Chapter 11: Understanding the Statement of Cash Flows

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All right, so you know we're always talking about these huge companies and how much money they make?

Oh, yeah.

Well, today we're going to like totally unpack one of the key financial statements that helps us understand like exactly where all that cash is coming from and going to.

And the cool thing is this isn't just for accountants.

Right.

You know, this is for like anyone who's interested in business or investing.

So this is a deep dive into the statement of cash flows.

That's it.

Now you're probably already familiar with balance sheets and income statements.

Those are like the staples.

They give us a snapshot of a company's financial position and their profitability.

But the statement of cash flows, this is where things get really interesting because it tells us why a company's cash balance has changed.

So we're going beyond just the what and the how much and we're diving into the why behind the numbers.

Exactly.

It's like the detective work of financial statements.

Yeah.

Totally.

You did see the story behind those numbers.

You get to follow the money trail.

Right.

So our mission today is to totally demystify this statement of cash flows.

We're going to break down its purpose, how it's structured using both the indirect and the direct methods, which might sound a little intimidating.

Yeah, a little bit.

But trust me, we're going to make it super clear.

Yeah, we'll break it down.

And by the end of this deep dive, you'll be able to look at a real world statement of cash flows and be like, aha, I get it.

Yeah.

You'll be able to analyze it like a pro.

Right.

Now, the chapter we're diving into today highlights four main reasons why the statement is so important.

Okay, let's hear them.

First, it helps us predict future cash flows by looking at past trends.

Right.

It's all about patterns and understanding where cash has been coming from and going to.

Exactly.

And second, it lets us evaluate management decisions.

Are they using cash wisely to grow the business?

Yeah.

They're making smart investments.

Are they squandering it?

The statement can tell us a lot about that.

For sure.

Now, the third purpose, this one's especially important for investors and lenders.

Yeah.

This is a big one.

It directly shows us a company's ability to pay dividends and interest.

Exactly.

If you're a shareholder, you want to know if those dividends are coming.

And if you've lent money to a company, you need to be confident they can pay you back.

And finally, the statement of cash flows reveals the relationship between net income and actual cash flows.

Aha.

This is where things get really interesting.

Right.

Because sometimes a company might look profitable on paper.

Yeah.

They have a nice net income number.

But in reality, they're struggling to generate actual cash.

Exactly.

It's like that friend who always seems to have the latest gadgets but can never spot you for lunch.

That's a perfect analogy.

And the chapter gives a great example of this with FastTech Company.

Oh, yeah.

FastTech.

They had a decent net income, but their cash flow was a mess.

Yeah.

Low cash balance, slow inventory turnover.

Like their inventory was just sitting there.

And it was taking them forever to collect payments from customers.

Huge red flags.

Exactly.

So the key takeaway here is that both strong net income and robust cash flow are essential for a company's success.

Absolutely.

You need both to be healthy in the long run.

Okay.

So now that we understand why the statement of cash flows is so important, let's get into the how.

Okay.

Let's break it down.

The chapter explains two main methods for preparing it.

The indirect method and the direct method.

Right.

And the indirect method, that's the one most companies use.

Yeah.

It seems like it's the more popular approach.

Yeah.

It's kind of like starting with net income and working our way backward to figure out the cash flow from operations.

Okay.

So we're taking that net income number and making adjustments to reconcile it with the actual cash flow.

Exactly.

We're adjusting for things that didn't involve cash or that were accounted for in other activities like investing or financing.

Got it.

So what's the typical structure of this indirect method?

It's pretty straightforward.

You've got three main sections.

Yeah.

Cash flows from operating activities.

Cash flows from investing activities and cash flows from financing activities.

So basically operating is the day -to -day business stuff.

Investing is buying and selling long -term assets.

Yeah, like property and equipment.

And financing is about how the company raises and manages its capital through debt and equity.

You got it.

That's the big picture.

Okay.

