Cash Flows from Operating Activities

The first section of the statement of cash flows is described as cash flows from operating activities or shortened to operating activities. Operating activities are also referred to as company operations.

Operating activities are the business activities other than the investing and financial activities.

Here is the operating activities section of Example Corporation’s SCF which we will be referring to in our discussion:

Note that the combination of the positive and negative amounts in this section add up to a positive 262,000. Hence, it is described as “Net cash provided by operating activities”. If the amounts had added up to a negative amount, the description would be “Net cash used by operating activities”.

Indirect Method for Preparing the Cash Flow Statement

Companies may choose to use either the direct method or the indirect method when preparing the SCF section cash flows from operating activities. However, the indirect method is the dominant method used and the one we will explain.

Under the indirect method, the SCF section cash flows from operating activities begins with the amount of net income, which is taken from the company’s income statement. Since the net income was based on the accrual method of accounting, the amount of net income must be adjusted to the cash amount.

If an adjustment to the amount of net income is in parentheses, it is subtracted from net income. It indicates that the cash amount was less than the related amount on the income statement. Adjustments in parentheses can also be interpreted to be unfavorable for the company’s cash balance.

An adjustment to net income that is not in parentheses is a positive amount, which indicates the cash amount was more than the related amount on the income statement. A positive adjustment can also be interpreted to be favorable for the company’s cash balance.

Adjustments to Convert the Net Income Amount to the Cash Amount

In the case of Example Corporation, the section cash flows from operating income begins with the company’s net income for the year: $230,000.

A large corporation often has 10 or more adjustments to convert the amount of net income to the amount of cash. However, we will limit our discussion to some of the more common adjustments shown on Example Corporation’s statement of cash flows:

• Depreciation and amortization 63,000. Since this adjustment amount appears without parentheses, it indicates that the cash amount will be $63,000 more than the amount of net income. The reason is depreciation and amortization expense reduced the company’s net income, but it did not reduce the company’s cash balance. In other words, without this noncash expense of $63,000, the company would have seen its cash increase by $230,000 + $63,000.

• Loss on sale of equipment 15,000. This amount appears without parentheses and therefore the company’s cash amount will be more than the net income. The reason is that Example Corporation’s net income had been reduced by this loss of $15,000. However, the company did not pay out the $15,000. Therefore, it is added to the amount of net income, causing the cash from operations to be greater by $15,000. (If cash is received from the sale of this noncurrent asset, the amount received is reported as a positive amount on the SCF in the section cash flows from investing activities.)

• If there was a gain on the sale of a noncurrent asset, the amount of the gain would have increased net income. However, since the entire amount of cash received from the sale of a noncurrent asset is reported under cash flows from investing activities, the gain is subtracted from the amount of net income.

• Increase in accounts receivable (21,000). Since this amount is in parentheses, it communicates that the company collected less cash than the amount of sales reported on the income statement. This is determined by examining how the balance in accounts receivable changed during the year. If the company’s receivables increased, it indicates that not all sales on the income statement were collected. This is viewed as unfavorable for the company’s cash balance. Therefore, the amount of the increase in accounts receivable is deducted from the amount of net income.

• If the balance in the company’s accounts receivable had decreased, it indicates that the company collected more than the amount of sales reported on the income statement. Therefore, the amount of the decrease in receivables would be added to the amount of net income. The decrease in receivables is positive, favorable, and good for the company’s cash balance.

• Decrease in prepaid expenses 3,000. If the balance in the current asset prepaid expenses had decreased, it meant that $3,000 of the amount of expenses on the income statement did not require using $3,000 of cash. Therefore, we add $3,000 to the amount of net income. In other words, using part of the prepaid amount instead of paying cash was favorable/positive for the company’s cash balance.

• If the balance in prepaid expenses had increased during the year, it means the company had paid out more cash than the amount reported as expense on the income statement. Therefore, the increase in this current asset is subtracted from the amount of net income. In other words, increasing the balance in prepaid expense was not good for the company’s cash balance.

• Decrease in accounts payable (28,000). If the balance in the current liability accounts payable had decreased, it indicates that the company paid its suppliers more than the amount of expenses reported on the income statement. As a result, the decrease in payables is shown in parentheses. Paying the suppliers more than the related expenses reported on the income statement had a negative or unfavorable effect on the company’s cash balance.

• If the balance in accounts payable had increased, it would indicate the company paid its suppliers less than the expenses reported on the income statement. Paying out less cash is good/favorable for the company’s cash balance. Therefore, an increase in payables is added to the amount of net income.

