• Home
• 2.1 Introduction
• 2.2 SEC Interactive Data
• 2.3 Accessing SEC Data
• 2.4 Additional Information
• 2.5 Touring the 10-K
• 2.6 Primary Statements
• 2.7 M D&A
• 2.8 Item 6 Selected Data
• 2.9 Mini Case Studies
• 2.10 Summary
• A.1 Balance Sheet
• A.2 Income Statement
• A.3 Cash Flow Statement
• A.4 Stockholders' Equity
• A.5 Statement Linkages
• A.6 Common Size Analysis
• 2.11 Questions

At the end of the day investors want management to generate earnings consistently and convert these earnings to cash flows.  In an earlier section we presented the income statement and in this section we present a statement that measures management’s performance with respect to converting earnings to cash.  You will see that in the most popular form of this statement information is presented in precisely this format.  That is, it reconciles the change in cash over the period of time starting with accounting earnings.  As a result, this statement is popular with a large number of participants in the financial markets because it is both informative and relatively transparent to users who have limited accounting accrual knowledge.  It further helps consumers of corporate financial reporting with respect to a wide range of every day decisions including:

This statement is required from SFAS 95 and technically this statement has evolved from narrowing the definition of a fund in a “source and use of funds” statement to “Cash and Marketable Securities.”  That is, this statement is designed to answer the following simple question:

How did balance of cash and marketable securities change over the current accounting period?

The consolidated statement of cash flows answers this question by organizing activities around the following three categories:

In addition, at the end of the statement additional “supplemental cash flow Information” is also provided.

Understanding the Structure of a Cash Flow Statement

Before taking a closer look at real world cash flow statements it is useful to understand the structure.  Fortunately, unlike other major accounting statements the structure is well defined within two broad methods:  Direct and Indirect Methods.  The objective of each method is to reconcile the closing balance of cash (and marketable securities) with the opening balance of cash (and marketable securities).  The direct method organizes activities into the set of activities that directly affect the cash flow “T” account.  The indirect method starts with accounting net income and undoes the effects from accrual accounting to identify cash income.  This latter method is by far the most prevalent for large companies but both are used in practice.

Direct Method for Constructing the Consolidated Statement of Cash Flows

This method tracks the movement of cash through the consolidated entity for the accounting period.  That is, the direct method provides the report in the following form:

Organization of the Direct Method

To extract more information out of this flow of cash through the entity it is organized by activities:

For each set of activities the direct method lists the Cash Receipts and Disbursements

Example of the Direct Method:  First Solar (Ticker FSLR)

Cash Inflows and Outflows from Operating Activities typically include:

Bottom Line:  Cash Flow from Operating Activities

The next category is cash flows from Investing Activities

Typically these include:

Bottom Line:  Cash Flows from Investing Activities

Remark:  Cash flows from financial assets and/or liabilities include available-for-sale or held-to-maturity securities but not trading securities.  Trading securities are deemed part of operating activities (SFAS 102)).  In addition, sale of cash equivalents are excluded because these are already reflected in the balance of Cash and Marketable Securities.  Recall, this the account being reconciled by this statement.

For the case of First Solar, their Cash Flows from Investing Activities, is:

The final category is cash flows from Financing Activities

Typically these include:

Bottom Line:  Cash Flows from Financing Activities

Again for First Solar, the Cash Flows from Financing Activities is presented as follows:

Finally, a set of supplementary information is provided at the end which for First Solar is:

This includes foreign currency adjustments to cash and cash equivalents as well as usually dividend information.  For the current example First Solar does not pay dividends and so no dividend information is provided.

The direct method, as the name suggests, lists the sources and uses of cash classified by the three activity categories (Operating, Investing and Financing).

Indirect Method for Constructing the Consolidated Statement of Cash Flows

The second, and more popular method, is referred to as the Indirect Method.  This method provides a reconciliation of the change in cash starting with accounting net income and undoing the impact from accrual accounting.

