FA 45 - Statement of Cash Flows Explained

Summary

This financial accounting module delves into the significance of the statement of cash flows, emphasizing cash's crucial role in a company's survival. It clarifies why cash is unique among assets due to its direct impact on solvency. The script also discusses the challenges of presenting cash flow information, contrasting the simplicity of a T-account with the complexity of a real-world business's transactions. It introduces the categorization of cash flows into operating, investing, and financing activities, highlighting the importance of each for understanding a company's financial health and the two methods of presenting the operating section: direct and indirect.

Takeaways

• 💡 The statement of cash flows is a crucial financial statement because cash is a vital asset for a company's survival.
• 🏦 Cash is considered a 'life-and-death' asset for businesses, as running out of cash can lead to bankruptcy.
• 🔍 Investors find the statement of cash flows particularly interesting due to the potential for manipulation in other areas of accounting.
• 📋 Cash is seen as a reliable number, which is why it receives its own financial statement for closer scrutiny.
• 🤔 The initial misconception about the cash flow statement is that it simply tracks the beginning and ending cash balances, but it's more complex.
• 📈 A T-account can track cash transactions but becomes impractical for businesses with a high volume of transactions.
• 📊 The standard format for a cash flow statement categorizes transactions into operating, investing, and financing activities.
• 🛒 Operating activities relate to the day-to-day business operations and include cash inflows from sales and outflows for expenses.
• 🏭 Investing activities involve the purchase and sale of long-term assets, such as property, plant, and equipment.
• 💼 Financing activities pertain to long-term funding sources like borrowing from banks or issuing shares, including dividend payments.
• 🔄 The operating section of the cash flow statement can be presented using either the direct or indirect method, with the indirect method being more commonly used.
• 📚 The video script promises to cover both the direct and indirect methods for preparing the operating section of the cash flow statement in future lessons.

Q & A

Why is the statement of cash flows considered so important in financial accounting?

The statement of cash flows is important because cash is a critical asset for a company's survival. If a company runs out of cash, it cannot pay its bills and may become bankrupt. Investors and outsiders are very interested in a company's cash position as it is a life-and-death asset.

Why is cash considered a more reliable figure compared to other balance sheet accounts?

Cash is considered a more reliable figure because it is not based on estimates like many other assets, which can be manipulated. When looking at a company's cash balance, investors can trust the number as it is a solid, verifiable amount.

What is the main difference between a cash T-account and a statement of cash flows?

A cash T-account records all cash transactions in a simple debit and credit format, showing the beginning balance, all deposits and withdrawals, and the ending balance. A statement of cash flows, however, summarizes these transactions into more meaningful categories such as operating, investing, and financing activities.

What are the three main categories of cash flow activities?

The three main categories of cash flow activities are operating, investing, and financing. Operating activities relate to the day-to-day business transactions, investing activities involve the purchase and sale of long-term assets, and financing activities pertain to the company's long-term funding sources and obligations.

How does the operating section of the cash flow statement differ from the net income calculation?

While net income is derived from revenues and expenses, the operating section of the cash flow statement includes not only these items but also changes in current assets and current liabilities. This provides a more detailed view of the cash inflows and outflows related to the company's day-to-day operations.

What types of transactions are classified as investing activities in the cash flow statement?

Investing activities include transactions related to the purchase and sale of long-term assets, such as property, plant, equipment, and investments in other companies or financial instruments.

What are financing activities in the context of the cash flow statement?

Financing activities involve the company's long-term funding sources and obligations, such as borrowing from banks, issuing debt, receiving equity from shareholders, and paying dividends.

What are the two methods for presenting the operating section of the cash flow statement?

The two methods for presenting the operating section are the direct method and the indirect method. The direct method lists the actual cash receipts and payments, while the indirect method starts with net income and adjusts for non-cash items and changes in working capital.

Why might a company prefer the indirect method for the operating section of the cash flow statement?

Most companies prefer the indirect method because it is easier to prepare as it starts with the net income figure from the income statement and then makes adjustments for non-cash items and changes in working capital, which are readily available from the company's accounting records.

What is the purpose of summarizing cash flow transactions into categories in the statement of cash flows?

Summarizing cash flow transactions into categories helps investors and other stakeholders to better understand the sources and uses of cash, the company's operating performance, and its investing and financing strategies, making the statement more informative and easier to analyze.

How does the statement of cash flows relate to the balance sheet and the income statement?

