and Amortization $500
Increase in Prepaid Interest ($11,000)

With $120,000 in total debt at a 10% interest rate, John’s Pizzeria owed $12,000 in interest for 2019.  If John’s Pizzeria paid the full $12,000 on January 1st, then, we will record a prepaid interest asset of $11,000 on the balance sheet as of January 31st because John’s Pizzeria still has 11 months of pre-paid interest ahead of it.  Going forward, John’s Pizzeria will still expense $1,000 of monthly interest expense in the income statement but will not incur any new cash outflow since the interest was already pre-paid.  At the end of February, the pre-paid interest asset will decrease to $10,000.

We show the increase of the $11,000 Prepaid Interest asset as a use of cash in the cash flow statement.  Another way to think of this:  the January income statement reflected $1,000 of interest expense, but John’s Pizzeria sent $12,000 out the door in January, so we must show the $11,000 additional cash used in the cash flow statement.

8. Owed federal and state taxes at an assumed rate of 40% of pre-tax profits – has not paid taxes yet

John’s Pizzeria – Statement of Cash Flows
For the Period Ending January 31, 2019

Cash Flows from Operating Activities  
Net Income $450
Decrease in Inventory $8,000
Increase in Accounts Receivable ($1,000)
Increase in Salaries Payable $2,000
Increase in Prepaid Rent ($1,000)
Increase in Accounts Payable (electric bill) $500
Decrease in Supplies $250
Depreciation and Amortization $500
Increase in Prepaid Interest ($11,000)
Increase in Taxes Payable $300

The January income statement includes $300 of income tax expense, which has not yet been paid, so we will add back the $300 in the cash flow statement and record a taxes payable liability on the balance sheet.  The increase of a liability account represents a source of cash.

9. Purchased furniture for $500

John’s Pizzeria – Statement of Cash Flows
For the Period Ending January 31, 2019

Cash Flows from Operating Activities  
Net Income $450
Decrease in Inventory $8,000
Increase in Accounts Receivable ($1,000)
Increase in Salaries Payable $2,000
Increase in Prepaid Rent ($1,000)
Increase in Accounts Payable (electric bill) $500
Decrease in Supplies $250
Depreciation and Amortization $500
Increase in Prepaid Interest ($11,000)
Increase in Taxes Payable $300
Total Cash Flows from Operating Activities ($1,000)
Cash Flows from Investing Activities
Capital Expenditures ($500)
Total Cash Flows from Investing Activities ($500)

The purchase of fixed assets such as furniture, equipment, buildings, land, etc is classified as capital expenditures, which falls under the Cash Flows from Investing Activities section of the cash flow statement.

This $500 purchase of furniture will serve to increase the balance of the FF&E account on the balance sheet, whereas the $500 in depreciation will serve to decrease the balance of the FF&E reserve account on the balance sheet.  Remember – an increase of an asset account is shown as a decrease in cash.  Since capex always increases the FF&E asset, capex is always shown as a decrease of cash in the cash flow statement.

When a company sells a fixed asset (reduction in the FF&E asset), this is shown as a cash increase under the Cash Flow from Investing Activities section.  This type of activity will usually be labeled as “Sale of FF&E” or “Sale of Fixed Assets” and will be shown separately from capex.

Notice in the cash flow statement that we have also added lines to sum up the total cash flows from operating activities and investing activities.

10. Paid a dividend to equity owners of $50

John’s Pizzeria – Statement of Cash Flows
For the Period Ending January 31, 2019

Cash Flows from Operating Activities  
Net Income $450
Decrease in Inventory $8,000
Increase in Accounts Receivable ($1,000)
Increase in Salaries Payable $2,000
Increase in Prepaid Rent ($1,000)
Increase in Accounts Payable (electric bill) $500
Decrease in Supplies $250
Depreciation and Amortization $500
Increase in Prepaid Interest ($11,000)
Increase in Taxes Payable $300
Total Cash Flows from Operating Activities ($1,000)
Cash Flows from Investing Activities
Capital Expenditures ($500)
Total Cash Flows from Investing Activities ($500)
Cash Flows from Financing Activities
Dividends to Equity Holders ($50)
Total Cash Flows from Investing Activities ($50)
Total Change in Cash ($1,550)

The final entry in our January cash flow statement will be the payment of a $50 dividend to the owner of the business (John).  In January, there was $450 of net income available to pay a dividend or pay down debt, and John elected to pay a dividend of $50 to himself, which is shown as a use of cash in the cash flow statement.