Tracy John A. Accounting for Dummies
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know that its cash decreases when a business pays down its debt, returns
some of the capital that its owners had previously invested in the business,
and invests in new fixed assets (buildings, machines, equipment, vehicles,
and so on).
Most people also know there is another important source of cash: making
profit. However, things get a little tricky regarding this source of cash. One
problem is this: Instead of saying that a business “earns profit,” people say
that a business “makes money.” Therefore, many people assume that the
bottom-line profit for the year increases cash exactly the same amount — no
more, and no less. Not true: The actual amount of cash flow from making
profit is invariably different than the amount of profit earned for the period.
Earning profit and generating cash flow from the profit are two different
things. You’re talking about apples and oranges when you’re talking about
profit and cash flow from profit.
Here’s a very brief explanation of why profit and cash flow from profit are
different amounts. When a business makes sales on credit, sales revenue is
recorded before cash is collected from customers. Cash inflow from credit
sales takes place after recording the sales revenue. Also, many expenses
are recorded before cash is paid for the liabilities incurred by the expenses.
So, cash outflow for the expenses takes place after recording the expenses.
Furthermore, the recording of depreciation expense does not require a cash
outlay in the period. You could simply add back depreciation expense to
bottom-line profit to get a rough (and I mean rough) measure of cash flow
from making profit. But this shortcut ignores the other factors that affect
cash flow from profit, and I don’t recommend it.
Note: Because I use the same business example in this chapter that I use
in Chapters 4 and 5, you may want to take a moment to review its 2009
income statement in Figure 4-1. And you may want to review Figure 5-1,
which summarizes how the three types of activities changed its assets,
liabilities, and owners’ equity accounts during the year 2009. (Go ahead,
I’ll wait.)
Suppose the president of the business asks me, the chief accountant (con-
troller), for an executive summary of the company’s sources and uses of cash
during the year ended December 31, 2009. The president does not want a
formal, detailed financial statement with all the bells and whistles. He wants a
very brief summary that speaks to him as the very busy chief executive of
the business. Here’s what I would prepare for him:
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Executive Summary for Company’s President
Sources and Uses of Cash During the Year 2009
Cash flow from making profit $1,515,000
Cash distributions from profit ($750,000) $765,000
to shareowners
Cash flow from increasing debt $250,000
Cash flow from capital invested by owners $150,000
Cash available for general business purposes $1,165,000
Capital expenditures during year ($1, 265,000)
Cash decrease during year ($110,000)
The president would do a critical review of the strategic decisions that were
made during the year. For example, was it prudent to take on more debt? Why
did the shareowners invest an additional $150,000 in the business, and will
they invest additional capital during the coming year? Should the business
have distributed about half of the cash flow from profit to its owners? I return
to these issues in the last section of the chapter, “Being an Active Reader.”
You may be wondering how I got the information to prepare the executive
summary of cash flows for the president. I extracted the relevant information
from the company’s asset, liability, and owners’ equity accounts. I examined
the increases and decreases entered in the accounts during the year to deter-
mine the amounts you see in the executive summary. This is no problem;
I’m an accountant, you know. Accountants prepare detailed spreadsheets in
which changes in the asset, liability, and owners’ equity accounts are ana-
lyzed and classified in order to prepare a statement of cash flows, or an exec-
utive summary such as the one I show here. Computer software programs
can be used for this purpose.
The president of the business can request any particular accounting report
or summary that he wants. The president is not limited or restricted to the
format and content of the three financial statements that are prepared for
external reporting. If the president wants an executive summary of cash
flows, as opposed to a formal statement of cash flows as it is presented in
the external financial report of the business, then as controller I prepare the
executive summary. I know which side my bread is buttered on. There are no
restrictions regarding how to report cash flows internally (inside the busi-
ness to its managers). If the president doesn’t like or doesn’t understand the
information I give him in the executive summary of cash flows, he will let me
know in no uncertain terms.
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You may be wondering in particular how I got the $1,515,000 amount for cash
flow from making profit (see the executive summary). And, you may be won-
dering why this cash flow amount is different than the $1.69 million bottom-
line profit number reported in the company’s income statement for the year
(see Figure 4-1 in Chapter 4).
One purpose of the statement of cash flows is to report the cash flow from
making profit and to explain the difference between the cash flow number
and the bottom-line profit number in the income statement. The cash flow
number is based on actual cash inflows and outflows; the profit number is
based on accounting for sales revenue and expenses. Remember the follow-
ing points:
If a business makes credit sales, the total cash inflow from customers is
different than the total sales revenue recorded in the year (unless the
business collects all its credit sales before the end of the year).
