It is a measure of how much cash a company has available or spent over a certain time period. An income statement does not provide a measure of cash generated. A corporation may have generated sales of one million dollars in a year. If only 20% of its sales were paid in cash, it means total cash generated during the year was only $200,000.00
A cash flow statement will determine how much cash is generated in a year. It is broken into 3 parts:
- Cash from operating activities
- Cash from investing activities
- Cash from financing activities
A net result from operating activities, investing activities and financing activities will give total amount of cash spent or received in a given period.
Cash from Operating Activities:
Cash from operating activities represents generation of cash from net income. In preparing cash flow statement, we have to adjust income based on revenues received in cash. We also have to make adjustments to expenses paid in cash. Both these adjustments affect income statement.
Example Income Statement:
Our revenue = 10,000,000.00 (We collected it in cash)
We received an invoice for 2,000,000.00 (We did not pay this invoice)
Net income = 8,000,000.00
Example Cash Flow:
Net income = 8,000,000.00
Add back invoice we did not pay = 2,000,000.00
Cash from operations = 10,000,000
Let us assume that out of our sales of 10,000,000 we only collected 8,000,000 in cash.
Following is analysis of this assumption:
Income Statement:
Revenue = 10,000,000
Invoice we did not pay = 2,000,000.00
Net Income = 8,000,000.00
Cash Flow:
Net Income = 8,000,000.00
Revenue we did not collect = (2,000,000.00)
Add back invoice we did not pay = 2,000,000
Cash from operations = 8,000,000.00
So cash from operations = Net Income + Expenses we did not pay – Revenue we did not receive.
Income statement has other components to it that need to be looked at to get a better understanding of cash flow. This will help us determine which items can be considered cash or non-cash.
Revenue:
If sales are on credit you need to remove accounts receivable from net income.
Cost of Goods Sold:
Cost of goods sold is the cost of inventory. We expense COGS and reduce inventory when recording cost of goods sold. A reduction in inventory will result in positive cash flow.
Operating Expenses:
Accrued expenses are added back to net income.
Depreciation:
Depreciation expense is always added back to net income when calculating cash flow from operations.
Interest Expense:
Interest expense is almost always considered as cash expense, so it is not added back on the cash flow statement.
Taxes:
If we expended taxes but did not pay yet, these are called deferred taxes.
Following table explains income statement line items and accounts related to them and if they can be deferred.
| Net Income Line Item | Possible Deferrable Items | Effect in Cash from Operations |
| Revenue | Yes | Change in Accounts Receivable |
| Cost of Goods Sold | Yes | Change in Inventory and Accounts Payable |
| Operating Expenses | Yes | Change in Accrued Expenses and Prepaid Expenses |
| Depreciation | Yes | Depreciation |
| Interest | No | Non (Some Exceptions) |
| Taxes | Yes | Deferred Taxes |
We can generalize above table towards cash flow from operating activities as under:
Cash flow from operating activities = Net income + (Changes in accounts Receivable + Changes in Inventory + Changes in Accounts Payable + Changes in Accrued Expenses + Changes in Prepaid Expenses) + Depreciation + deferred Taxes
A definition for changes in working capital = (Changes in Accounts Receivable + Changes in Inventory + Changes in Accounts Payable + Changes in Accrued Expenses + Changes in Prepaid Expenses)
We can merger this changes in working capital definition in our equation as below:
Cash from Operating Activities = Net Income + Depreciation + Deferred Taxes + Other non-cash items + Changes in Working Capital.
Cash from Investing Activities:
Cash from investing activities come from:
- Capital expenditure lik investing in property, plant or equipment.
- Buying or selling assets.
- Buying, selling, spinning off or splitting of businesses.
- Buying or selling of marketable and non-marketable securities.
Cash from Financing Activities:
Cash from financing activities comes from:
- Raising or buying back equity or preferred securities.
- Distributions to equity holders.
Let us see this flow in financial statements in the following examples.
Raw material cost = 50 / per item
Selling price for the item = 100
We purchase raw material for building 10 items = 500
| Cash Flow | Balance Sheet |
| Net Income = 0 | Cash = (500) |
| Changes in inventory = (500) | Inventory = 500 |
| Total changes in cash = (500) |
Vendor allows us to pay him later for inventory we bought. We end up in incurring a liability of Accounts Payable.
| Cash Flow | Balance Sheet |
| Changes in inventory = (500) | Cash = 0 |
| Changes in Accounts Payable = 500 | Inventory = 500 |
| Total changes in Cash = 0 | Accounts Payable = 500 |
Let us say we sell one item for 100. It will have following effect on the income statement:
1 – Revenue will be recorded for 100.
2 – COGS will be recorded for 50.
Let us also assume that tax rate = 40%
Our income statement will look as below:
| Income Statement |
| Revenue = 100 |
| Taxes at 40% = 40 |
| Net Income = 60 |
Our Cash Flow and Balance Sheet will look as below:
| Cash Flow | Balance Sheet |
| Net Income = 60 | Cash = 60 |
| Total Changes in Cash = 60 | Inventory = 500 |
| Accounts Payable = 500 | |
| Retained Earnings (Net Income) = 60 |
COGS will look as below:
| Income Statement |
| COGS = (50) |
| Taxes at 40% = 20 |
| Net Income = (30) |
COGS is a part of inventory that we need to reduce because one item is sold. This will result in positive cash flow and will affect cash flow and balance sheet as below:
| Cash Flow | Balance Sheet Adjustments |
| Net Income = (30) | Cash = 20 |
| Changes in Inventory = 50 | Inventory = (50) |
| Total changes in cash = 20 | Retained Earnings (Net Income) = (30) |
Our Balance Sheet will change after adjustments as below:
| Balance Sheet Adjustments | Balance Sheet After Adjustments |
| Cash = 20 | Cash = 80 |
| Inventory = (50) | Inventory = 450 |
| Retained earnings (Net Income) = (30) | Accounts Payable = 500 |
| Retained Earnings (Net Income) = 30 |
Let us assume that we sell one more item at 100 but this sale is on credit. Our income statement will look as below after this sale.
