Cash Flows and the Cash Flow Statement

Accounting is based upon accrual concepts that report revenues as earned and expenses as incurred, rather than when received and paid. Accrual information is perhaps the best indicator of business success or failure. However, one cannot ignore the importance of cash flows. For example, a rapidly growing successful business can be profitable and still experience cash flow difficulties in trying to keep up with the need for expanded facilities and inventory. On the other hand, a business may appear profitable on an accrual basis, but may be experiencing delays in collecting receivables, and this can impose severe liquidity constraints. Or, a business may be paying generous dividends, but only because cash is being produced from the disposal of core assets. Sophisticated analysis of the balance sheet and income statement will often reveal such issues.

The Statement of Cash Flows

Rather than depending upon sophisticated financial statement users to do their own detailed cash flow analysis, the accounting profession has seen fit to require another financial statement that clearly highlights the cash flows of a business entity. This required financial statement is appropriately named the Statement of Cash Flows. The Statement of Cash Flows can be seen as an outgrowth of the FASB's conceptual framework. In the previous chapter, it was pointed out that the FASB cited one objective of financial reporting as follows: Information should be helpful in assessing the amounts, timing, and uncertainty of an organization's cash inflows and outflows. The applicable rules require that the statement of cash flows provide three broad categories that reveal information about operating activities, investing activities, and financing activities. In addition, businesses are required to reveal significant noncash investing/financing transactions.

Cash and Cash Equivalents

In preparing the statement of cash flows, companies broadly define "cash" to consist of cash and items that are equivalent to cash. As a general rule, cash equivalents are short-term, highly liquid investments that mature in 90 days or less.

Operating, Investing, and Financing Activities

Cash inflows from operating activities consist of receipts from customers for providing goods and services, and cash received from interest and dividend income (as well as the proceeds received upon the sale of "trading securities"). Cash outflows consist of payments for inventory, employee salaries and wages, taxes, interest, and other normal business expenses (and the cost of "trading securities" purchased). To generalize, cash from operating activities is generally linked to those transactions and events that enter into the determination of income. However, another way to view "operating" cash flows is to include anything that is not an "investing" or "financing" cash flow as described below.

Investing Activities

Cash inflows from investing activities result from items such as the sale of stock and bond investments (other than "trading"), disposal of long-term productive assets, and receipt of principal repayments on loans made to others. Cash outflows from investing activities include payments made to acquire long-term assets or long-term investments (other than "trading") in other firms, loans made by the entity to others, and similar items.

Financing Activities

Cash inflows from financing activities relate to the proceeds received when a company issues its own stock or bonds, borrowings under mortgage notes and loans, and so forth. Cash outflows for