Now before we even dive into those sections, the chapter mentions this thing called a check figure.

Oh yeah, the check figure.

This is a really important concept.

So what is it exactly?

Basically it's the net increase or decrease in the company's cash over the period, which we can find by comparing the beginning and ending cash balances from the balance sheet.

So it's like our target, the number we're trying to explain with the statement of cash flows.

Exactly.

And the chapter uses this example of the Red Roadster Superstore.

They call it TRRS.

TRRS, okay.

And their cash balance decreased by $8 ,000 during 2018.

So as we go through their statement, we're going to figure out why their cash went down by that amount.

All right.

Challenge accepted.

So let's start with that first section.

Cash flows from operating activities using the indirect method.

We're starting with net income.

What happens next?

Okay.

So after we grab that net income figure, we got to make some adjustments.

Adjustments.

Okay.

What kind of adjustments?

Well, there are two main categories,

non -cash expenses and changes in current assets and liabilities.

All right.

Let's tackle non -cash expenses first.

What are those all about?

So these are expenses that get recorded on the income statement, but they don't actually involve any cash leaving the company in the current period.

Okay.

Give me an example.

Sure.

The biggest one is depreciation.

Depreciation.

That's the wear and tear on assets over time, right?

Exactly.

And it gets subtracted from revenue to calculate net income.

But no cash actually changes hands.

Right.

So to reflect the actual cash flow, we add depreciation back to net income in the operating activities section.

Okay.

So it's like we're undoing that subtraction.

Precisely.

We're putting that cash back in the picture.

Makes sense.

What other non -cash expenses might we need to adjust for?

Well, there's depletion, which is similar to depreciation, but applies to natural resources.

Ah, like oil wells or mines.

Exactly.

And then there's amortization, which is used for intangible assets like patents and copyrights.

Okay.

So all of those get added back to net income to reflect the real cash flow.

Yes.

Because they all reduce net income without actually using up any cash.

Got it.

So that's non -cash expenses.

What about changes in current assets and liabilities?

How do those affect things?

All right.

So current assets, these are things like accounts receivable and inventory.

Right.

Things the company expects to convert to cash within a year.

And then current liabilities, these are short -term obligations like accounts payable.

Okay.

So what happens when these balances change?

Well,

any increase in a non -cash current asset actually decreases cash flow from operations.

Wait, really?

Why is that?

Think of it this way.

If a company's accounts receivable increases, it means they've made more sales on credit, but they haven't actually collected that cash yet.

Oh, I see.

So even though the sale is recorded as revenue and contributes to net income, the cash hasn't come in yet.

Exactly.

So we got to subtract that increase in accounts receivable from net income to get the real cash flow.

Okay.

And I'm guessing a decrease in accounts receivable would have the opposite effect.

You got it.

If accounts receivable decreases, it means they've collected more cash than the revenue they recognized.

So we add that decrease back to net income.

Makes sense.

Now, what about current liabilities?

Well, it's kind of the reverse logic.

A decrease in a current liability means they paid off some of those obligations.

Which means they used PASH.

Right.

So we subtract that decrease from net income.

And an increase in a current liability would mean they've essentially conserved cash.

Exactly.

They haven't paid those obligations yet.

So we add that increase back to net income.

Okay.

I think I'm starting to get the hang of this.

So after we've made all those adjustments for non -cash expenses and changes in current assets and liabilities, what do we end up with?

That gives us the net cash provided by or used in operating activities.

And that's the first section of our statement of cash flows.

Exactly.

What's next?

On to the next adventure.

Cash flows from investing activities.

All right.

Let's invest.

What falls under this category?

This section is all about the long -term assets.

The things a company uses for more than just day -to -day operations.

Okay.

And expects to generate revenue from over a longer period.

So like property, plant, and equipment.

Bingo.

What the chapter calls plant assets.

And also long -term investments, like buying stocks or bonds of other companies.

Makes sense.

