What is a Cash Flow Statement?
The Cash Flow Statement tracks the real inflows and outflows of cash from operating, investing and financing activities over a specified period of time.
How to Understand Cash Flow Statement (Step-by-Step)
The importance of the cash flow statement (CFS) is tied to the reporting standards established under accrual accounting.
- Revenue Recognition (ASC 606) → Revenue is recognized once the product/service is delivered to the customer (and “earned”), as opposed to when a cash payment is received (i.e. the revenue recognition principle).
- Matching Principle → Expenses are incurred in the same period as the coinciding revenue to match the timing with the benefit (i.e. the matching principle).
- Non-Cash Items → Depreciation is a common example of a non-cash expense recorded on the income statement, yet the real cash outflow occurred in the initial year of the capital expenditure (Capex).
The net income as shown on the income statement – i.e. the accrual-based “bottom line” – might not be an accurate depiction of what is actually occurring to the company’s cash.
Therefore, the statement of cash flows is necessary to reconcile net income to adjust for factors such as:
- Depreciation and Amortization (D&A)
- Stock-Based Compensation (SBC)
- Changes in Working Capital (e.g. Accounts Receivable, Inventory, Accounts Payable, Accrued Expenses)
In effect, the real movement of cash during the period in question is captured on the statement of cash flows – which brings attention to operational weaknesses and investments/financing activities that do not appear on the accrual-based income statement.
The impact of non-cash add-backs is relatively straightforward, as these have a net positive impact on cash flows (e.g. tax savings).
However, for changes in net working capital, the following rules apply:
- Increase in NWC Asset and/or Decrease in NWC Liability ➝ Decrease in Cash Flow
- Increase in NWC Liability and/or Decrease in NWC Asset ➝ Increase in Cash Flow
Focusing on net income without looking at the real cash inflows and outflows can be misleading because accrual-basis profits are easier to manipulate than cash-basis profits. In fact, a company with consistent net profits could potentially even go bankrupt.
Cash Flow Statement (CFS): Indirect Method vs. Direct Method
The two methods by which cash flow statement (CFS) can be presented are the 1) indirect method and 2) direct method.
Statement of Cash Flows: Indirect Method Accounting Format
Under the indirect method, the cash flow statement is broken out into three distinct sections.
|1. Cash Flow from Operating Activities (CFO)||
|2. Cash Flow from Investing Activities (CFI)||
|3. Cash Flow from Financing Activities (CFF)||
Cash Flow Statement Formula (CFS)
If the three sections are added together, we arrive at the “Net Change in Cash” for the period.
Subsequently, the net change in cash amount will then be added to the beginning-of-period cash balance to calculate the end-of-period cash balance.
The shortcomings regarding the income statement (and accrual accounting) are addressed here by the CFS, which identifies the cash inflows and outflows over a certain time span while utilizing cash accounting – i.e. tracking the cash coming in and out of the company’s operations.
Cash Flow Statement Example: Apple (AAPL) Fiscal Year 2022
The following is a real world example of a cash flow statement prepared by Apple (AAPL) under GAAP accrual accounting standards.
Apple Cash Flow Statement Example (Source: AAPL 10-K)
How are the 3-Statements Linked?
Assuming the beginning and end of period balance sheets are available, the cash flow statement (CFS) could be put together (even if not explicitly provided) as long as the income statement is also available.
- Net Income: Net income from the income statement flows in as the starting line item on the cash flow from operations section of the CFS.
- Change in NWC: Net working capital (NWC) line items on the balance sheet are each tracked on the CFS.
- Capex and PP&E: Cash outflows from the purchase of long-term fixed assets (PP&E) are accounted for in the capital expenditures (Capex) line item of the cash flow from investing section.
- Retained Earnings: Issuance of common or preferred dividends are deducted from net income, with the remaining profits flowing into the retained earnings account.
- Debt and Equity Issuances: Capital raising efforts such as issuing debt or equity financing is recorded in the cash flow from financing section.
- Ending Cash: The ending cash balance stated on the cash flow statement becomes the cash balance recorded on the balance sheet for the current period.
Cash Flow Statement Calculator (CFS) – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Step 1. How to Build Cash Flow Statement (CFS)
Suppose we are provided with the three financial statements of a company, including two years of financial data for the balance sheet.
The completed statement of cash flows, which we’ll work towards computing throughout our modeling exercise, can be found below.
Step 2. Income Statement Calculation (P&L)
In Year 1, the income statement consists of the following assumptions.
- Revenue: $100m
- (–) COGS: $40m
- Gross Profit: $60m
- (–) OpEx: $20m
- (–) D&A: $10m
- EBIT: $30m
- (–) Interest Expense (6% Interest Rate) = $5m
- Pre-Tax Income = $25m
- (–) Taxes @ 30% = $8m
- Net Income = $18m
Step 3. Cash Flow Statement Calculation (CFS)
The net income of $18m is the starting line item of the CFS.
In the “Cash from Operations” section, the two adjustments are the:
- (+) D&A: $10m
- (–) Increase in NWC: $20m
Next, the only line item in the “Cash from Investing” section is capital expenditures, which in Year 1 is assumed to be:
- (–) Capex: $40m
Likewise, the only “Cash from Financing” line item is the mandatory debt amortization (i.e. required pay down of debt principal):
- (–) Mandatory Debt Amortization: $5m
The beginning cash balance, which we get from the Year 0 balance sheet, is equal to $25m, and we add the net change in cash in Year 1 to calculate the ending cash balance.
- Cash from Operations: $48m
- (+) Cash from Investing: -$40m
- (+) Cash from Financing: -$5m
- Net Change in Cash: $3m
Upon adding the $3m net change in cash to the beginning balance of $25m, we calculate $28m as the ending cash.
- Beginning Cash: $25m
- (+) Net Change in Cash: $3m
- Ending Cash: $28m
Step 4. Balance Sheet Calculation (B/S)
On the Year 1 balance sheet, the $28m in ending cash that we just calculated on the CFS flows into the current period cash balance account.
For the working capital assets and liabilities, we assumed the YoY balances changed from:
- Accounts Receivable: $50m to $45m
- Accounts Payable: $65m to $80m
Operating assets declined by $5m while operating liabilities increased by $15m, so the net change in working capital is an increase of $20m – which our CFS calculated and factored into the cash balance calculation.
For our long-term assets, PP&E was $100m in Year 0, so the Year 1 value is calculated by adding Capex to the amount of the prior period PP&E and then subtracting depreciation.
- PP&E – Year 1: $100m + $40m – $10m = $110m
Next, our company’s long-term debt balance was assumed to be $80m, which is decreased by the mandatory debt amortization of $5m.
- Long-Term Debt – Year 1: $80m – $5m = $75m
With the assets and liabilities side of the balance sheet complete, all that remains is the shareholders’ equity side.
- Common Stock and APIC – Year 1: $20m
The formula in Year 0 of the retained earnings balance serves as a “plug” for the accounting equation to remain true (i.e. assets = liabilities + equity).
But for Year 1, the retained earnings balance is equal to the prior year’s balance plus net income.
- Retained Earnings – Year 1: $30m + $18m = $48m
Note that if there were any dividends issued to shareholders, the amount paid out would come out of retained earnings.
Step 5. Financial Model Balance Check (Assets = Liabilities + Equity)
In our final step, we can confirm our model is built correctly by checking that both sides of our balance sheet in Year 0 and Year 1 are in balance.
- Accounting Equation: Assets = Liabilities + Equity