Cash Flow Statement: Activities, Methods & Preparation
Understanding Cash Flow Activities
It is important to first identify the resources generated or used by the business during the accounting period, classified into three main areas:
- Cash generated by or used for operating activities.
- Cash generated by or used for investment activities.
- Cash generated by or used in financing activities.
Operating Activities Cash Flow
Cash flow from operating activities represents the cash generated from the main, regular income-producing activities of the business. These are the primary source of revenue. This area also includes other activities that cannot be classified as investing or financing.
It includes all cash inflows and outflows directly related to the normal business operations of the economic entity, typically derived from net income after adjustments. The most significant cash flows in this section include:
- Cash sales
- Collections from credit sales made to customers
- Cash purchases
- Payments to suppliers for goods purchased
- Payments of salaries to employees
- Payments of all business operating costs
- Tax payments
Note: This section excludes non-cash expenses or income related to operations, such as depreciation and amortization.
Investment Activities Cash Flow
Cash flow from investment activities involves the purchase and sale of long-term assets and other investments not included in cash and cash equivalents. These relate to transactions involving long-term assets that caused an inflow or outflow of cash.
Important: Credit operations are not included until payment is received or the credit arising from that operation is settled.
Financing Activities Cash Flow
Cash flow from financing activities results from transactions that cause changes in the size and composition of the entity’s equity capital and borrowings. The most significant cash flows in this section include:
- Short-term and long-term credits received (unless related to business operations, in which case they belong in the operating section)
- Capital repayments
- Dividends paid (excluding stock dividends)
- Borrowings
- Settlement payments of interest
- Capital contributions from shareholders
Methods for Cash Flow Statements
There are two primary methods for preparing the cash flow statement:
- Direct Method: Presents major classes of gross receipts and payments. This requires analyzing the cash and bank accounts in the general ledger in detail and classifying each cash flow into its corresponding section (operating, investing, financing). This method is less common in large companies but may be applied by small businesses with fewer transactions.
- Indirect Method: This method is more popular. It starts with net income and adjusts it for non-cash items (like depreciation) and changes in balance sheet accounts (like accounts receivable or payable) to arrive at cash flow from operations. It requires comparing balance sheet accounts from one period to another, using at least two statements of financial position (referring to the beginning and end of the period covered by the Cash Flow Statement), an income statement for the same period, and additional information regarding operations and developments during the period.
Preparing the Cash Flow Statement
Follow these steps to prepare the statement:
- Determine the overall increase or decrease in cash and cash equivalents for the period.
- Determine the net change (increase or decrease) for each balance sheet account between the beginning and end of the period.
- Analyze each change to identify the underlying cash inflows and outflows and their nature (operating, investing, or financing).
- Classify these cash flows into the three main sections: operating, investing, and financing activities.