What is Cash Flow Statement?

At the very beginning of this journey we mentioned that there are three financial statements - balance sheet, income statement, and cash flow statement. We have covered the first two, and now let's look at their relationships between we go into the third statement.

A balance sheet has two sides. On the left side, it shows the assets; on the right side, it shows the liabilities and stockholder’s equity. An income statement functions like a funnel where at the very top we have the revenue of the company, and by deducting all costs, expenses, and taxes from the revenue, we will arrive at the net profit of the company.

For our fictional company, it has a 5.2 million dollars net profit for its first year of operations. The shareholders have decided to distribute 1 million dollars as dividends, and keep the other 4.2 million dollars as retained earnings in the company. If our company makes another 5.8 million dollars of net profit in the next year and have decided to keep every penny in the company, the company will have a total of 10 million dollars of retained earnings by the end of the second year. Here we can see that balance sheet shows us the current status of the company's financial situation, while income statement shows the process of a period of time.

Cash Flow Statement

Cash flow statement might look the most daunting amongst the three financial statements. It is long, and includes a primary table and appendix. Both parts have a lot of information. However, even though cash flow statements look the most complex, it is actually the easiest financial report. First, let’s look at what is cash flow.

Definition of Cash Flow

Cash flow is such an simple concept that everyone can understand easily. Just like what the name tells us, Cash Flow is simply cash flowing in and out of the company. Cash inflow means money I receive, and cash outflow means money I spend. 

Therefore, cash flow statements tell us the amount of money I receive and spend. That's it.

For example, sometimes we hears people say they are doing some bookkeeping for themselves. They rarely would make a balance sheet or an income statement. More often than not, bookkeeping is just some sort of financial journaling, detailing every single transaction the person has made. To write down these journal entries, one does not need any accounting skills. All that is needed is simple addition and subtraction.

And that is all you need to do cash flow statements well.

How to Cash Flow

Different from doing a personal financial journal, we categorize business activities into:

1. operating activities
2. investing activities
3. financing activities

Even though a company might have all kinds of business activities, sometimes well over tens of thousands in a year, from an accountant’s perspective, companies only have these three kinds of business activities. So all cash inflows and outflows will be divided in these three categories.

In fact, I can also do my own bookkeeping based on this categorization. 

For example, if I get paid today from my company, what kind of cash flow is this?

Put it in another way: if my household is the company, me going out to work every day is the company's main business operations. In addition, since I'm receiving money from my company, this is a cash inflow from my operating activity.

After I got paid, I bought some groceries on my way home. From the household's perspective, the action of buying groceries should also be my operating activity, because it happens every day. This is an operating cash outflow. Other than groceries, we can easily come up with other similar operating cash outflows such as the wage I pay to the hourly cleaners, the personal income tax, etc. 

Once I have been working a while, I have saved some money and am ready to buy a house and a car. Such purchases don't happen every day, and from the household's perspective, both are investing cash outflow since we are paying somebody money. If I sold my house or car and received money, it should be investing cash inflow. 

What if I got a loan when I purchase the house or car? Getting a loan is also often called getting "financing", and it's easy to conclude that this is financing cash inflow (because I'm receiving money from the bank). On the other hand, when the payment terms kick in for me to pay back interests and principal, the expenses related to the loan are financing cash outflows.

So even as an individual who wants to bookkeep his own expenses, I can still separate the records into the three categories. This classification will not add, but reduce complexity.

Cash Flow Statement for Company

For a company, what cash inflow and outflow are there?

Operating Cash Inflow

Similar to households, a company's most common operating cash inflow is sales. When we sell something, we will generally receive cash, sooner or later. This is an important operating cash inflow.

One interesting item that might appear on the cash flow statement is a cash inflow tax item. How can tax become a cash inflow?

One possible explanation is that certain companies might receive tax returns for operating in certain industries that are encouraged by the government. An even more common explanation that applies to almost all companies is that since companies will "charge" value-added tax on top of the product price and withhold it on behalf of the tax bureau, it will show up as an operating cash inflow.

Operating Cash Outflow

Next, I might need to buy inventories such as raw materials, pay salaries to my employees, and pay taxes to the tax bureau, etc. All of these business activities will incur operating cash outflow.

Investing Cash Inflow

What will lead to the investing cash inflow? There are two possibilities. 

One possibility is when I sold my investment. For example, the sales of buildings, equipments, machines, vehicles (investment in the company), or the sales of stocks or bonds of the companies I invest (investment outside the company), all of which bring in cash inflows.

Another possibility is when my investments pay dividends. For example, a subsidiary may pay me dividends, which is a return on my investment. This return also brings me cash inflow.

Investing Cash Outflow

There are only two kinds of investment for business: investing in the company and investing outside the company. The former will become tangible and intangible assets of the company, while the latter will become stocks, bonds, or other finance products in other companies. No matter the investment is inside or outside of the company, money spent on investment is investing cash outflows.

Financing Cash Inflow

For companies, there are two way to financing money: issuing debt or issuing stock. Whichever option the company selects, it will bring cash inflow. 

Financing Cash Outflow

If a company issues debt, it will need to pay interests upon the debt's maturity. If a company issues stock, it may need to distribute dividends to shareholders. Both debt payments and dividends are financing cash outflows. 

These are easy to understand. But there is actually another activity that might incur financing cash inflow - leasing. 

Not all leasing contracts are the same. From an accounting perspective, we need to differentiate leases by the size of payments and the length of contracts. Short-term and small leases are categorized into operating leases, and long-term and big leases are categorized into capital leases. Even though both are leases, from an accounting perspective, capital leases are actually considered purchases of assets by way of debt, and each term of lease payment will be treated as interest payment, or financing cash outflow. Capital leases actually show up on the balance sheet under liabilities as "long-term payable".

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Now that we've gone over the basics of a cash flow statement of a company, we will dig deeper into what the statement shows us in the next few episodes.