The Cash Flow Statement
The primary purpose of the cash flow statement is to provide information about an
entity’s cash receipts and cash payments during a period.
A secondary objective is to provide information about its operating, investing, and
financing activities.
The cash flow statement reports the cash receipts, cash payments, and net change
in cash that result from operating, investing, and financing activities during a
period. The format used reconciles the beginning and ending cash balances.
The statement is generally prepared using “cash and cash equivalents” as its basis.
Cash equivalents are short term, highly liquid investments that are both:
Readily convertible to known amounts of cash, and so near to their maturity, that
their market values are relatively unaffected by changes in interest rates.
Since cash and cash equivalents are viewed as the same, transfers between them
are not treated as cash receipts and cash payments, and are not reported in the
cash flow statement.
Classification of Cash Flows
The cash flow statement classifies cash receipts and cash payments by operating,
investing, and financing activities.
Operating activities include the cash effects of transactions that create
revenues and expenses. They affect net income.
Investing activities include (a) acquiring and disposing of investments and
productive long-lived assets, and (b) lending money and collecting on
those loans. They affect investments that are not cash equivalents and
long-term asset accounts.
Financing activities include (a) obtaining cash from issuing debt and repaying
the amounts borrowed, and (b) obtaining cash from shareholders and
providing them with a return on their investment. They affect long-term
liability and equity accounts.
Note that (1) operating activities involve income statement items. These items
are also affected by noncash current asset and current liability accounts.
(2) Investing activities involve cash flows resulting from changes in
investments and long-term asset items. (3) Financing activities involve
cash flows resulting from changes in long-term liability and shareholders’
equity items.
Significant financing and investing activities that do not affect cash are not
reported in the body of the cash flow statement. These noncash activities
are reported in a separate note to the financial statements, which satisfies
the full disclosure principle.
Format of the Cash Flow Statement
The cash flows from the operating activities section always appears first,
followed by the investing activities and the financing activities section.
Individual inflows and outflows from investing and financing activities are
reported separately.
The reported operating, investing, and financing activities result in net cash
being either provided or used by each activity. The amounts of net cash
provided or used by each activity are totalled to show the net increase or
decrease in cash for the period. This amount is then added to or
subtracted from the beginning-of-period cash balance to obtain the end-ofperiod cash balance. Finally, any significant noncash investing and
financing activities are reported in a note to the statement.
Usefulness of the Cash Flow Statement
The information in a cash flow statement should help investors, creditors, and others
assess:
1) The entity’s ability to generate future cash flows.
2) The entity’s ability to pay dividends and meet obligations.
3) The reasons for the difference between net income and net cash provided
(used) by operating activities.
4) The cash investing and financing transactions during the period.
Preparing the Cash Flow Statement
Unlike the three other basic financial statements, the cash flow statement is
not prepared from the adjusted trial balance. The information to prepare
the cash flow statement usually comes from three sources:
1) Comparative balance sheet.
2) Current income statement.
3) Additional information.
Preparing the cash flow statement from these data sources involves three
steps:
Step 1: Determine the net increase (decrease) in cash. The net increase
(decrease) in cash is the ending cash less the beginning cash.
Step 2: Determine the net cash provided (used) by operating activities.
Analyse the current year’s income statement as well as the
comparative balance sheets and selected additional data.
Step 3: Determine net cash provided (used) by investing and financing
activities. Comparative balance sheet data and selected additional
information are analysed for their effects on cash.
The conversion of net income from an accrual basis to a cash basis to
determine net cash provided (used) by operating activities may be done
using (1) the indirect method or (2) the direct method.
Using the Information in the Financial Statements
In the cash flow statement, cash provided by operating, investing, and
financing activities is intended to indicate the cash generating capability of
the company. A ratio analysis of the cash flow statement can evaluate
liquidity, profitability, and solvency.
Cash current debt coverage: measures liquidity. It indicates the amount of cash
generated by operating activities for every dollar of current liabilities. The formula
is:
Net Cash Provided
by
Operating Activities

Average Current
Liabilities
=
Cash Current
Debt Coverage
Cash return on sales: measures profitability. It is the cash basis counterpart to the
profit margin ratio, calculated under the accrual basis of accounting. The
formula is:
Net Cash Provided
by
Operating Activities

Net Sales
=
Cash Return
on Sales
Cash flow per share: measures profitability. It is the cash basis counterpart to the
earnings per share ratio, calculated under the accrual basis of accounting. It is
an optional measure that may be included on the face of the cash flow
statement or in a cross-referenced note to this statement. Earnings per share
must be disclosed on the income statement or cross-referenced by note to the
income statement. The formula for cash flow per share is:
Cash Flow from
Operating, Investing,
and Financing
Activities

Number of
Common Shares
=
Cash Flow Per
Share
Cash total debt coverage: measures long-term solvency. It is the cash basis
counterpart to the debt to total assets, calculated under the accrual basis of
accounting. The cash total debt coverage ratio demonstrates a company’s ability
to repay its liabilities from the net cash provided by operating activities without
having to liquidate the assets used in its operations. The formula is:
Net Cash Provided
by
Operating Activities

Average Total
Liabilities
=
Cash Total
Debt Coverage