Here are a few questions for you: Why look at cash flow as a key measure of the performance of your business? Why not just settle for profit, as found on the income statement? Or your company’s assets or owners’ equity, as revealed by the balance sheet?
Well, first of all, as you may recall, profit is not the same as cash. Profit is merely based on promises to pay, so it’s not actual money coming into your company.
For that reason, if you take the time to understand the cash flow statement, you can see how good your company is at turning profit into cash, so that you can pay your employees and your other bills. After all, cash is a reality check.
On top of this, as useful as the income statement and balance sheet are, they’re still made up of numbers that may be skewed in one direction or another. And this is because both of the statements are the result of using certain assumptions and estimates rather than others. For instance, three of these include deciding when to recognize revenue, whether a certain cost is a capital expenditure or expense, and how to treat the depreciation of assets.
However, cash is a bit different. You see, because it’s a number that’s least affected by the artistic side of finance, there’s much less room for manipulation of the numbers on the cash flow statement.
Calculating the Cash Flow Statement
With that said, you can actually calculate a cash flow statement just by looking at one income statement and two balance sheets. Now, the income statement will cover a certain period of time, such as a month, quarter, or year. And the first balance sheet will cover the beginning of that same period, while the second balance sheet will cover the end of that period.
Now, the beautiful thing about building the cash flow statement is that the calculations aren’t hard. In fact, they involve no more than adding, subtracting, and possibly a bit of multiplication.
Basically, what we’re trying to do in this process is reconcile net profit to cash. In other words, we’re asking ourselves, “Given that our company has earned a certain amount of net profit, what effect does that have on our cash flow?”
Starting with Net Profit
Now, you may wonder, “Why do we need to start with net profit?” Well, to answer that question, let’s suppose that every transaction was completed only in cash, and there were no noncash expenses such as depreciation. In that case, net profit and cash flow would be exactly the same.
However, in most companies everything isn’t a cash transaction. And as such, we need to figure out which line items on the income statement and balance sheet had the effect of increasing or decreasing cash, making cash flow different from net profit. In other words, we need to find adjustments to net profit that, when added up, help us to arrive at changes in cash flow.
Now, there are three main adjustments to net profit that we need to make in order to construct the cash flow statement. So, let’s dig deeper into each of them.
Adjusting for Depreciation
The first adjustment is for depreciation. Depreciation is deducted from gross profit on the way to calculating net profit. On top of that, accumulated depreciation is also subtracted from the value of property, plant, and equipment to arrive at the net amount of these assets.
However, depreciation is an expense that’s charged to a period on the income statement but isn’t actually paid out in cash. As such, it has no effect on cash flow. So, you need to add this amount back in when determining cash flow.
Adjusting for Assets and Liabilities
The second adjustment involves assets. And the key rule here is that if an asset increases, cash decreases. So, you subtract this increase in assets from net profit.
The third adjustment applies to a liabilities. And here, the direct opposite is true. If a liability increases, cash increases as well, so you add the increase in liabilities to net profit.
And with that said, let’s see how all of this comes together with a basic example. Here are the income statement and balance sheets for the company we’ll be working with:
Income Statement
(in thousands)
| Year ending December 31, 2007 | |
| Sales | $8,000 |
| Cost of goods sold | 6,000 |
| Gross profit | $2,000 |
| Sales, general, and administrative expenses | 1,000 |
| Depreciation | 300 |
| Operating profit | $700 |
| Interest | 200 |
| Taxes | 300 |
| Net profit | $200 |
Balance Sheets
(in thousands)
| December 31, 2007 | December 31, 2006 | |
| Assets | ||
| Cash | $100 | $50 |
| Accounts receivable | 1,300 | 1,200 |
| Inventory | 1,200 | 1,600 |
| Property, plant, and equipment | 2,300 | 2,200 |
| Total assets | $4,900 | $5,050 |
| Liabilities | ||
| Accounts payable | $1,000 | $1,100 |
| Short-term debt | 100 | 150 |
| Current portion of long-term debt | 55 | 50 |
| Long-term debt | 1,020 | 1,150 |
| Total liabilities | $2,175 | $2,450 |
| Owners’ equity | ||
| Common stock, $1 par value | $75 | $75 |
| Additional paid-in capital | 1,100 | 1,100 |
| Retained earnings | 1,550 | 1,425 |
| Total owners’ equity | $2,725 | $2,600 |
| Total liabilities and owners’ equity | $4,900 | $5,050 |
2007 Footnotes
| Depreciation (in thousands) | $300 |
| Number of common shares (in thousands) | 75 |
| Earnings per share | $2.66 |
| Dividends per share | $1.00 |
Once again, there are three things we need to do in order to reconcile net profit to cash:
- Look at the change in each line item from the beginning balance sheet to the ending balance sheet.
