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IFT Notes for Level I CFA® Program

R23 Understanding Cash Flow Statements

Part 1


 

1.  Introduction

The cash flow statement provides important information about a company’s cash receipts and payments during an accounting period. It is a vital information source that assists users to evaluate a company’s liquidity, solvency, and financial flexibility.

2.  Components and Format of the Cash Flow Statement

2.1.     Classification of Cash Flows and Non-Cash Activities

Under both IFRS and US GAAP, cash flows are categorized as operating, investing, or financing activities on the cash flow statement.

Operating activities: These are activities related to the normal operations of a company. Examples include:

  • Cash inflows such as cash collected from sales, commissions, royalties, etc.
  • Cash outflows such as cash payments for inventory, salaries, and operating expenses.
  • Cash payments and receipts related to trading securities (securities that are not bought as investments).

Investing activities: These are activities associated with acquisition and disposal of long-term assets. Examples include:

  • Cash from sale of property, plant, and equipment.
  • Cash spent to purchase property, plant, and equipment.
  • Cash payments and receipts related to investment securities (not trading securities).

Financing activities: These are activities related to obtaining or repaying capital. Examples include:

  • Issuance or repurchase of a company’s own preferred or common stock.
  • Issuance or repayment of debt.
  • Dividend payments to shareholders.

Example

JFK Enterprises recorded the following for the year 2015:

Purchase of equipment                                       $70,000

Gain from sale of van                                           $8,000

Receipts from sale of van                                    $18,000

Dividends paid on ordinary share capital        $10,000

Interest and preference dividend paid              $12,000

Salaries paid                                                            $40,000

What is the net cash flow from investing activities?

Solution:

We first need to identify cash flows associated with investing activities. These are the purchase of equipment and the receipts from the sale of van. The gain from sale of van is not a cash flow item. The remaining items pertain to either operating or financing cash flows. Therefore, the net cash flow from investing activities is:

Net cash flow from investing activities = Purchase of equipment + Receipt from sale of van

Net cash flow from investing activities = -$70,000 + $18,000 = $52,000

Non-cash transactions

A non-cash transaction is any transaction that does not involve an outflow or inflow of cash. Significant non-cash transactions must be disclosed in either a footnote or a supplemental schedule to the cash flow statement. Analysts should incorporate non-cash transactions into the analysis of past and current performance and include their effects in estimating future cash flows. An example of a non-cash transaction is the conversion of face value $1,000,000 convertible bonds to common stock.

2.2.     A Summary of Differences between IFRS and US GAAP         

The reporting of interest paid/received and dividends paid/received is different between IFRS and US GAAP. The differences between the two standards are summarized in the table below.

Cash flow IFRS US GAAP
Interest received Operating or investing Operating
Interest paid Operating or financing Operating
Dividends received Operating or investing Operating
Dividends paid Operating or financing Financing

In addition to the points made above, IFRS and US GAAP also have some differences with respect to bank overdrafts, taxes paid, and the format of the cash flow statement. These are outlined in the table below.

Cash Flow IFRS US GAAP
Bank overdrafts Considered part of cash equivalents. Not considered part of cash equivalents and classified as financing.
Taxes paid Generally categorized as operating, but a portion can be allocated to investing or financing if it can be specifically identified with these categories. Operating.
Format of statement Both direct and indirect formats are allowed but the direct format is encouraged. Both direct and indirect formats are allowed but the direct format is encouraged. A reconciliation of net income to cash flow from operating activities must be provided regardless of method used.

 

2.3.     Direct and Indirect Methods for Reporting Cash Flow from Operating Activities           

Under IFRS and US GAAP, there are two acceptable formats for reporting cash flow from operating activities: indirect and direct.

  • The indirect method shows how cash flow from operations can be obtained from reported net income through a series of adjustments.
  • The direct method shows the specific cash inflows and outflows that result in reported cash flow from operating activities.

Indirect Format Sample

With the indirect method, we start with net income and make several adjustments for non-cash, non-operating items to arrive at the cash flow from operations. Shown below is a sample of the indirect format for a fictitious company called K2 Corp.

Net income 2,775
Depreciation 1,000
Gain on sale of equipment (200)
Increase in accounts receivable (150)
Increase in inventory (600)
Increase in pre-paid expenses (30)
Increase in accounts payable 300
Increase in wages payable 10
Increase in tax payable 5
Increase in other accrued liabilities 100
Decrease in interest payable (10)
Cash flow from operations 3,200

Direct Format Sample

In the direct format, we look at the specific cash inflows and outflows that resulted in cash flow from operating activities. This method is encouraged by both IFRS and US GAAP.

Cash from customers 24,850
Cash paid to suppliers (10,300)
Cash paid to employees (7,990)
Cash paid for other operating expenses (1,930)
Cash paid for interest (510)
Cash paid for taxes (920)
Cash flow from operations 3,200

Notice that while the presentation formats are different, the cash flow from operations number is the same under both methods.


FRA Understanding Cash Flow Statements Part 1