Information in the statement of cash flows sheds some light on a company’s ability to generate income in the future. Learn how—in the statement of cash flows—the cash flows are separated into three categories: operating activities, investing activities, and financing activities.
- The statement of cash flows is the baby of the financial statements. The balance sheet and the income statement have been around for over 500 years. In contrast, the statement of cash flows first started appearing in just 1988. So, it's brand new in an accounting sense. As we talk about the statement of cash flows, you're going to think this thing is so awesome. Why didn't they invent it sooner? I actually asked myself that same question. Now, the idea is so simple. Cash, how much cash did you receive? How much cash did you pay? On the statement of cash flows, the cash flows are separated into three categories, operating activities, investing activities, and financing activities.
To start, operating activities are the things you do every single day. Your operations, you collect cash from your customers and hopefully lots of it. You pay wages, you pay utilities, you pay your taxes, you pay your interest. Operating activities, they're the routine stuff that you do hundreds of times a day. Now in the context of the statement of cash flows, when we say investing activities, we primarily mean investing in the productive capacity of the business. So, cash outflows from investing activities are buying new buildings, buying new land, buying some new equipment, spending cash to enhance the productive capacity of the business.
Now, cash inflows from investing activities come from selling a truck or some land when you don't need it anymore. Now, how often does a company do investing activities? Occasionally, but not everyday. These are not routine things. I don't go out and buy a building for my business every single day. Investing activities happen occasionally. We're investing in the productive capacity of the business. Now, financing activities are just what they sound like. I'm getting the cash to buy what I need in my business.
I'm borrowing some money. I'm getting new investments from owners. Those are cash inflows from financing activities. Well, what about cash outflows? Well, you're repaying those loans. You're paying dividends to the owners. Those are cash outflows from financing activities. Now, how often do you do financing activities? Occasionally, but not very often. Now, let's look at the cash flows of three companies that we're all familiar with, Microsoft, Ford Motor Company, and McDonald's.
All three companies generated cash from operation, and that's a good thing. Microsoft then used that cash to expand its operations through investing activities. They also used that cash from operations to pay dividends and divide their own stock back. Ford, they tell a different story. Their investment in the productive capacity of their business was greater than the cash generated from operations. As a result, they borrowed money as shown by their positive cash flow from financing activities.
And McDonald's, well that's a different story altogether. They generated cash from operations and they used some of that cash for increasing the productive capacity of their business through investing activities. Then, they paid a dividend, a financing activity, and they bought back a lot of stock. A lot. So, where did they get the cash to do that given their change in cash was a negative six billion dollars? Well, they had a lot of cash to start off the year with. Now, you might think that the statement cash flows is a replacement for the income statement.
But, the two statements have very different objectives. The income statement measures the results of operations for a period of time. Net income is the accountant's best estimate at reflecting a company's economic performance for a period. The statement of cash flows on the other hand provides details as to how that cash account changed during the period. The statement of cash flows reports the period's transactions and events in terms of their impact on cash. The statement of cash flows provides important information from a cash flow perspective that compliments the income statement and the balance sheet, providing a more complete picture of a company's operations and financial position.
It is important to note that the statement of cash flows does not include any transactions or accounts that are not already reflected in the balance sheet or the income statement. It simply provides information relating to the cash flow effects of those transactions. Users of financial statements, particularly investors and creditors, need information about a company's cash flows in order to evaluate the company's ability to generate positive cash flows in the future to meet its obligation and to pay dividends.
In some cases, careful analysis of cash flows can provide early warning of impending financial problems. Again, it's important to reiterate that the statement of cash flows does not replace the income statement. Information contained in the income statement can be used to facilitate the preparation of a statement of cash flows. Information in the statement of cash flows sheds some light on the company's ability to generate income in the future.
The statement of cash flows and the income statement provide complimentary information about different aspects of the business. So, just to review the three activities contained on the statement of cash flows. Operating activities, those are things that I do every single day repetitively over and over. Conducting operating activities is the reason my business exist. Investing and financing activities, those happen occasionally.
This is the statement of cash flows. It's only been around for 25 years, but it's been an awesome 25 years.
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