The statement of cash flows ties changes in the balance sheet accounts to the income statement's net income. It explains the movement of cash resulting from operating, investing, and financing activities, providing a more comprehensive view of the company's financial health beyond what is shown in the balance sheet and income statement.

Outlines

00:00

💰 Importance of Cash and the Cash Flow Statement

The first paragraph introduces the significance of cash in a company's financial health, emphasizing that cash is a critical asset without which a company cannot operate. It explains why cash is unique among balance sheet accounts and why it deserves a dedicated financial statement. The statement of cash flows is important to investors as it provides insight into the company's liquidity and solvency. The paragraph also touches on the trustworthiness of cash figures compared to other balance sheet items that can be subject to manipulation. It concludes with a discussion about the traditional method of tracking cash through T-accounts and the limitations of this approach for larger, more complex businesses.

05:02

📊 Understanding the Format of the Cash Flow Statement

The second paragraph delves into the structure of the cash flow statement, explaining that it categorizes transactions into three main activities: operating, investing, and financing. Operating activities pertain to the day-to-day business operations that generate cash inflows and outflows, such as sales and expenses. Investing activities involve the acquisition and disposal of long-term assets, which are crucial for the company's growth and expansion. Financing activities reflect the company's long-term funding sources and obligations, including borrowing and equity transactions. The paragraph also discusses the two methods of presenting the operating section of the cash flow statement: the direct method, which lists actual cash receipts and payments, and the indirect method, which starts with net income and adjusts for non-cash items and changes in working capital. The speaker mentions that both methods are acceptable under GAAP, but most companies prefer the indirect method.

10:04

🚀 Moving Forward with Cash Flow Statement Examples

The final paragraph signals the end of the current discussion and hints at the continuation in the next video where practical examples of cash flow statements will be examined. It serves as a transition, indicating that the theoretical concepts introduced in the previous paragraphs will be applied to real-world scenarios, providing a deeper understanding of how the cash flow statement is constructed and interpreted in practice.

Keywords

💡Statement of Cash Flows

The 'Statement of Cash Flows' is a financial statement that provides information about a company's cash receipts and payments during a particular period. It is central to the video's theme as it is the main subject being discussed. The script emphasizes its importance by explaining why cash is so special and why it warrants its own statement, separate from other financial statements.

💡Cash

In the context of the video, 'cash' refers to the liquid asset of a company, which is critical for its survival. The script highlights that without cash, a company cannot pay its bills and will eventually become bankrupt. Cash is portrayed as a life-and-death asset, which is why it is the focus of the statement of cash flows.

💡Balance Sheet

A 'Balance Sheet' is a financial statement that presents a company's financial position by listing its assets, liabilities, and equity at a particular date. The script mentions it to contrast with the cash flow statement, emphasizing that while cash is just one item on the balance sheet, it is given special attention due to its importance.

💡Asset

An 'Asset' is any resource owned by a company that has future economic value. The video script discusses assets in the context of their importance to a company, especially cash, which is considered a crucial asset due to its direct impact on the company's ability to operate.

💡Bankruptcy

'Bankruptcy' is a legal status for a person or company who is unable to repay their outstanding debts. The script uses this term to illustrate the dire consequences of a company running out of cash, emphasizing the critical nature of cash management.

💡Investors

In the script, 'investors' are individuals or entities interested in a company's financial health, particularly its cash position. The video explains that investors find the statement of cash flows valuable as it provides a trustworthy view of the company's cash transactions.

💡Accounting Manipulation

'Accounting Manipulation' refers to the practice of altering financial statements to misrepresent a company's financial health. The script mentions this to highlight why cash is considered a solid number, as it is less susceptible to manipulation compared to other estimates in accounting.

💡T-Account

A 'T-Account' is a basic bookkeeping tool used to summarize debits and credits for a particular account. The script uses the T-Account as an example of how cash transactions can be tracked, but also points out its limitations when dealing with a large number of transactions.

💡Operating Activities

In the context of a cash flow statement, 'Operating Activities' refer to the day-to-day business transactions that affect a company's cash inflows and outflows. The script explains that these activities are a major part of the statement of cash flows and include revenues, expenses, and changes in current assets and liabilities.

💡Investing Activities

'Investing Activities' are transactions related to the acquisition or disposal of long-term assets. The script describes these activities as part of the cash flow statement, providing examples such as the purchase of a store or equipment, which are significant for understanding a company's investment strategies.

💡Financing Activities

'Financing Activities' involve transactions related to how a company is funded, including borrowing from banks and issuing shares. The script mentions these activities to explain how a company's long-term funding is reflected in the cash flow statement, including the payment of dividends.