We can illustrate the above for Amazon.com.  Amazon places a lot of weight on their Cash flow Statement and Free Cash Flows in general.  As a result, they provide a very detailed cash flow statement as follows:

Example of the Indirect Method:  Amazon (Ticker AMZN)

Operating Activities for Amazon:

Operating activities are the principal revenue generating activities of a firm. 

The operating activity section for Amazon is pretty detailed as illustrated below:

The actual line items provide a pretty good representative example:

The above includes operating activity accruals such as depreciation and amortizations, the contribution to cash if working capital decreases and use of cash if working capital increases, and revenue recognition adjustments.

There is always some judgment required to classify items.  For example, if the cash receipts and disbursements are related to transactions that can be identified with financing and investing activities then the classification of these cash flows is in these other categories.  Similar comments apply gains and losses included in the profit or loss but again are related to cash flows from investing activities.

Investing Activities for Amazon:

In particular, these activities change the productive capacity of a stock and the details of the line items are as follows:

You can observe that the above includes traditional items such as purchases of fixed assets and technology related expenditures.  It also includes the impact of financial assets and liabilities other than instruments classified as cash equivalents or held for trading.  That is, financial assets and liabilities that are classified as “Held-to-Maturity” or “Available-for-Sale” unless they are classified as financing activities.  Finally, for the case of financial assets and liabilities that are accounted for as a hedge then the appropriate classification in a cash flow statement is that they are accounted for in the same manner as the cash flows from the underlying hedged item.  That is, if this relates to financing activities then this is classified in the financing activity section.

Financing Activities for Amazon:

The financing activities provide details about cash raised, rolled over and repaid during the accounting period arising from both debt and equity:

Examples of cash flows arising from financing activities are provided above which are cash proceeds from issuing debt, equity or related instruments.  Other examples, not included above are cash flows arising from payments made by a lessee for the reduction of an outstanding liability relating to a capital (under US GAAP) or a finance (under IFRS) lease.

Supplemental Information for Amazon.com:

The supplementary information provided by Amazon provides a sample of the items included in this section:

Again, for the case of Amazon no dividend information is included because Amazon does not pay dividends currently.

Reconciling A Cash Flow Statement for Real World Companies

In a textbook example it is straightforward to reconcile the changes in balance sheet accounts over the period with the indirect method for constructing a cash flow statement.  For example, the change in accounts receivable is either a source of cash if accounts receivable decreases and a use of funds if accounts receivable increase.   Similarly, an increase in inventory is a use of funds and a decrease in inventory is a source of funds.  Combined, the changes in the working capital provide a net source or use of cash.  Typically, public companies use the indirect method for reporting their cash flow statement.  However, rarely do the changes in the balance sheet amounts appear to match what is on the consolidated cash flow statement. 

For example, Amazon reports the following in their Balance sheets:

That is, the change in Inventory equals 3,202 – 2,171 = $1,031 (use of funds) in the Balance sheet depicted above versus the report number in the cash flow statement of 1,019 as a use of funds.  Often an even greater discrepancy appears on a company's cash flow statement. 

So the question arises is whether there is something wrong?

The answer is no because discrepancies between the consolidated statements can arise for various reasons.

1.  Assets can be written off due to impairments, retirements and other reasons that lead to reclassifications.

2.  Foreign currency translations are made at different times -- end of period for the consolidated balance sheet but at the time of the transaction for the subsidiary.

3.  Changes in the entities being consolidated due to acquisitions and sales.

These differences can lead to differences in the line items on a cash flow statement but ultimately the cash balances are reconciled e.g., Cash and Cash Equivalents at beginning and the end of the period should be directly reconciled.

In the above Amazon reports:

Cash and Cash Equivalents, January 1: 3,444

Cash and Cash Equivalents December 31:  3,777

These same amounts can be verified in Amazon’s Consolidated Balance Sheet depicted above.  In other words, companies impose as a constraint that opening and closing cash balances reconcile even though individual line items will vary.