The Statement of Cash Flows: How to Read Financial Statements Like a Pro (Part 3)

A Crash Course in Balance Sheets, Income Statements, and Statements of Cash Flows

Hello friends!  The wait is finally over. Today we’ll be diving into part 3 of 3 of our financial statement analysis miniseries.  In this module, we’ll be learning all about the statement of cash flows. I know you’re excited as I am!  

And for those of you who missed it, check out Part 1 of the miniseries: The Balance Sheet and Part 2 of the miniseries: The Income Statement.

Let’s dive in!

Part 3: The Statement of Cash Flows

There are three sections to the Statement of Cash Flows: 1) cash flows from or used by operating activities; 2) cash flows from or used by investing activities; 3) and cash flows from or used by financing activities.

Of the three sections, operating activities oftentimes holds the most weight. These typically relate directly to the company’s main business activities. For example, if we return to Mikaela’s Ice Cream, the company’s primary business objective is to generate cash by selling ice cream. It is not by investing in real estate, stock, or other assets or by taking out business loans. However, the company does perform these ancillary functions as a means to operating and selling ice cream and it does affect the company’s cash flow.

And these are important, nonetheless! For example, in my post Fall Button Down vs. NextEra Energy, Inc. (NEE), I discuss how NextEra Engery Inc.’s investment in property, plant, and equipment may enable future growth. As an investor, company growth often translates into higher returns. So, having the know-how to analyze a company’s Statement of Cash Flows is an important part of stock picking.

Also, similar to the Income Statement, the Statement of Cash Flows shows activity over a period of time, as opposed to a point in time, like the Balance Sheet.

Direct vs. Indirect Statement of Cash Flows

There are two methods that can be used to prepare the Statement of Cash Flows: the direct or the indirect method. Under the direct method, the cash inflows and cash outflows are listed out to determine the net cash flows from operating activities. Conversely, the indirect method, starts with net income and adds or subtracts changes in asset and liability accounts, from the balance sheet, to determine the net operating cash flows. Both the investing activities and financing activities sections look the same under either method of presentation.

In my experience, many companies choose to use the indirect method. For starters, the indirect method is easier and requires less time to prepare. Moreover, if a company chooses to use the direct method, they must still show a reconciliation of net income to cash flow from operating activities. Check out this article from Investopedia if you want to read more about the differences between the two methods.

And now, let’s go through an example using the indirect method:

Cash Flows Provided By (Used In) Operating Activities

The first section that we’ll examine is the cash flows provided by or used in operating activities. As you might’ve noticed, the connotation varies depending on whether cash flow is a positive or negative value. For example, in the year ended December 31, 2023, net cash of $15,800 (+ value) was provided by operating activities. Conversely, net cash of $12,000 (- value) was used in operating activities for the year ended December 31, 2022.

Also, because we are using the indirect method, we start with net income. This is shown on the face of the Income Statement. Then, we add back depreciation and/or amortization. Depreciation and amortization are non-cash charges, since there is no exchange of cash when the expense is incurred. As we determined previously, the depreciation expense recorded for the year ended December 31, 2023 and December 31, 2022 was $3,500 and $3,300, respectively. There is no amortization expense.

Next, we have our changes in operating assets and liabilities. These are calculated from the Balance Sheet. For example, our change in accounts receivable is a $300 decrease. Looking at a snippet of the Balance Sheet below, we see our accounts receivable went from $200 to $500.

$200 minus $500 equals negative $300. This is the change in accounts receivable shown above on the Statement of Cash Flows. Follow a similar process for each account balance. Note that for liability accounts, the sign flips. For example, accounts payable were $400 as of December 31, 2022 and $1,600 as of December 31, 2023. $400 – $1,600 gives us negative $1,200. Now, simply flip the sign to arrive at the positive $1,200 value shown on the Statement of Cash Flows for the “accounts payable, accrued expenses and other liabilities” line.

Cash Flows Provided By (Used In) Investing Activities

The next section of the Statement of Cash Flows is the cash flows provided by (used in) investing activities. This section oftentimes includes additions to or proceeds from the sale of property, plant and equipment, purchases of or proceeds from marketable securities, and business acquisitions, net of cash acquired.

In our example above, the $1,000 fixed asset addition is the only investing activity we had between December 31, 2022 and December 31, 2023. How do we know that? Besides the fact that I wrote it in my Balance Sheet post, you can oftentimes find information regarding fixed asset additions in the notes to the financial statements. Also, note that additions to property, plant and equipment should always be a negative value on the Statement of Cash Flows. Why is that? Because, you’ll need to spend cash to purchase the asset. And any form of cash outflow is a negative value on the Statement of Cash Flows.

Cash Flows Provided By (Used In) Financing Activities

The third and final section of the Statement of Cash Flows is the cash flows provided by (used in) financing activities. This section oftentimes includes proceeds from or payments of long-term debt, payments for taxes on equity awards, payments to repurchase stock, and dividend payments.

Let’s return to our example. As you might recall from our analysis of the Balance Sheet, Mikaela’s Ice Cream took out a loan of $420,000 in 2022. We determined that the 2023 loan payment amount would be $14,000. Both transactions affect cash. Hence, the Statement of Cash Flows reflects both transactions. And both transactions are classified under financing activities.

You’ll see the $14,000 included in payments of long-term debt for the year ended December 31, 2023. The $240,000 is reflected under proceeds from long-term borrowing for the year ended December 31, 2022.

Cash and Cash Equivalents

Once we have the cash flows provided by (used in) operating activities, investing activities, and financing activities, we add those subtotals to get the increase or decrease in cash and cash equivalents.

Simply by looking at our Balance Sheet, we know what the change in cash should be. As of December 31, 2022, our cash balance was $4,000. A year later, our cash balance was $4,800. The change? An increase of $800. So what amount should we expect to see on the Statement of Cash Flows for the change in cash and cash equivalents for the year ended December 31, 2023? That’s right! The $800! And lo and behold, we see that amount reflected above.

Now, let’s add in our beginning cash balance. As you might expect, our beginning cash balance at December 31, 2023 is also our ending cash balance of $4,000 as of December 31, 2022. So, taking the $800 change in cash and adding the $4,000 beginning cash balance gives us $4,800. This amount represents our ending cash at December 31, 2023. Its shown both at the bottom of the Statement of Cash Flows and on the Balance Sheet.

Go Forth and Analyze the Statement of Cash Flows

Hopefully this article helped provide a greater understanding of the Statement of Cash Flows and its inter-relatedness to the Income Statement and Balance Sheet.

Do you feel like you have a solid understanding? Try your hand at analyzing the statement of cash flows for publicly traded companies using the SEC’s Edgar Search Tool. Still have questions? Check out my FAQ page. Or, reach out to me directly. I’d love to hear from you!

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