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5. Cash flow statement: its contents and informational aims

The cash flow statement shows the entity's performance in terms of cash flows, i.e. from where the cash inflows have come and to where the cash outflows have gone.

The cash flow statement is divided in three parts: cash from operating activities, cash from investing activities, cash from financing activities.

Cash from operating activities is made of cash outflows, spent to run the reporting entity's core operations, e.g. paying trade creditors, paying workforce, bills and consultants; and cash inflows, deriving from selling the products or services typical of the reporting entity.

Cash from investing activities is made of cash outflows spent to purchase non-current assets and cash inflows deriving from disposing of those assets.

Cash from financing activities is made of cash inflows deriving from obtaining loans and other credit, and cash outflows spent to repay those debts.

Each of the three parts can show a net cash inflow or a net cash outflow as a result, respectively if the cash inflows of those activities are higher or lower than the cash outflows. However, it is typical for an entity that the operating activities show a positive net cash flow, the investing activities result in a negative net cash flow and the financing activities result in a negative net cash flow. This typical situation is the scenario of an entity that is creating more cash than it uses for running its core operations, uses cash to maintain and perhaps expand its assets and uses cash to pay back its lenders.

Other scenarios are made of the various possible combinations of positive and negative results. For example in the year when an entity has borrowed a substantial amount of money, the cash from financing activities is likely to be a positive figure. The meaning is that in that year the entity might have improved its liquidity position, by borrowing more money; in the years to come that money must be returned to the lenders, hence the cash from financing activities will show a reverse effect, i.e. it will contribute to deplete the cash resources of the reporting entity.

Again, you might come across entities that report a positive cash flow from investing activities. This is typically due to the entity disposing of non-current assets, i.e. properties plant and equipment or financial assets or indeed intangible assets. Regardless whether or not the entity has made a gain out of the disposal, i.e. whether or not it has sold the asset at a higher value than its net book value, as long as it has sold the asset for a price, a positive cash flow is derived from that disposal.

These examples should lead to a reflection about the difference between cash and economic performance. The latter example, taken to the extreme, leads to a reporting entity that can potentially become cash rich in the short term, but that is depleting its capital assets, compromising its capacity to produce profits in the medium and long term.

On the other hand, you might come across reporting entities whose fast paced expansion absorbs more liquidity than it produces, despite being profitable. A worked example is reported in appendix C, where the case of fictitious consulting company called 'Consulando' is presented. Consulando expands at such a fast pace that every month it needs larger amounts of cash to pay for the services it provides to ever more clients, whilst the amounts of cash that it receives from the clients served in the previous months is never sufficient to cover for the current needs. Once Consulando will stop expanding, the cash inflows will catch up with the cash outflows and the business profitability will be reflected also in accumulation of cash, as illustrated in figure 6. The peril is, of course, that before Consulando has saturated the entire demand that it potentially can, its managers decide or are forced to slow down the expansion, because of lack of access to immediate cash.

the cash flow and the margin trends of Consulando compared see appendix C for calculations and assumptions.

Figure 6 - the cash flow and the margin trends of Consulando compared see appendix C for calculations and assumptions.

If Consulando were to close its accounts on 31st August 2009, its cash flow statement would show a negative cash flow from operations most likely compensated by a positive cash flow from financing activities or, if the reporting entity was cash rich from previous activities, the negative cash flow from operations would most likely not need to be compensated by financing activities and the net change in cash at the end of the year would be negative. In this scenario, drawing a conclusion that Consulando is not performing well would be wrong.

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