How to Create Cash Flow Statement?

Now that our company has been established, raw materials and fixed assets procured, first sales made, and our company also invested in R&D and procured raw materials for the next year and paid taxes and distributed a portion of the net profit to shareholders, let's look at how our cash flow changes during the whole process.

Cash Flow Changes for the Fictional Company

These are all the economic activities that have occurred from the establishment of the company, to the end of its first year of business operations. All activities are related to the increase or decrease of the company's cash positions. 

Next we are going to define each activity as operating activity, investment activity, or financing activity, and mark it as either inflow or outflow.

Cash Flow Item Categorization

1. Shareholder investment: shareholders invested 32 million dollars to establish the company. This is a financing activity which caused an increase in cash, so it is a cash inflow from financing activity.
2. Bank loan: the company then borrowed 51 million dolloars from the bank. This is also a financing activity, albeit a debt financing activity, which caused the cash inflows as well. So it is also a cash inflow from financing activity.
3. Fixed asset procurement: the company then spent 57 million to purchase fixed assets like buildings, equipments and so on. Since fixed assets can have long-term economic impact on the company, this economic activity belongs to the investing category. And since the company is spending money to procure such fixed assets, it should be a cash outflow from investing activity.
4. Land usage rights procurement: the company then paid 1.5 million for the right to use the land for a period of time. We know that the acquisition of land usage rights is an intangible asset, and it does not belong to our daily operations. So it is also a cash outflow from investing activity.
5. Raw material procurement: this activitiy belongs to daily operations, and it causes a decrease in cash, so it is a cash outflow from operating activity.
6. Manufacturing expenses: the company needs to hire staff and put the fixed assets - plant and quipment - to work in order to produce final products. This caused another 8 million dollars of cash decrease. (Recall that we didn't have enough cash to pay our fees and our electricity company generously granted us a six-month grace period, pushing the payment term to the next year.) This economic activity is a cash outflow from operating activity.
7. Sales of products: the company then makes its first sales from all the products it produced. This is a cash inflow from operating activity.
8. Prepayment for raw materials: the company then pays 1.5 million to buy raw materials for the next year. Since the company is paying money out for raw materials, this economic activity is a cash outflow from operating activity.
9. Expenses: the company paid 4 million for various types of expenses, including the salary of sales personnel, expense of sales department, salary of management personnel, and expense for management, etc. All of these belong to the daily operation of the company. This is still a cash outflow from operating activities.
10. R&D: research and development can often be confused as an investment into intangible assets, but because of the conservative nature of accountants and the highly uncertain and risky nature of R&D activities, it is actually considered management expenses. As a result, R&D is a cash outflow from operating activity (NOT investing activity).
11. Interest payment to bank loans: at the very beginning we have secured a loan from the bank, which has interests. Our company is then liable to pay 1.3 million dollars of interest to the bank. This is obviously a cash outflow from financing activities.
12. Income tax: the company still makes profits after deducting all costs, expenses and interests. Since paying such income tax is an activity happening in the process of operations, it should be a cash outflow from operating activities.
13. Profit distribution: the company then allocates 1 million profits to the shareholder and keeps the other 4.2 million in the company. This is money flowing out of the company from its bank account to the shareholder's bank account, so it is a cash outflow from financing activities.

The 13 economic activities showed us how cash goes in and out of our company, making this table essentially our cash flow statement. Now let's take a look at the final result by further digging one step deep.

Further Analysis

1. Net Cash Flow from Financing Activities: the company was created by the shareholder's initial investment o 32 million dollars, and it further borrowed 51 million dollars from the bank. Even though it paid some interests (1.3 million) and dividends (1 million) to the above two parties, the company still nets 80.7 million dollars from such financing activities as cash inflow.
2. Net Cash Flow from Investing Activities: the company has a negative 58.5 million dollars of investment,meaning that the company has made investment of this amount. If this number is positive, it means that the company has generated positive returns from its investments. To emphasize, investing activities can not only mean investment outside of the company, but also inside the company, such as investment in fixed assets and equipment, etc.
3. Net Cash Flow from Operating Activities: finally what is the net cash flow of its operating activities? After putting all the numbers together, we get a nagative 1 million dollars. Somebody might say that the company has netted losses in its operating activities, but we all know that the company actually made a net profit of 5.2 million dollars and distributed 1 million to the shareholders. So the company actually didn't lose money. 

Then what actually happened here from operating activities? The company made money only from its sales and spent money everywhere, from raw material purchases, operating expenses, to R&D, etc. The fact that the net cash flow from operating activities is negative means the money it generates from sales is insufficient to cover all the raw material costs, staff salaries, and taxes, etc. In other words, the company cannot make ends meet and it needs to find cash from other places.

That other place for our company is financing. Without financing activities, the company will not have enough money to support its operating and investing activities, both of which netted negative cash flows.

Does the company "have money"?

Before we answer this, we should all agree that the company "makes money" - after all, it has generated 5.2 million dollars of net profit in its first year of operations. 

However, can we come to the conclusion that it "has money"?

Considering that it has a negative net cash flow from operating activities, we cannot arrive at this conclusion. The company actually relies on financing to sustain its operations.

How is it possible that a profitable company doesn't have money? 

In fact, this is entirely possible. It actually is also possible for a company to have money and not make money, i.e. making a profit, at the same time, making the situation all more confusing.

Making Money or Having Money: which would you rather be?

We can probably all agree that a company that makes money and has money is in the best situation. We can also agree that a company that doesn't make money and has no money is in the worst situation. But if you had to choose between making money and having money, which situation would you rather be in?

For this question, different people have different ideas. You might say earning money is more important, because a company's purpose is to make a profit. But you might say that having money is more important, since a company cannot survive without sufficient cash in the bank. Let's leave this question for now and we will revisit when we have acquired more knowledge in the future.

Let's go back to our company. The cash flow for its financing activities, investing activities, and operating activities are 80.7 million, -58.5 million, and -1 million respectively. We can easily get its net cash flow by adding the above three, making it 21.2 million dollars.

The number might be familiar to us because it has appeared somewhere else; in fact, this is our final cash position after one year operation of the business!

How does this "coincidence" happen?

Well there is actually no coincidence. If you recall, we actually covered that the net cash flow can be calculated from subtracting this year's cash by last year's cash. However, since our company was just established, the difference between the two is actually this year's cash position. 

This is what a cash flow statement looks like

... using our fictional company as an example.