The total cash outlay for expenses during the year is different than the
total amount of expenses recorded in the year.
The statement of cash flows begins with the cash flow from making profit, or
cash flow from operating activities as accountants call it. Operating activities is
the technical term that accountants have adopted for sales and expenses,
which are the “operations” that a business carries out to earn profit. I don’t
think it’s the best term in the world, but we are stuck with it; it’s part of the
official language of accounting.
Meeting the Statement of Cash Flows
I hate to start out like this, but I have to tell you that a business has its choice
between two quite different methods of reporting cash flow from operating
activities in its statement of cash flows. Financial reporting standards permit
either approach. I first show you the preferred method, and then the alterna-
tive. Figure 6-1 presents the statement of cash flows for our business example
dressed to the nines, in formal attire. This is not a condensed version; it’s the
real thing, not an executive summary. One main difference, as compared with
the executive summary of cash flows I prepared for the president, is seen in
the first section, Cash Flows from Operating Activities.
What you see in the first section of the statement of cash flows is called the
direct method for reporting cash flow from operating activities. I think the
term “direct” is meant to refer to the cash flows connected with sales and
expenses. For example, the business collects $25.55 million from customers
during the year, which is the direct result of making sales.
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Note in Figure 6-1 that cash flow from operating activities for the year is
$1,515,000, which is $175,000 less than the company’s $1,690,000 net income
for the year (refer to Figure 4-1). When issuing the financial reporting standard
for the statement of cash flows, the Financial Accounting Standards Board
(FASB) thought that financial report readers would compare cash flow from
operating activities with net income, and they would want some sort of expla-
nation for the difference between these two important financial numbers.
Therefore, the FASB decreed that the statement of cash flows should also
include a reconciliation schedule to explain the difference between cash flow
from operating activities and net income. Or, a business can use the alterna-
tive method for reporting cash flow from operating activities. The alternative
Typical Business, Inc.
Statement of Cash Flows
for Year Ended December 31, 2009
(Dollar amounts in thousands)
Cash Flows from Operating Activities
Collections from sales
Payments for products
Payments for selling, general, and
administrative costs
Payments for interest on debt
Payments on income tax
Cash flow from operating activities
$25,550
($24,035
$1,515
)
)
($15,025
($7,750
($375
($885
)
)
)
)
))
)
$100
$150
$150
($750
Cash Flows from Investing Activities
Expenditures on property, plant, and equipment ($1,275
Cash Flows from Financing Activities
Short-term debt increase
Long-term debt increase
Capital stock issue
Dividends paid stockholders
Decrease in cash during year
Beginning cash balance
Ending cash balance
($350
($110
$2,275
$2,165
Figure 6-1:
The
statement
of cash
flows —
using the
direct
method
for
presenting
cash flow
from
operating
activities.
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method starts with net income, and then makes adjustments in order to rec-
oncile cash flow from operating activities with net income. This alternative
method is called the indirect method, which I show in Figure 6-2.
Typical Business, Inc.
Statement of Cash Flows
for Year Ended December 31, 2009
(Dollar amounts in thousands)
Cash Flows from Operating Activities
Net income
Adjustments to net income for
determining cash flow:
Accounts receivable increase
Inventory increase
Prepaid expenses increase
Depreciation expense
Accounts payable increase
Accrued expenses increase
Income tax payable increase
Cash flow from operating activities
$1,690
($175
$1,515
($450
($725
($75
$775
$125
$150
$25
)
)
)
)
)
)
)
)
Cash Flows from Investing Activities
Expenditures on property, plant, and equipment ($1,275
$100
$150
$150
($750
Cash Flows from Financing Activities
Short-term debt increase
Long-term debt increase
Capital stock issue
Dividends paid stockholders
Decrease in cash during year
Beginning cash balance
Ending cash balance
($350
($110
$2,275
$2,165
Figure 6-2:
The
statement
of cash
flows —
using the
indirect
method
for
presenting
cash flow
from
operating
activities.
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The indirect method for reporting cash flow from operating activities focuses
on the changes during the year in the assets and liabilities that are connected
with sales and expenses. I explain these connections in Chapter 4. (You can
also trace these changes back to Figure 5-1, which includes the start-of-year
and end-of-year balances of the balance sheet accounts for the business
example.)
While there are obvious differences in the first section of the statement of
cash flows between the two methods for reporting cash flow from operating
activities, the other two sections of the statement — cash flow from investing
activities and cash flow from financing activities — are the same. The level of
detail disclosed in these two sections varies from business to business. For
example, some companies report one aggregate amount for all capital expen-
ditures (investments in new long-term operating assets), whereas others give
a more detailed breakdown.
