Classifying cash flows doesn’t have to be confusing

The statement of cash flows is arguably the most misunderstood and underappreciated part of a company’s annual report. But it can also provide valuable insight to stakeholders who understand its uses and potential weaknesses. The guidance on divvying up cash flows among operating, investing, and financing activities is often confusing.

Here’s an overview to help clarify what’s involved.

3 types of cash flows

The statement of cash flows customarily shows the sources and uses of cash and its equivalents. The term “sources of cash” refers to money that’s entering the business. Conversely, “uses of cash” refers to money that’s exiting the business.

Under U.S. Generally Accepted Accounting Principles (GAAP), the statement is typically organized into three sections:

Cash flows from operations. This section usually starts with accrual-basis net income. Then it’s adjusted for items related to normal business operations, such as:

  • Gains or losses on asset sales
  • Income taxes
  • Stock-based compensation
  • Net changes in accounts receivable, inventory, prepaid assets, accrued expenses, and payables

It’s also adjusted for depreciation and amortization — a noncash expense meant to reflect the wear and tear on equipment and other fixed assets. The bottom of this section shows the cash provided (or used) in the process of producing and delivering goods or providing services. Several successive years of negative operating cash flows can be a warning sign that a business is struggling and may be worth more dead than alive.

Cash flows from investing activities. If a company buys or sells property, equipment or marketable securities, the transaction shows up in this section. It reveals whether a business is reinvesting in its future operations — or divesting assets for emergency funds.

Business acquisitions (and disposals) are generally reported in this section, too. However, contingent payments from an acquisition are classified as cash flows from investing activities only if they’re paid soon after the acquisition date. Later contingent payments are classified as financing outflows (below). Any payment over the liability is classified as an operating outflow.

Cash flows from financing activities. The third section shows the company’s ability to obtain funds from either debt from lenders or equity from investors. It includes new loan proceeds, principal repayments, dividends paid, issuances of securities or bonds, additional capital contributions by owners, and stock repurchases.

Noncash transactions are reported in a separate schedule at the bottom of the statement of cash flows or in a narrative footnote disclosure. For example, if a business purchases equipment directly using loan proceeds, the transaction typically appears at the bottom of the statement, rather than as a cash outflow from investing activities and an inflow from financing activities. Other examples of noncash financing transactions are: 1) issuing stock to pay off long-term debt, and 2) converting preferred stock to common stock. No cash changes hands, but investors and lenders want to understand these transactions.

In addition, U.S. companies that enter into foreign currency transactions customarily report the effect of exchange rate changes as a separate item in the reconciliation of beginning and ending balances of cash and cash equivalents.

Get it right

It’s not always clear how to classify transactions under GAAP. Managers may be especially confused about how to classify transactions that have aspects of more than one type of activity, such as taxes paid on investment gains, redemptions of employee stock options, sales of receivables, and dividends received from investments, installment sales, and purchases. Sometimes it’s unclear from the guidance whether the cash flow should be split into two activities or allocated to one specific activity.

If you’re unsure how to report an item on the statement of cash flows or disclose it in the footnotes, discuss it with your KraftCPAs advisor.

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