| Income Statement |
| Revenue = 100 |
| Taxes at 40% = (40) |
| Net Income = 60 |
Cash Flow Statement and Balance Sheet will look as below after this transaction:
| Cash Flow | Balance Sheet Adjustments |
| Net Income = 60 | Cash = (40) |
| Change in Accounts Receivable = (100) | Accounts Receivable = 100 |
| Total Changes in Cash = (40) | Retained Earnings (Net Income) = 60 |
Balance sheet after adjustments:
| Balance Sheet Adjustments | Balance Sheet After Adjustments |
| Cash = (40) | Cash = 40 |
| Accounts Receivable = 100 | Inventory = 450 |
| Retained Earnings (Net Income) = 60 | Accounts Receivable = 100 |
| Accounts Payable = 500 | |
| Retained earnings (Net Income) = 90 |
Adjustments to COGS and Inventory:
| Income Statement |
| COGS = (50) |
| Taxes at 40% = 20 |
| Net Income = (30) |
| Cash Flow | Balance Sheet Adjustments |
| Net Income = (30) | Cash = 20 |
| Change in Inventory = 50 | Inventory = (50) |
| Total Change in Cash = 20 | Retained Earnings (Net Income) = (30) |
Updated Balance Sheet:
| Balance Sheet Adjustments | Balance Sheet After Adjustments |
| Cash = 20 | Cash = 60 |
| Inventory = (50) | Inventory = 400 |
| Retained Earnings (Net Income) = (30) | Accounts Receivable = 100 |
| Accounts Payable = 500 | |
| Retained earnings (Net Income) = 60 |
Let us now assume that the remaining 8 items are sold out of which 4 are sold on credit. The income statement is:
| Income Statement |
| Revenue = 800 |
| Taxes at 40% = (320) |
| Net Income = 480 |
We need to remove 400 from net income on the cash flow statement:
| Cash Flow | Balance Sheet Adjustments |
| Net Income = 480 | Cash = 80 |
| Changes in Accounts Receivable = (400) | Accounts Receivable = 400 |
| Total Changes in Cash = 80 | Retained earnings (Net Income) = 480 |
Adjusted Balance Sheet:
| Balance Sheet Adjustments | Balance Sheet After Adjustments |
| Cash = 80 | Cash = 140 |
| Accounts Receivable = 400 | Inventory = 400 |
| Retained Earnings (Net Income) = 480 | Accounts Receivable = 500 |
| Accounts Payable = 500 | |
| Retained Earnings (Net Income) = 540 |
Adjustment to COGS for removal of inventory:
| Income Statement |
| COGS = (400) |
| Taxes @ 40% = 160 |
| Net Income = (240) |
| Cash Flow | Balance Sheet Adjustment |
| Net Income = (240) | Cash = 160 |
| Change in Inventory = 400 | Inventory = (400) |
| Total Change in Cash = 160 | Retained Earnings (Net Income) = (240) |
Adjusted Balance Sheet:
| Balance Sheet Adjustments | Balance Sheet After Adjustments |
| Cash = 160 | Cash = 300 |
| Inventory = (400) | Inventory = 0 |
| Retained Earnings (Net Income) = (240) | Accounts Receivable = 500 |
| Accounts Payable = 500 | |
| Retained Earnings (Net Income) = 300 |
Let us say we collect 500 on accounts receivable.
| Cash Flow | Balance Sheet Adjustments |
| Net Income = 0 | Cash = 500 |
| Accounts Receivable = 500 | Accounts Receivable = (500) |
| Total Changes in Cash = 500 | Retained Earnings (Net Income) = 0 |
Let us add these adjustments to balance sheet:
| Balance Sheet adjustments | Balance Sheet After Adjustments |
| Cash = 500 | Cash = 800 |
| Accounts Receivable = (500) | Inventory = 0 |
| Retained Earnings (Net Income) = 0 | Accounts Receivable = 0 |
| Accounts Payable = 500 | |
| Retained Earnings (Net Income) = 300 |
Let us pay our liabilities from the cash available:
| Cash Flow | Balance Sheet Adjustments |
| Net Income = 0 | Cash = (500) |
| Accounts Payable = (500) | Accounts Payable = (500) |
| Total Change in Cash = (500) | Retained Earnings (Net Income) = 0 |
Let us add these adjustments to final balance sheet:
| Balance Sheet Adjustments | Balance Sheet After adjustments |
| Cash = (500) | Cash = 300 |
| Accounts Payable = (500) | Inventory = 0 |
| Retained Earnings (Net Income) = 0 | Accounts Receivable = 0 |
| Accounts Payable = 0 | |
| Retained Earnings (Net Income) = 300 |
Disclaimer:
This information is for educational purposes only. It does not constitute any legal advice or opinion. Please do not use any of its contents without seeking a professional advice.
References:
Financial modeling and valuation by Paul Pignataro
Mansoor Suhail (Mani)
Accountant
BSBA – EA – ICIA – RA
Tax for Canada and U.S.A
Web: www.theaccountingandtax.com and www.taxservicesguru.com
Blog: http://taxservicesguru.blogspot.ca
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