The Cash Flow Statement

The Cash Flow Statement


Business measure profitability based on net income, or the difference between revenue and expenses.  Under the accrual method of accounting, a business recognizes revenue when earned, and expenses are matched against the revenue against the revenue they (expenses) help create, regardless of when cash is actually earned or paid.  Managers are more concerned about cash flow than accounting net income.  Even a profitable business can fail if there is not enough cash on hand.  If a business is not generating enough cash from operations, it will have to find other ways to generate cash such as borrowing, issuing stock, or selling off assets.  From a supply chain point of view, it is very important to diagnose the issues which could cause a firm not to generate enough cash to operate.  The cash flow statement is an excellent statement to see the effects of decisions on the business that effect cash flow.


Neither the income statement nor the balance sheet provides managers with the information needed to fully understand the changes in cash flow and the source of those changes.  Such differences in net income and cash flows are the reason GAAP requires every firm to report a statement of cash flows.


There are three general types of cash flows in a business:  operating, investing, and financing activities. Operating activities are the cash inflows and outflows that involve the day to day business activities with customers, suppliers, employees, landlords, and others.  Operating activities directly affect the supply chain, and consist of the accounts that we mentioned during our discussion of the C2C:  accounts receivable, inventory, and accounts payable. Other accounts affect by operating accounts include cost of goods sold, sales, expenses, prepaids and accruals.  Investing activities are the cash inflows and outflows related to the purchase and disposal of investments and long lived assets.  Financing activities include exchanges of cash with stockholders and cash exchanges with lenders.  This cash could be from issuing stock or loans from creditors.


The statement of cash flows is intended to provide a cash-based view of a company’s business activities during an accounting period.  The cash flows statement gives a more granular view of the C2C, and hones in more on what specific changes caused a change in the C2C. The cash flow statement uses the same transactions report on the income statement and balance sheet but covert these accrual statements to a cash based statement.  When one looks at the balance sheet and income statement, the changes in the cash account boil down to the changes in liabilities and equity as well as and changes in non-cash assets, which is every asset except the cash account. 


In order to understand the changes in cash from the income statement and balance sheet, one must discern how changes in the balance sheet and income statement affect cash.  Here is a little chart which helps in understanding this process:


                                                Assets              Liabilities and Equity


                        Increase               –                                  +

                        Decrease              +                                 –


This chart illustrates increases in cash occur when assets decrease and liabilities increase.  This makes sense; for example when an asset decreases in value, it depreciates and since depreciation is a “non-cash” expense, cash actually increases.  Another example is when a firm reduces an asset such as accounts receivable and inventory.  The firm generates cash as these assets decrease, just as illustrated by the cash to cash cycle.  Increase in liabilities and equity generate cash.  When a firm does not pay its bills according to terms, it conserves cash that would not other wise be there, so cash increases.  Increases in short or long term debt increase cash. An increase in equity consists of issuance of new stock (increase in cash), buy back of stock (decrease in cash) increases in retained earnings (increase in cash) and payout of dividends (decrease in cash). 


A decrease in cash has the opposite effect on assets, liabilities and equity.


For the supply chain, this is huge.  This shows that the supply chain needs to focus on reducing assets as much as possible, while in turn optimizing performance.  This is why lean supply chain initiatives seek to reduce costs as well as optimize assets and reduce financing costs because cash flow form operating activities are the only true continuing source of cash for the business.  Any improvements in the supply chain should focus on the business as a whole and not just on one part of the business to optimize performance.


There are three methods used to show cash flow statements: indirect, direct, and uniform cash flow analysis (UCA).  We will focus our learning of the cash flow statement using the indirect method, which is a simpler method and illustrates the supply chain’s affect on cash and corporate performance.


As stated in week one, a firm desires to match cash inflows with outflows, but this is not always the case.  It is important to highlight the changes and dig deeper to find the underlying causes of the changes.


The first lines of the indirect method cash flow statement are net income and depreciation.  They begin the process of converting net income to operating cash flows.  As stated earlier depreciation is a “non-cash expense; what this means is that the expense was deducted from operational cash flows, but cash did not leave the firm so it must be added back to operational flows to cash the accrual accounting to cash basis accounting.  The second step in accounting for operational cash flows is to account for current assets and current liabilities.  The way one accounts for these changes is to look at the previous period balance sheet and then calculating the changes in these accounts during the next reported balance sheet.  In order to do a cash flow statement, one needs at least two balance sheets reflecting previous and next periods and an income statement which shows the activities occurring between the two balance sheets.  As stated earlier, increases in current assets will deduct from operational cash flow (net income and depreciation and amortization); decrease in current assets will increase operational cash flow.  Increases in current liabilities will increase operational cash flow and decreases in current liabilities will decrease operational cash flow.  The same effect with assets and liabilities will occur with investing activities and financing activities.


Once a firm completes and indirect method cash flow statement, the change in cash at the end of a period should match the amount of cash available to a firm.  The cash flow highlights specific changes that occurred from period to period so that one can see the effect of management decisions.  What is more powerful however is the interpretation and evaluation of the cash flow statement.  As stated earlier, operating cash flow is the only sustainable cash flow a firm may have.  If there is not enough operational cash flow to cover the investing and financing activities of the firm, then one must get behind the numbers and correct the causes.  A ratio that illustrates whether operating cash flows and net income are in sync is the Quality of income ratio, which is net cash flow from operations/net income. A ratio near 1.0 means that operating cash flows and net income are synchronized.


There could be a number of causes that affect the operating cash flows, and we talked about many of them in week one when we discussed the C2C.  The are five general causes that could illustrate the deviations in cash flow:


  • Seasonality/Cyclicality – seasonal variations in sales, A/R and inventory could vary from one quarter to the next.  Cyclicality issues (or changes in the business cycle) need detection as soon as possible, because they could have a detrimental effect on cash flow.
  • The product or corporate life cycle – new products or new companies often experience rapid sales growth, but working capital accounts such as A/R and inventory could grow faster than collected sales.  This will reduce operating cash flows below net income, and if not dealt with, they could cause increased borrowing and an overall increase in supply chain costs.
  • Changes in revenue and expense recognition.  Cases of fraudulent financial reporting involve aggressive revenue recognition (recording revenue before they are earned, which is a violation of the Sarbanes-Oxley Act of 2002) or delayed expense recognition (failing to report expenses when they are incurred).  Both tactics overstate net income (make it seem more than what it truly is), but the tactics do not affect cash flow.  The cash account will not balance with these tactics, which will prompt more of an investigation.
  • Changes in working capital – This is at the heart of supply chain management.  The supply chain affects working capital management the most and should prompt more of a look than most areas.  Since we have talked in depth about the relationship of working capital and supply chain management, no further discussion is necessary here.
  • Changes in property, plant, and equipment – mistakes here can make the supply chain less efficient, and can put a firm out of business.  As stated earlier, the supply chain seek to maximize the use of assets, so the purchase of any asset must “cost justify” it self with corresponding cash flows.  In addition, site location decisions of manufacturing plants and distribution centers (property and plant) must incorporate changes in transportation rates, manufacturing costs, labor costs, global logistics costs and potential lost sales due to lack of responsiveness to customers.  A ratio to judge whether operational cash flow can generate enough cash to cover capital expenditures is the capital acquisitions ratio, which is cash from operations/cash paid for property, plant and equipment.  One must see the changes from accounting period to accounting period to fully grasp the cash changes in equipment as well as property and plant assets.