Dissecting the Difference Between
Cash Flow and Net Income
A positive cash flow from operating activities is the amount of cash gener-
ated by a business’s profit-making operations during the year, exclusive of its
other sources of cash during the year. Cash flow from operating activities
indicates a business’s ability to turn profit into available cash — cash in the
bank that can be used for the needs of business. As you see in Figure 6-1 or
Figure 6-2 (take your pick), the business in our example generated $1,515,000
cash from its profit-making activities in the year. As they say in New York,
“That isn’t chopped liver.”
The business in our example experienced a strong growth year. Its accounts
receivable and inventory increased by relatively large amounts. In fact, all its
assets and liabilities intimately connected with sales and expenses increased;
their ending balances are larger than their beginning balances (which are the
amounts carried forward from the end of the preceding year). Of course, this
may not always be the case in a growth situation; one or more assets and lia-
bilities could decrease during the year. For flat, no-growth situations, it’s
likely that there will be a mix of modest-sized increases and decreases.
The following sections explain how the asset and liability changes affect cash
flow from operating activities. As a business manager, you should keep a
close watch on the changes in each of your assets and liabilities and under-
stand the cash flow effects caused by these changes. Investors should focus
on the business’s ability to generate a healthy cash flow from operating activ-
ities, so investors should be equally concerned about these changes. In some
situations these changes can signal serious problems!
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I realize that you may not be too interested in the details that I discuss in the
following sections. With this in mind, at the start of each section I present the
punch line. If you wish, you can just read this and move on. But the details
are fascinating (well, at least to accountants).
Note: Instead of using the full phrase “cash flow from operating activities”
every time, I use the shorter term “cash flow” in the following sections. All
data for assets and liabilities are found in the two-year balance sheet of the
business (see Figure 5-2).
Accounts receivable change
Punch Line: An increase in accounts receivable hurts cash flow; a decrease
helps cash flow.
The accounts receivable asset shows how much money customers who
bought products on credit still owe the business; this asset is a promise
of cash that the business will receive. Basically, accounts receivable is the
amount of uncollected sales revenue at the end of the period. Cash does
not increase until the business collects money from its customers.
The business started the year with $2.15 million and ended the year with $2.6
million in accounts receivable. The beginning balance was collected during
the year, but the ending balance had not been collected at the end of the
year. Thus the net effect is a shortfall in cash inflow of $450,000. The key
point is that you need to keep an eye on the increase or decrease in accounts
receivable from the beginning of the period to the end of the period. Here’s
what to look for:
If the amount of credit sales you made during the period is greater than
what you collected from customers during the period, your accounts
receivable increased over the period, and you need to subtract from net
income that difference between start-of-period accounts receivable and
end-of-period accounts receivable. In short, an increase in accounts
receivable hurts cash flow by the amount of the increase.
If the amount you collected from customers during the period is greater
than the credit sales you made during the period, your accounts receiv-
able decreased over the period, and you need to add to net income that
difference between start-of-period accounts receivable and end-of-period
accounts receivable. In short, a decrease in accounts receivable helps
cash flow by the amount of the decrease.
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In our business example, accounts receivable increased $450,000. Cash col-
lections from sales were $450,000 less than sales revenue. Ouch! The busi-
ness increased its sales substantially over the last period, so you shouldn’t
be surprised that its accounts receivable increased. The higher sales revenue
was good for profit but bad for cash flow.
The “lagging behind” effect of cash flow is the price of growth — managers
and investors need to understand this point. Increasing sales without increas-
ing accounts receivable is a happy situation for cash flow, but in the real
world you usually can’t have one increase without the other.
Inventory change
Punch Line: An increase in inventory hurts cash flow; a decrease helps cash
flow.
Inventory is usually the largest short-term, or current, asset of businesses
that sell products. If the inventory account is greater at the end of the period
than at the start of the period — because unit costs increased or because the
quantity of products increased — the amount the business actually paid out
in cash for inventory purchases (or for manufacturing products) is more than
what the business recorded in the cost of goods sold expense for the period.
In our business example, inventory increased $725,000 from start-of-year to
end-of-year. In other words, to support its higher sales levels in 2009, this
business replaced the products that it sold during the year and increased its
inventory by $725,000. The business had to come up with the cash to pay for
this inventory increase. Basically, the business wrote checks amounting to
$725,000 more than its cost of goods sold expense for the period. This step-
up in its inventory level was necessary to support the higher sales level,
which increased profit even though cash flow took a hit.