So if a company buys a new factory or some expensive machinery, that would show up as a cash outflow here?

Absolutely.

Increases in these long -term asset accounts usually mean cash is going out.

And if they sell off some old equipment, that would be a cash inflow.

Right on.

Decreases in these accounts mean cash is coming in.

Now the chapter uses TRRS's plant assets as an example.

They walk us through how to figure out how much they invested in new assets.

Yeah.

They started the year with $219 ,000 worth of plant assets, ended with $343 ,000, and had $18 ,000 in depreciation.

And they also sold some assets for $62 ,000.

So how do we put all that together?

The chapter uses a T account approach, which is a really helpful way to visualize it.

Okay.

So the beginning balance plus any purchases minus depreciation minus the book value of

Exactly.

And by plugging in the numbers we know, we can solve for the unknown.

The amount of new plant assets acquired.

And for TRRS, that turns out to be $196 ,000.

So that's a cash outflow in the investing section.

Right on.

And remember that sale of plant assets for $62 ,000.

That's our cash inflow here.

Oh yeah.

And that's the same sale that resulted in that $8 ,000 gain we adjusted for in the operating section, right?

Exactly.

It's important to keep those two things separate.

The gain or loss, which affects net income, and the actual cash from the sale, which goes in the investing section.

Got it.

Any other types of investing activities we should be aware of?

Yeah.

The chapter mentions buying or selling long -term investments and lending money to others, which creates notes receivable.

Okay.

So those would all go in the investing section, depending on whether cash is coming in or going out.

All right.

We've covered operating activities and investing activities.

That leaves us with the final piece of the puzzle.

Cash flows from financing activities.

The grand finale.

What's happening in the financing world?

So this is all about how a company raises capital and manages its debt and equity, right?

You got it.

It's all about the long -term money.

Okay.

So things like issuing new stock or borrowing money through long -term loans, those would be cash inflows.

Yes.

Because cash is coming into the company.

And things like paying back debt, paying dividends to shareholders, or buying back their own stock, those would be cash outflows.

Exactly.

All those activities use up cash.

The chapter uses TRRS again to illustrate dividend payments.

They had beginning retained earnings of $86 ,000, net income of $50 ,000, and ending retained earnings of $119 ,000.

So we can figure out their dividend payments by using that retained earnings formula, right?

Yep.

Beginning balance plus net income minus dividends equals ending balance.

And that means TRS paid out $17 ,000 in dividends, which is a cash outflow in the financing section.

That's right.

And they also purchased $3 ,000 of their own stock, which is another cash outflow because they're using cash to buy those shares back.

So once we've accounted for all the cash flows from operating, investing, and financing activities, we should end up with the net increase or decrease in cash for the period.

And that should match our check figure from the beginning.

It all comes full circle.

Exactly.

And that, my friends, is the indirect method of preparing the statement of cash flows.

We did it.

But wait, there's more.

The chapter also explains the direct method.

So what's the deal with that?

All right.

So the direct method, it's like the alternative route.

Fewer companies use it, but some people find it more straightforward and informative, especially for understanding those operating activities.

And just to be clear, both methods ultimately arrive at the same net change in cash, right?

Absolutely.

It's just a different way of presenting the information, particularly the operating activities section.

So where exactly do they differ?

The main difference is that the direct method lists the major categories of cash receipts and disbursements directly.

Okay.

So instead of starting with net income and adjusting it, we're looking at the actual cash coming in and going out.

Exactly.

It's a more granular view of those operating activities.

So what kind of things would we see in the direct methods operating activities section?

Well, for cash receipts, the big one is cash collections from customers.

Okay.

So that's all the cash they received from sales.

Both cash sales and collections on account.

Yep.

And then you'd also see cash receipts of interest and dividends if they received any.

And on the disbursement side?

You'd see payments to suppliers for inventory and other operating expenses.

Okay.

Payments to employees for salaries and wages and payments for interest and income taxes if they made any during the period.

