Level 1 CFA® Exam:
Cash Flow Statement - Introduction
The role of the statement of cash flows is to determine the sources of money and exact amounts that come from different activities. We can divide cash flows into:
- cash flows from operating activities,
- cash flows from investing activities, and
- cash flows from financing activities.
Cash flows from operating activities, which are also called cash flow from operations, are:
- related to everyday business operations, and
- are the cash flows not included in investing or financing activities.
Cash flows from investing activities are cash flows from operations related to the acquisition or disposal of long-term assets.
Cash flows from financing activities are cash flows from activities related to the issuing or repayment of capital used to finance the company’s operations.
Let’s have a look at some examples of cash flows and categorize them into different categories.
We will begin with cash flows from operating activities. The examples include:
- cash and collected receivables for sold goods and provided services,
- money spend on the purchase of inventory,
- salaries,
- taxes,
- cash inflows and outflows related to trading securities.
Now, examples of investing cash flows. These include:
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Now let’s talk about the direct and indirect methods of preparing cash flow statements.
Cash flows from both financing and investing activities are prepared using the so-called direct method only. The direct method is about listing all inflows and outflows of cash and summing them up.
There is also the so-called indirect method. However, it may be used only in the case of cash flows from operations.
The indirect method assumes starting with net income and adjusting it by all relevant cash flows that are either:
- included (if they were not present in net income), or
- excluded (if they were non-cash items or non-operating items).
The indirect method also assumes adjusting net income for changes in working capital items, such as receivables, inventories, or accounts payable.
Remember that IFRS and U.S.GAAP allow using both methods to prepare cash flow from operations but they encourage companies to apply the direct method. HOWEVER, most companies use the indirect method. In the next lesson, we will see how cash flows from operations are prepared under both methods.
Now let’s briefly talk about the advantages of the indirect and direct methods.
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In your exam, you should know that based on the cash flow statement, we can assess the company's:
- liquidity,
- solvency, and
- financial flexibility.
We define liquidity as the company's ability to meet short-term obligations. On the other hand, solvency is the company's ability to meet long-term obligations. Finally, financial flexibility is the company's ability to exploit the opportunities arising for the company and the ability to react to financial adversities.
We should know that in different business stages, companies will be characterized by different cash flow patterns.
Startup
The usual cash flow pattern for this kind of a company is as follows:
- cash flows from operating activities are negative, which means that the company doesn’t earn too much money because it is still in its early stage,
- cash flows from investing activities are negative, which means that the company invests a lot,
- cash flows from financing activities are positive, which means that the company raises capital that is used for investing and financing everyday operations.
Company in Late Stage of Growth
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Mature Company
The best cash flow pattern for this kind of a company is as follows:
- cash flows from operating activities are positive, which means that the company earns money,
- cash flows from investing activities are negative, which means that the company invests, so it is probably maintaining its position in the market,
- cash flows from financing activities are negative, which means that the company repays debt and redistributes net income in the form of dividends to its owners.
- We can divide cash flows into: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.
- Cash flows from operating activities, which are also called cash flow from operations, are: related to everyday business operations and are the cash flows not included in investing or financing activities.
- Cash flows from investing activities are cash flows from operations related to the acquisition or disposal of long-term assets.
- Cash flows from financing activities are cash flows from activities related to the issuing or repayment of capital used to finance the company’s operations.
- The direct method is about listing all inflows and outflows of cash and summing them up.
- Indirect method may be used only in the case of cash flows from operations.
- Liquidity is the company's ability to meet short-term obligations.
- Solvency is the company's ability to meet long-term obligations.
- Financial flexibility is the company's ability to exploit the opportunities arising for the company and the ability to react to financial adversities.
- In different business stages, companies are characterized by different cash flow patterns.