Quick Guide to Changes in Current Asset Balances

When adjusting a company’s net income for changes in the balances of the current assets, the following may be a helpful guide:

• If a current asset’s balance (other than cash) had increased, the amount of the increase is subtracted from the amount of net income. The increase in a current asset (other than cash) had a negative/unfavorable effect on the company’s cash balance.

• If a current asset’s balance (other than cash) had decreased, the amount of the decrease is added to the amount of net income. The decrease in a current asset (other than cash) had a positive/favorable effect on the company’s cash balance.

Quick Guide to Changes in Current Liability Balances

When adjusting a company’s net income for changes in the balances of the current liabilities, the following may be a helpful guide:

• If a current liability’s balance (other than loans payable) had increased, the amount of the increase is added to the amount of net income. The increase in a current liability had a positive/favorable effect on the company’s cash balance.

• If a current liability’s balance (other than loans payable) had decreased, the amount of the decrease is subtracted from the amount of net income. The decrease in a current liability had a negative/unfavorable effect on the company’s cash balance.

The adjustments reported in the operating activities section will be demonstrated in detail in “A Story To Illustrate How Specific Transactions and Account Balances Affect the Cash Flow Statement” in Part 3.

Next, we will discuss the cash flows involving a company’s investing activities.

Cash Flows from Investing Activities

The investing activities section of the SCF reports the cash inflows and cash outflows related to the changes that occurred in the noncurrent (long-term) assets section of the balance sheet.

Examples of investing activities include the following:

• Capital expenditures (additions to property, plant and equipment)
• Proceeds from the sale of property, plant and equipment
• Purchase of long-term investments
• Proceeds from the sale of long-term investments

Our discussion uses Example Corporation’s cash flows from investing activities:

Capital expenditures are the amounts spent for acquiring, adding, and/or improving noncurrent assets used in a business. (Large amounts spent for repairing an existing asset are reported as expenses on the current period’s income statement.)

Since the amount spent by Example Corporation for capital expenditures required an outflow of cash, the amount appears in parentheses: (300,000). You can also think of the amount spent as unfavorable for the company’s cash balance and/or cash used.

Proceeds from sale of equipment 40,000 is a positive amount since this is the amount of cash that was received. In other words, the $40,000 was an inflow of cash and therefore favorable for Example Corporation’s cash balance.

(Also see our discussion of Cash Flows from Operating Activities for the reporting of the gains and losses on the sale of noncurrent assets.)

Amounts spent to acquire long-term investments are reported in parentheses, since it required an outflow or use of cash.

The proceeds (cash received) from the sale of long-term investments are reported as positive amounts since the proceeds are favorable for the company’s cash balance.

Cash Flows from Financing Activities

The cash inflows and outflows from financing activities are related to the changes in the following balance sheet sections:

• Noncurrent (long-term) liabilities
• Stockholders’ equity (or owner’s equity)
• Loans and similar debt reported under current liabilities

Examples of the descriptions and amounts typically reported under cash flows from financing activities include the following:

• Proceeds from long-term debt
• Repayment of long-term debt
• Proceeds from issuing capital stock
• Payment of dividends
• Purchase of treasury stock
• Change in short-term debt

Our discussion of financing activities will use the following section of Example Corporation’s SCF:

Assume that Example Corporation issued a long-term note/loan payable that will come due in three years and received $200,000. As a result, the amount of the company’s long-term liabilities increased, as did its cash balance. Therefore, this inflow of $200,000 is reported as a positive amount in the financing activities section of the SCF.

Next, assume that Example Corporation distributed $110,000 of cash dividends to its stockholders. The $110,000 cash outflow has an unfavorable or negative effect on the company’s cash balance. As a result, the amount will be shown in the financing section of the SCF as (110,000).

When Example Corporation repays its loan, the amount of the principal repayment will appear in parentheses (since it will be an outflow of cash).

If Example Corporation issues additional shares of its common stock, the amount received will be reported as a positive amount.

Reconciling the Increase in Cash from the SCF with the Change in Cash Reported on the Balance Sheet

The three net cash amounts from the operating, investing, and financing activities are combined into the amount often described as net increase (or decrease) in cash during the year.

In Example Corporation the net increase in cash during the year is $92,000 which is the sum of $262,000 + $(260,000) + $90,000.

As was shown in the Example Corporation’s SCF the net increase for the year was added to the beginning cash balance to arrive at the ending cash balance.

The ending cash balance should agree with the amount reported as cash on the company’s December 31, 2023 balance sheet.

Supplemental Information

Since all transactions cannot be adequately communicated through the relatively few amounts reported on the financial statements, companies are required to have notes to the financial statements.

Some required information for the SCF that will be disclosed in the notes includes significant exchanges that did not involve cash, the amount of interest paid, and the amount of income taxes paid.