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Cash Flow Statement

Summary Text

This video introduces the cash flow statement, which is possibly the most straight forward of the three primary financial statements. Whereas both the income statement and balance sheet reflect an accrual basis of accounting, the cash flow statement starts with net income and translates the economic activity of the firm from an accrual basis to a cash basis. 

The cash inflows and outflows are divided into three categories, which can be seen in the screenshot below. The definitions provided for Cash Flow from Operating Activities (CFO), Cash Flow from Investing Activities (CFI) and Cash Flow from Financing Activities (CFF) will be referenced in the notes that follow.

Cash Flow Statement Defined and Simplified 

To demonstrate how these three categories are typically represented on the cash flow statement, the video provides a simple cash flow statement. 

Cash Flow Statement Template


Having introduced the components of the cash flow statement, the video again emphasizes the relationship between net income and the cash flow statement. This is a critical relationship in financial models. As you can see in the image below, the cash flow statement will link directly to the income statement:

Cash Flow Statement Starts with Net Income


As you work through the cash flow statement from top to bottom you are effectively converting the economic activity of the company from an accrual basis of accounting to a cash basis. To work towards the cash balance calculation: 
1. Calculate cash from operations: 
  • Start with net income.
  • Add back non-cash items. In the video, depreciation and amortization are listed as non-cash items because they are commonly referenced examples. 
  • Adjust for changes in working capital. Recall that as an asset increases it consumes cash, and as a liability increases it provides cash. 
2. Calculate cash flow from investing activities: 
  • The video uses capital expenditures as an example. Future videos will introduce more examples. 
3. Calculate cash flow from financing activities: 
  • This category will be elaborated upon in future videos describing working models. 
4. Sum all three categories to arrive at cash balance.

Cash Flow From Operating Activities

The video then shifts focus to cash flow from investing activities. The only example provided in this video is a cash outflow: capital expenditures. Capital expenditures include the purchase of long-term assets or property, plant and equipment (PP&E).

Cash Flow From Investing Activities 

The purpose is to provide the back drop for an illustrated example demonstrating the conversion of the company’s economic activity from net income (accrual basis of accounting) to cash, which can be seen on the page that follows.
To illustrate how this works the video revisits the example where the company purchases a crane for $5M in the first period.

Cash Basis Income Statement


On the income statement the crane would be depreciated over 5 periods to reflect its useful life, but the $1M sums in each period do not reflect a cash outflow, because depreciation is a non-cash item.

Accrual Basis Income Statement


On the cash flow statement you are adjusting net income to arrive at the company’s cash balance. In this example that requires adding back depreciation (non-cash item), and under cash flow from investing activities, subtracting $5M to accurately represent the purchase of the crane in period 1. 

Depreciation and Capital Expenditures on the Cash Flow Statement


So why is this information important? Cash is the lifeblood of a company. People may argue that net income or earnings per share are more important, but I would have to disagree (this is the opinion of the author – if you are a student and your professor says otherwise I would advise agreeing with him / her for the final exam…)(after the test remember “cash is king”). Knowing a company’s cash balance and its ability to generate cash helps make important decisions surrounding working capital and the purchase of equipment. 

Cash is King

And of course, a company’s cash (or liquidity) is very important in managing a company’s liabilities. 
Next the video reverts back the fully integrated model to demonstrate how the cash flow statement works in a financial model. The first relationship highlighted is that the cash balance calculated on the cash flow statement links to cash on the balance sheet (see arrow on left-hand side of model). In this way the cash flow statement adjusts the asset side of your balance sheet in each consecutive accounting period. As a reminder, the video then shows that net income (assuming no dividends) adjusts the equity account (retained earnings) in each accounting period (see arrow on right-hand side of model). 

Cash Flow Statement in a Three Statement Model


With that in mind, recall that the balance sheet is just a formal presentation of the accounting equation. If the cash flow statement adjusts the left hand side of the equation, or assets, by the company's cash flow in that period, and the income statement adjusts the right-hand side of the equation, or stockholders’ equity, by net income, THEN it follows that the cash flow statement, which starts with net income, is making adjustments so that the accounting equation holds true. And that is how the accounting equation is balanced in financial models, and therefore how the balance sheet is balanced in financial models.

Accounting Equation Balanced in a Three Statement Model

To elaborate on this concept, consider what would happen if all of the accounts on the balance sheet maintained the same value in each period. Without any fluctuation in balance sheet accounts the effect on cash would be zero.


Cash Impact of Changes in Working Capital Accounts

To take it one step further, what that means is that in any example where all items on the balance sheet are held constant, net income and net cash flow would have the same value. The videos concluding remarks highlight three concepts, all of which can be seen in the image below. 

Cash Flow Statement Overview



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