💡Direct Method

The 'Direct Method' is an approach to presenting the operating section of the cash flow statement, showing each individual cash receipt and payment. The script mentions this method as one of the two ways to present the operating activities, indicating a preference by standard setters.

💡Indirect Method

The 'Indirect Method' is another approach to presenting the operating section of the cash flow statement, starting with net income and adjusting for non-cash items and changes in working capital. The script notes that most companies prefer this method, despite the direct method being preferred by standard setters.

Highlights

Introduction to Module 11 focusing on the Statement of Cash Flows and its importance.

Cash is considered a life-and-death asset for a company as it is crucial for operational sustainability.

Investors are particularly interested in cash due to its reliability compared to other balance sheet accounts.

The statement of cash flows is unique because it is solely dedicated to cash transactions.

A cash T-account is a simple method to track cash flow but can become unwieldy for larger companies.

The standard format for a cash flow statement categorizes transactions into operating, investing, and financing activities.

Operating activities relate to the day-to-day business operations and cash flows.

Investing activities involve the purchase and sale of long-term assets.

Financing activities pertain to long-term funding sources and dividend payments.

The operating section of the cash flow statement can be presented using either the direct or indirect method.

The direct method is preferred by standard setters for the operating section but is less commonly used by companies.

The indirect method is more commonly chosen by companies for the operating section despite the preference for the direct method.

Both the direct and indirect methods are acceptable under Canadian GAAP and global standards.

The course will cover both methods for understanding and preparation of the cash flow statement.

The statement of cash flows provides insight into a company's liquidity and financial health.

The video concludes with an anticipation of exploring examples of cash flow statements in the next video.