So basically we're seeing the actual cash flows related to the core operations of the business.

Exactly.

No more starting with net income and making all those adjustments.

And what about things like depreciation expense?

Depreciation doesn't appear in the operating activities section under the direct method.

Why not?

Because it's a non -cash expense.

Remember, there's no actual cash outflow involved.

Right, of course.

So it just gets left out entirely.

That's right.

And what about the investing and financing activities sections?

Do those change with the direct method?

Not really.

Those sections are pretty much the same regardless of which method is used for the operating activities.

Okay.

So the main difference is really just in that operating activities section.

Exactly.

Now, the chapter also explains how to calculate those operating cash flows under the direct method.

Yeah.

It's all about connecting the dots between the income statement and the balance sheet.

And they use some specific examples to illustrate this, like calculating cash collections from customers.

Right.

You start with sales revenue and then adjust for the change in accounts receivable.

Because if accounts receivable increased, it means some of that revenue hasn't been collected in cash yet.

Exactly.

So you subtract the increase to get the actual cash collections.

And the chapter also talks about calculating payments for inventory and other operating expenses using a similar approach.

Yep.

It all comes down to analyzing those changes in the balance sheet accounts to figure out the real cash flows.

Okay.

That makes sense.

Now, towards the end of the chapter, they introduce this concept of free cash flow.

Oh, yeah.

Free cash flow.

It's a really useful metric.

So what is it exactly?

Basically, it's the cash a company has left over from its operations after paying for its necessary investments in long term assets.

Okay.

So it's like the cash they have available for other things like paying dividends, reducing debt, or even investing in new opportunities.

Exactly.

A healthy free cash flow is a good sign.

It means the company has some financial flexibility.

And the chapter wraps up with a really interesting comparison between Sears and Walmart from a few years back.

Yeah.

A classic tale of two companies.

And it really highlights how powerful the statement of cash flows can be in revealing a company's true financial picture.

Sears was struggling.

They had negative cash flow from operations for years.

Meaning their core business was actually consuming cash instead of generating it.

Yeah.

Not a good sign.

And while they did have positive cash flow from investing activities.

It turned out that was mostly because they were selling off assets, not buying new ones.

Right.

More of a sign of decline than growth.

And on the other hand, Walmart was generating strong positive cash flow from operations.

Yeah.

They were a cash machine.

Investing in new assets and returning cash to their shareholders through dividends and share buybacks.

It was a stark contrast.

And it showed how the statement of cash flows can help us spot potential problems and identify companies that are truly financially healthy.

So to sum it all up, the statement of cash flows is like this essential tool for understanding a company's financial story.

Absolutely.

It's a must read for anyone who wants to get a complete picture.

It goes beyond just profits and losses or assets and liabilities.

Right.

It shows us the actual movement of cash, where it's coming from, where it's going.

It's like following the money trail.

Exactly.

And it helps us predict future cash flows, evaluate management decisions, see if a company can meet its obligations and understand the true quality of their earnings.

All crucial insights for investors, lenders, and even employees.

Absolutely.

And just to recap,

there are two main methods for preparing it.

The indirect method and the direct method.

Both lead to the same net change in cash, but present the information differently.

So whether you're evaluating an investment, trying to understand your own company's finances, or just managing your personal budget, understanding cash flow is a super valuable skill.

No doubt about it.

And that brings us to our final thought for today.

Now that you know how to analyze a statement of cash flows, what are some things you might look for to really assess a company's long -term sustainability and growth potential?

Hmm.

Interesting question.

What might strong net income be hiding?

Or what temporary challenges might be obscuring a fundamentally sound business?

It's all about digging deeper and using this knowledge to make informed decisions.

Exactly.

So go forth, explore those cash flows, and unlock the secrets of financial health.

Yeah.

Happy analyzing.

All right.

That's it for today's Deep Dive.

Thanks for joining us.

See you next time.