Prepaid expenses change
Punch Line: An increase in prepaid expenses (an asset account) hurts cash
flow; a decrease helps cash flow.
A change in the prepaid expenses asset account works the same way as a
change in inventory and accounts receivable, although changes in prepaid
expenses are usually much smaller than changes in those other two asset
accounts.
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The beginning balance of prepaid expenses is charged to expense this year,
but the cash for this amount was actually paid out last year. This period (the
year 2009 in our example), the business pays cash for next period’s prepaid
expenses, which affects this period’s cash flow but doesn’t affect net income
until next period. In short, the $75,000 increase in prepaid expenses in this
business example has a negative cash flow effect.
As it grows, a business needs to increase its prepaid expenses for such things
as fire insurance (premiums have to be paid in advance of the insurance
coverage) and its stocks of office and data processing supplies. Increases
in accounts receivable, inventory, and prepaid expenses are the cash flow
price a business has to pay for growth. Rarely do you find a business that
can increase its sales revenue without increasing these assets.
The depreciation factor
Punch Line: Recording depreciation expense decreases the book value of
long-term operating (fixed) assets. There is no cash outlay when recording
depreciation expense. Each year the business converts part of the total cost
invested in its fixed assets into cash. It recovers this amount through cash
collections from sales. Thus, depreciation is a positive cash flow factor.
The amount of depreciation expense recorded in the period is a portion of
the original cost of the business’s fixed assets, most of which were bought
and paid for years ago. (Chapters 4 and 5 explain more about depreciation.)
Because the depreciation expense is not a cash outlay this period, the
amount is added to net income to determine cash flow from operating activi-
ties (see Figure 6-2).
For measuring profit, depreciation is definitely an expense — no doubt about
it. Buildings, machinery, equipment, tools, vehicles, computers, and office
furniture are all on an irreversible journey to the junk heap (although build-
ings usually take a long time to get there). Fixed assets (except for land) have
a limited, finite life of usefulness to a business; depreciation is the accounting
method that allocates the total cost of fixed assets to each year of their use in
helping the business generate sales revenue.
In our example, the business recorded $775,000 depreciation expense for
the year. Instead of looking at depreciation as only an expense, consider the
investment-recovery cycle of fixed assets. A business invests money in its
fixed assets that are then used for several or many years. Over the life of
a fixed asset, a business has to recover through sales revenue the cost
invested in the fixed asset (ignoring any salvage value at the end of its useful
life). In a real sense, a business “sells” some of its fixed assets each period to
its customers — it factors the cost of fixed assets into the sales prices that it
charges its customers.
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For example, when you go to a supermarket, a very small slice of the price
you pay for that quart of milk goes toward the cost of the building, the
shelves, the refrigeration equipment, and so on. (No wonder they charge so
much!) Each period, a business recoups part of the cost invested in its fixed
assets. In the example, $775,000 of sales revenue went toward reimbursing
the business for the use of its fixed assets during the year. In short, deprecia-
tion is a positive cash flow factor. The depreciation amount is imbedded in
sales revenue, and sales revenue generates cash flow.
The business in our example does not own any intangible assets and, thus,
does not record any amortization expense. (See Chapter 5 for an explanation
of intangible assets and amortization.) If a business does own intangible
assets, the amortization expense on these assets for the year is treated the
same as depreciation is treated in the statement of cash flows. In other
words, the recording of amortization expense does not require cash outlay in
the year being charged with the expense. The cash outlay occurred in prior
periods when the business invested in intangible assets.
Changes in operating liabilities
Punch Line: An increase in a short-term operating liability helps cash flow; a
decrease hurts cash flow.
The business in our example, like almost all businesses, has three basic liabil-
ities inextricably intertwined with its expenses:
Accounts payable
Accrued expenses payable
Income tax payable
When the beginning balance of one of these liability accounts is the same as
its ending balance (not too likely, of course), the business breaks even on
cash flow for that account. When the end-of-period balance is higher than the
start-of-period balance, the business did not pay out as much money as was
recorded as an expense in the year.
In our business example, the business disbursed $640,000 to pay off last year’s
accounts payable balance. (This $640,000 was the accounts payable balance
at December 31, 2008, the end of the previous fiscal year.) Its cash this year
decreased $640,000 because of these payments. But this year’s ending balance
sheet (at December 31, 2009) shows accounts payable of $765,000 that the
business will not pay until the following year. This $765,000 amount was
recorded to expense in the year 2009. So, the amount of expense was $125,000
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