Transcripts

welcome to module 11 of our financial

accounting course this module is all

about the statement of cash flows now

you may be wondering like we have all

sorts of assets we have all sorts of

liabilities we have all sorts of equity

accounts why is cash so special you know

it's just a balance sheet account why is

cash so special that it gets its own

financial statement devoted just it this

is just all about cash and there's

really a couple of reasons

the first is cash is a really important

asset if a company runs out of money

they're dead right they can no longer

pay their bills they are bankrupt if you

can no longer pay your bills of you

creditor calls for money and you don't

have it you are dead if you can't pay

your employees anymore you are not going

to be in business for long so it's such

an important asset you know if a company

runs out of inventory big problem but

they can buy more inventory if they're

under the cash they're dead so it's this

life-and-death kind of an asset and so

investors and outsiders to a company are

of course very interested in cash the

other reason that the statement of cash

flows is very interesting to investors

is so many areas in accounting that

we've looked at can be manipulated so my

receivables I can set a higher or lower

allowance for doubtful accounts and

therefore I can change my receivables

balance in my bad debt expense I can

manipulate that because it's based on an

estimate my depreciation is based on an

estimate and therefore my the value of

my long-term assets is based on an

estimate and many of the company's

assets are based on estimates not cash

cash is thought of and I think is a very

solid number when I look at a company's

cash balance I can trust it so investors

say look that number we can trust so

let's look at the transactions sort of

flowing around that number and it's a

little bit more trustworthy than what we

might see on the income statement or

even on the balance sheet so that's sort

of the reason there's an amande for a

statement of cash flow from the producer

side from the accountants side I always

wondered about this as a beginning

student cuz I said okay well

cash flow obviously we're gonna start

with our beginning cash we're gonna say

here's how the cash went up and here's

how the cash went down and here's what

we ended our cash with like that's what

I figure and that's what a catch

statement cash flow is here's what cash

we started with here's how it's changed

here's what we ended with so okay I

thought that was a reasonable idea of a

statement cash flow and I thought well

we already have that like we have this

thing called the t-account right here's

what cash started with here's all the

deposits the cash here's all the

withdrawals from cash and here's the

amount of money we had at the end of the

year and truthfully this does a pretty

good job of what a cash flow statement

would do and for most of the companies

we've looked at in this course where you

know if you go back to chapter 2 and

look at the journal entries where we

would do a t-account for cash at the end

this t account for cash would be

sufficient for a cash flow statement and

the reason I say it would be sufficient

is because we have all the information

we need you know I could look at this

transaction I could say oh I remember

when I debited cash for a hundred

dollars or whatever the number is and

you could look back to the transaction

and figure out what happened and so you

could see the cash flowing in and the

cash flowing out but for any normal

company not even a big company but for a

normal company a cash t-account is gonna

be unwieldy and what I mean by that is

like if I go to a food truck here in

Kamloops right and I consider their cash

flow statement so the food truck is not

a big business it's a small business but

a food truck in Kamloops might see a

hundred customers per day I think a

hundred transactions most of them

involve in cash is a reasonable number

for a Kamloops based food truck to do so

if I think a hundred transactions if I'm

looking at my T account I have to do a

hundred lines so again if I do cash well

this is one two three four five well I'd

have to extend this let me zoom out here

so I don't know what that's doing there

zoom out a bit and it would have to go

and I think it would have to keep on

going and keep on going and keep on

going and that would be like maybe that

would get us you know to Y and that is

one day of transactions that is one day

worth of transactions for like a food

truck in Kamloops Walmart cameras would

be ten times longer than that or a big

business in this small city would be ten

times longer than that and so you can

quickly see okay a cash t-account isn't

gonna do the job because it would be 30

pages long and it would just be like

hard to even parse and so what we've

said is or what sensible standard

centers have said is okay we have to

summarize this these transactions that

are in this big long t account into

something a little bit more reasonable

something that investors can sink their

teeth into and they came up with a

standard or semi standard format for a

cash flow statement they said look we

want you to break your transactions down

into three categories we want you to

consider transactions to be either

operating investing or financing and all

of your cash flows we want you to

classify as either being operating

investing or financing here's the gist

of each operating is all about the

day-to-day business of the company so

how is the company generating funds in

its day-to-day business so you know

Walmart when they sell you stuff you

know their their cash inflow from making

a sale to a customer is an operating

cash flow paying their employees to do

work that's an operating cash flow

paying for operating expenses like the

utilities operating cash flow these are

the day-to-day business inflows and

outflows of cash our operating

activities these are kind of summarized

by activities that build to give us net

income so typical revenues and expenses

and I'll say operating revenues and

expenses it's not everything that gives

us a net income belongs here but most

items that build to give us a net income

as well as changes to our current assets

and current liabilities so those are the

big three areas we're worried about with

our operating and again there are

exceptions but that's the gist

so when the company buys more inventory

this would be an operating cash flow

when they pay off their accounts payable

it's an operating cash flow so current

assets and current liabilities their

investing activities are all about the

company buying and selling long-term

assets so when I think investing I think

about long-term assets so if I'm

thinking of Walmart they buy like the

the Kamloops Walmart location recently

changed and they sell groceries now and

they didn't use to sell groceries like

you know milk you can buy milk and

cheese at our Walmart you didn't use to

be able to do that and then so these big

refrigerators well walmart isn't selling

those refrigeration units where they

sell their meats and cheeses they're not

selling them to customers that is a long

term asset they're buying for themselves

that's not their inventory that's like

an improvement to the store and that is

a purchase of a long term asset and that

would be an investing activity when they

buy the store itself that's an investing

activity so buying and selling long-term

assets like shelves and and

refrigerators and other things like this

are long-term assets of Walmart they are

investing activities we could also have

investments here like when Facebook

bought Instagram they spent a billion

dollars cash I think it might have been

to stock but let's say it's cash for our

conversation well that would be an

investing activity on the cash flow

statement and again that's a long-term

asset financing activities this is where

as the company's long-term funding come

coming from think of long-term

liabilities you're borrowing money from

the bank or shareholders equity are we

getting money from our shareholders and

so under equity we would also account

for dividends right if a company pays a

cash dividend that falls under equity so

that falls in the financing section so

the majority of our interest here is

actually in the operating section and

because that's where the company's

day-to-day business we want to know how

company's day-to-day business is doing

but also we can see where the long-term

funding is coming from the financing

section and how they're using that long

funding the investing section now making

your life a little trickier is the fact

that the operating section can be done

two ways I don't know if that's a good

color we can do it either the direct

method or the indirect method and in my

class we're gonna learn to do both so

when you go through problems with me

you're gonna learn how to do both

methods both are accepted under Canadian

GAAP rules and I think pretty much

around the world that both methods are

acceptable the direct method is

preferred by standard setters but most

companies choose the indirect method and

we'll discuss that you know as we work

through one of the problems which is no

we're gonna learn how to prepare the

cash flow statement operating investing

in financing section and when we do the

operating section we're gonna do it both

ways no company would ever do it

actually both ways they would just

choose one or the other we're gonna do

both for every problem we look at and

with that out of the way I think we

should jump in and do some problems now

so in our next video we'll look at an

example of a cash flow statement that's

all for this video I can't wait to get

started

bye for now