- Determine whether the change resulted in an increase or decrease in cash.
- Add the cash increases to and subtract the cash decreases from net profit.
So, here are the steps in action:
| Observation | Action |
| Start with net profit, $200. | |
| Depreciation was $300. | Add that noncash expense to net profit. |
| Accounts receivable increased by $100. | Subtract that increase from net profit. |
| Inventory decreased by $400. | Add that increase to net profit. |
| Property, plant, and equipment increased by $400 after accounting for depreciation. (See note 1 below.) | Subtract that increase from net profit. |
| Accounts payable decreased by $100. | Subtract that decrease from net profit. |
| Short-term debt decreased by $50. | Subtract that decrease from net profit. |
| Current portion of long-term debt increased by $5. | Add that increase to net profit. |
| Long-term debt decreased by $130. | Subtract that decrease from net profit. |
| Owners’ equity increased by $125. | (See note 2 below.) |
Note 1
Why do we need to adjust for the depreciation when looking at the change in property, plant, and equipment, or PPE? Remember, every year the value of PPE is lowered by the amount of depreciation charged to the assets in this line item.
For instance, if you acquired a fleet of trucks for $200,000, the balance sheet after the purchase would include $200,000 for trucks on the PPE line. Then, let’s say that depreciation for the trucks was $20,000 for the year. In that case, at the end of 12 months, the PPE line item for trucks would be $180,000.
However, depreciation is a noncash expense. And because our goal is to determine a cash number, we need to account for this depreciation by adding it back into our calculations.
Note 2
Did you notice the dividends in the footnote of the balance sheet? If you multiply the dividends per share by the number of common shares, you get $75. And this amount is paid out in cash, so that the cash used by equity financing is $75.
Then, if you take the net profit of $200 and the subtract the dividend of $75, you get $125. (Again, these numbers are in thousands.) And this $125 is the exact amount by which owners’ equity increased.
So, now that we’ve taken the three action steps above, we can finally construct the cash flow statement.
Cash Flow Statement
(in thousands)
| Year ended December 31, 2007 | ||
| Cash from operating activities | ||
| Net profit | $200 | net profit on income statement |
| Depreciation | 300 | depreciation from income statement |
| Accounts receivable | (100) | change in accounts receivable from 2006 to 2007 |
| Inventory | 400 | change in inventory |
| Accounts payable | (100) | change in accounts payable |
| Cash from operations | $700 | |
| Cash from investing activities | ||
| Property, plant, and equipment | $(400) | PPE change adjusted for depreciation |
| Cash from investing | $(400) | |
| Cash from financing activities | ||
| Short-term debt | $(50) | change in short-term debt |
| Current portion of long-term debt | 5 | change in current long-term debt |
| Long-term debt | (130) | change in long-term debt |
| Equity | (75) | dividends paid from note 2 above |
| Cash from financing | $(250) | |
| Change in cash | 50 | cash from operations + cash from investing + cash from financing |
| Cash at beginning | 50 | from 2006 balance sheet |
| Cash at end | $100 | change in cash + cash at beginning |
And the cash at end, $100, is equal to the cash balance on the ending balance sheet from 2007.
So What?
Okay. By now, you might be wondering, “So what? Why should I care about all of this?”
Well, knowing your company’s cash situation will help you understand what’s going on now, as well as where the company could be headed.
For instance, if cash is coming in from operations, that’s a good thing, because it means that the company itself is generating cash.
On the other hand, suppose cash from investing is not a substantial negative number. If that’s the case, this could mean that the company isn’t investing in its future because management doesn’t believe it has room to grow.
And if cash is coming in from financing, it might be a positive sign for the future if shareholders are investing in your company’s stock.
So, looking at the cash flow statement may lead you to think of a number of questions, and they’re probably the right ones that you should be asking. After all, the answer to these questions will likely reveal a lot about the future direction of your company.
Leave a Reply