Three main sections of Statement of Cash Flows:
- Operating Activities: The principal revenue-generating activities of an organization and other activities that are not investing or financing; any cash flows from current assets and current liabilities
- Investing Activities: Any cash flows from the acquisition and disposal of long-term assets and other investments not included in cash equivalents
- Financing Activities: Any cash flows that result in changes in the size and composition of the contributed equity or borrowings of the entity (i.e., bonds, stock, cash dividends)
Cash flow definitions
Cash flows: Inflows and outflows of cash and cash equivalents
Cash: Cash on hand and demand deposits (cash balance on the balance sheet)
Cash equivalents: Cash equivalents include cash held as bank deposits, short-term investments, and any very easily cash-convertible assets – includes overdrafts and cash equivalents with short-term maturities (less than three months).
Cash flow classification
1. Operating cash flow
Operating activities are the principal revenue-producing activities of the entity. Operating cash flows typically include the cash flows associated with sales, purchases, and other expenses.
The company’s chief finance officer chooses between the direct and indirect presentation of operating cash flow:
2. Investing cash flow
Investing activities are the acquisition and disposal of non-current assets and other investments not included in cash equivalents. Investing cash flows typically include the cash flows associated with buying or selling property, plant, and equiipment (PP&E), other non-current assets, and other financial assets.
Cash spent on purchasing PP&E is called capital expenditures (or CapEx for short).
3. Financing cash flow
Financing activities are activities that result in changes in the size and composition of the equity capital or borrowings of the entity. Financing cash flows typically include cash flows associated with borrowing and repaying bank loans, and issuing and buying back shares. The payment of a dividend is also treated as a financing cash flow.
- Direct presentation: Operating cash flows are presented as a list of cash flows; cash in from sales, cash out for purchases, etc. Simple but rarely used method, as the indirect presentation is more common.
- Indirect presentation: Operating cash flows are presented as a reconciliation from profit to cash flow.
Preparation of a Statement of Cash Flows
The operating section of the statement of cash flows can be shown through either the direct method or the indirect method. For either method, the investing and financing sections are identical; the only difference is in the operating section. The direct method is a method that shows the major classes of gross cash receipts and gross cash payments. The indirect method, on the other hand, starts with the net income and adjusts the profit/loss by the effects of the transactions. In the end, cash flows from the operating section will give the same result whether under the direct or indirect approach, however, the presentation will differ.
The International Accounting Standards Board (IASB) favors the direct method of reporting because it provides more useful information that the indirect method. However, it is believed that greater than 90% of companies use the indirect method.
Direct method vs Indirect method of presentation
There are two methods of producing a statement of cash flows, the direct method, and the indirect method.
In the direct method, all individual instances of cash being received or paid out are tallied up and the total is the resulting cash flow.
In the indirect method, the accounting line items such as net income, depreciation, etc. are used to arrive at cash flow. In financial modeling, the cash flow statement is always produced via the indirect method.
Below is a comparison of the direct method vs the indirect method.
