Building a Cash Flow Statement

This is the last and final publication in our series dealing with cash flow concepts.  This article is going to explain how to go about building a cash flow statement.  And while you might never be asked to create a cash flow statement, understanding the concepts behind cash flow will give you a much greater appreciation for its value in evaluating the financial health of a company.

Advantages of the Cash Flow Approach

The reason market and stock analysts are so interested in cash flow is because it's arguably the single most important indicator of a company's financial well being.  Cash flow is not influenced by fancy accounting concepts like deferred income taxes or amortization of intangibles.

It's often difficult to figure out exactly how well a company is performing if you have to interpret all of the accrual accounting adjustments.  For this very reason, evaluating a company on a cash basis has a great deal of appeal to the financial community.

Simple Cash Flow Formula

When we begin to build a cash flow statement we want to keep the following in mind:

• We have a starting balance of cash at the beginning of our fiscal year.
• We might have increased cash via operations - we made money on the products or services we sell.
• We used cash throughout the year to pay for things - new assets and expenses.
• We might have raised cash throughout the year.

Using the above four pieces of information we can calculate a fifth value - the cash we have at the end of the year.  These building blocks of a cash flow statement are typically labeled as follows:

Cash and Cash Equivalents (Beginning)
+ Cash from Operations
- Cash Flows from Investing Activities
+ Cash Flows from Financing Activities
= Cash and Cash Equivalents (Ending)

So in order to build a cash flow statement, we only need to be concerned with five concepts.

Cash Flow Statements

The information from this point forward is really a tutorial in how to build a cash flow statement.  This statement is also known as a statement of changes in financial position.  We're going to walk through each step providing insights and examples at each step in the process.  And at the end we're going to provide you with a link where you can see everything we've discussed at play in a sample statement.

Cash and Cash Equivalents (Beginning)

The first step is to figure out where a company left off in the prior fiscal year - this will be the beginning balance for the current year.  You can find this value directly from a company's prior year statement of cash flow, the company's balance sheet, or we can calculate what we believe is the beginning value for cash.

Cash and cash equivalents are a current asset of a company and most times can be found simply by looking at the company's balance sheet for the prior year.  If you need to calculate this value, then cash and cash equivalents generally include cash itself, money market funds, certificates of deposit, savings accounts, and similar types of deposits.

In general, this is a current asset that can be readily exchanged for goods and services on short notice.  In our example, we're going to start our company off with $6,000,000 at the beginning of the year.

Cash from Operations

Next up we're going to look for cash generated by the operations of the company.  This is sometimes referred to as cash provided by operating activities.  To calculate the cash provided by operations we need a starting point - and the starting point is net income.

One of the advantages of evaluating a company on a cash basis is that it's not subject to accounting concepts that prevent us from getting a clear picture of a company's financial health.  Net income does include some of those accounting concepts so to truly understand the cash generated from operations we need to remove from the net income value what are called "non-cash transactions."

Items not Affecting Cash

The most common example of a non-cash transaction that does not affect cash flow is depreciation.  But there are two common classes of adjustments we need to make to net income to calculate cash from operations:

• Depreciation / Amortization of Assets
• Net Changes in Current Assets and Liabilities

So if a company claimed a depreciation expense in their income statement, we need to add that value back in.  Likewise, if a company had an increase in accounts payable, we need to subtract that value from net income.  What we're trying to figure out is how much cash exchanged hands throughout the year.  A company might have sold more goods and had a rise in accounts payable, but until that money is received it's not considered cash.

Cash from Operations Example

Let's see how the above concepts would be used in practice.  In this example, our company had net income of $8,000,000.  The depreciation expense was $4,000,000, while accounts receivables went up by $2,000,000 and accounts payable went up by $1,000,000.

In the above example we see that deprecation - which is a non-cash expense - would be added back to net income since money never really left the company's cash accounts.  While a rise in accounts receivables (money not yet received) needs to be subtracted from net income (the company did not get the money yet).

Cash Flows from Investing Activities

The next step in building our cash flow statement is to look at money a company spent on new capital investments.  If a company capitalizes an investment then that outflow of money does not show up on the income statement.  That's because accounting rules allow the company to depreciate (expense) the cost of the investment over time.

From a practical standpoint if a company purchases a new asset - such a new plant equipment or machinery - then they most likely paid for that asset with cash.  And when money leaves a company we've got an outflow of cash we need to show on our statement.

Cash Flows from Investing Activities Example

In this example let's say our company purchased a new computer system for $1,500,000 along with an assembly line machine for $2,000,000.  These were the only two capital investments made by the company for the year we're examining.   In this example, the company was also required to set aside $500,000 into a special decommissioning fund.

Normally a company might show one line item for the capital investments and label that line item as Additions to Plant.  In this example we're going to show these items separately.

So in this part of the cash flow statement we're seeing money that left the company to pay for assets.  They don't show up on the income statement because they are considered "investments."  These investments will be depleted over time either via depreciation or other accounting adjustments and at that point they show up as expenses on the income statement.

Cash Flows from Financing Activities

The final category of adjustments we need to address on a statement of cash flows is money raised via financing activities.  As was the case with cash from operations, we can have both positive and negative adjustments to cash flow depending on the financing activities the company engaged in during the year.

Typical adjustments appearing here include changes in long and short term debt (issuing and redemption), issuing of preferred stock, issuing of common stock, retirement of stock and stock dividends paid in cash.

Cash Flows from Financing Activities Example

In our example our company decided to raise $250,000 by issuing common stock.  They also issued around $500,000 in short term debt and redeemed around $3,000,000 in long term debt.  Finally, they paid a cash dividend on common stock of $2,000,000.

In this example our company used more money in their financing activities than they generated during the year.

Cash and Cash Equivalents (Ending)

Our final task is to calculate the ending cash balance for the company.  This involves simply adding up all of the adjustments to find out if there was a net increase or decrease to cash.  This value (either positive or negative) is then added to our starting balance to derive the ending balance.

Ending Cash Equivalents Example

Early on in this example we stated that our company started with a $6,000,000 balance of cash.  If you were to add up all of the adjustments you'd find we had a net increase of $2,750,000 to cash.  Therefore our ending balance stands at $8,750,000.

Cash Flow Statement Worksheet

As promised we're going to finish this article by providing you with a link to a cash flow statement spreadsheet.  In this worksheet you'll find all of the example information we used throughout this tutorial including the necessary calculations.

This article finishes up this three part series on cash flow, which also included building business cases using a cash flow approach as well as interpreting the result of a cash flow business case.

About the Author - Building a Cash Flow Statement

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