In this video you'll learn what the Statement of Cash Flow is
and how to prepare it using the Direct Method.
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Hey viewers,
welcome back to another episode of Accounting Stuff.
I'm James and today
I would like to introduce you to the
Cash Flow Statement. Three weeks ago I made a video
about the Accrual Basis of Accounting
and I said something along the lines of…
The Accrual Basis of Accounting doesn't explicitly track cash flow.
So this needs to be calculated separately using the
Direct or Indirect Method. After I posted that video I
received a couple of comments from you guys asking me to explain the
Cash Flow Statement and the Direct and Indirect Methods.
Hence today's video and don't worry a
lot of people get intimidated by the Statement of Cash Flows
but I promise you there is really no reason to be.
You might have heard the expression Cash is King.
Well in this video I'm going to explain why the
Cash Flow Statement is so important
and how to prepare it using the Direct Method.
We are going to cover the Direct Method first
because it's considered to be more valuable to investors and
anyone who reads the Cash Flow Statement.
However, many people opt for the Indirect Method instead.
If you stick around with me until the end.
I'll explain why. Right I think that's enough faffing…
Let's get started! First
I want to make one thing very clear…
Cash and Profit are not the same thing.
Profit is Revenue less Expenses It’s the bottom line on
an Income Statement and relates to a period of time.
Whereas you can think of Cash as a bank balance
at a point in time. Cash and Cash Equivalents
also include physical, petty cash amongst a few other things.
Although most conventional companies use bank accounts just like
you or I might have. I also want to make the point that
Cash Flows are different to Cash. Cash Flows relate to the
amount of cash that is flowed in or out of a business over a
period of time. Now that might sound
a bit more like profit, but it isn’t.
When using the Accrual Basis of Accounting,
we apply the Revenue Recognition
and Matching Principles so that means that
Revenue is recognised as it's earned,
not when Cash is received and Expenses are recorded
as they are incurred, not when Cash is paid out.
That means… Revenue doesn't equal Cash in
and Expenses doesn't equal… don't equal
Cash out. The biggest reason that
small businesses fail is because of poor
Cash Flow management. Many of these businesses
would have been profitable, but without having that
cash available they're unable to pay their staff,
their creditors, or the interest on their
bank loans and this throttles them.
That expression that I mentioned a moment ago…
Cash is King is used to emphasise the importance
of Cash Flow, particularly in small businesses.
Now I feel like I'm harping on about this so it's time to move on,
but I can't stress this point enough… It is crucial to keep a track
of your cash flows. And we do that using the
cash flow statement or statement of cash flows.
This is one of the three main Financial Statements along with the
Income Statement and Balance Sheet. We have all three of them here
made up for a company called Chudley Cannons incorporated.
I apologise for Harry Potter reference but I've been re-listening to the
audio books by Stephen Fry when I go to bed,
and I'm not gonna lie… It's been amazing!
I get to dream about sneaking through Hogwarts every night in my
Invisibility Cloak. It's great, Audible is offering a
free 30-day trial at the moment and they have all the books!
So you can check them out too. I'll stick a link to it in the
description below. But that's enough Harry Potter chat
for now… Back to the cash flow statement.
The first thing to note is that the cash flow statement
covers a period of time, and we put this in the header.
Remember I said that cash flows relate to the
amount of cash that has flowed in or out of a business
over a period of time. Here we have the year ended
the 31st of December. But this could easily cover
a quarter, or a month. I think it's easiest to interpret the
cash flow statement by starting at the bottom and working our way back up.
At the bottom, we have cash at the start and end
of the year which we get from the Balance Sheet,
over here. When we take the difference between
these numbers we get the net increase or decrease in cash
for the year. In this case it's $35,000.
This number is key to the statement of cash flows
because what we're going to do above is explain how and why
the cash balance changed over the course of the year.
We're going to summarise what cash was spent on
and what the sources were and reconcile it all back to this number.
And we do this by breaking it all down into three sections.
The last section is Cash Flow from Financing Activities.
Financing Activities include changes to share capital,
borrowings from a bank, or from third parties.
Here we have long term borrowings,
which I assume were from Gringots, the wizarding bank.
When a company borrows money there's a cash inflow,
so your cash balance increases. That's the case here since you can see
that we have a cash inflow of $20,000 because the number is positive.
But cash can also flow out of a business through
Financing Activities when you pay back a loan,
or buy back share capital. Above Financing Activities
we have Cash Flows from Investing Activities.
Investing Activities most commonly relate to the sale or purchase of
non-current assets, or investments in stocks and shares
that sit outside of the business's core operations.
When a business invests in non-current assets,
cash flows out because we have to pay
the suppliers cash for these assets. And on the flip side,
when we sell these assets off, cash flows back in.
Here the Chudley Cannons have 15,000 dollars of cash inflow
from the sale of PPE. Which is shorthand for
plant, property and equipment and 70,000 dollars of cash outflows
from the purchase of PPE. They are a Quidditch team
so they might have received the $15,000 by selling off their
old broomsticks in order to buy some of those new Nimbus 2001s
which cost them $70,000. This is an investing activity,
not an operating activity because buying and selling broomsticks
it's not the Chudley Cannons core business.
The broom sticks are long-term investments which
makes them non-current assets. This is different to inventory,
which describes assets that are intended to be sold during
the ordinary course of business. Which brings us on to the first
section of the Statement of Cash Flows…
Cash Flow from Operating Activities. Operating Activities are the
principal revenue-generating activities of a business.
That sounds like a mouthful, but it just means the cash
that we receive, or pay out during the course of our regular business.
Cash comes in when our customers pay us based
on our accounts receivable, and cash flows back out when
we pay our suppliers based on our accounts payable.
Now at the start of the video, I mentioned the
Direct and Indirect Methods of preparing a
Cash Flow Statement. And I haven't brought them
up again until now because everything that
we've covered so far is identical under each method.
Operating Activities is the only section that's different.
Today, I'm going to cover the Direct Method,
and soon I'll do another video on the Indirect Method.
You can subscribe to the channel so you don't miss out!
So the Direct Method… Under the Direct Method…
The Cash Flow from Operating Activities is laid out just like a
Cash Basis Income Statement. Under the Cash Basis of Accounting,
revenue is recognised when cash is received,
and expenses are recorded when cash is paid out.
When you work out your Operating Profit under this method,
it should match your Cash Flow from Operating Activities.
Let's check back on the Chudley Cannons…
This Cash Flow Statement has been prepared under the Direct Method.
So under Operating Activities, we first have cash receipts
from customers of two hundred and twenty eight thousand dollars.
The Cannons are sport team, so I would assume that the majority
of these earnings would come from ticket sales and the
sale of merchandise. This $228k of cash in
would match their revenue for the same period if
they were Cash Accounting. But we can see that their
Income Statement and Balance Sheet have been prepared under
the Accrual Basis. We know this because
their Income Statement shows depreciation which is a
non-cash transaction. So it wouldn't show up in an
Income Statement prepared under the Cash Basis.
Their Balance Sheet also contains inventory, receivables and payables,
none of which would appear in a Cash Basis Balance Sheet.
So we've covered cash receipts but the next four lines under
the Cash Flow from Operating Activities all relate to cash paid out.
Cash paid out to suppliers, employees, interest paid
and income taxes paid. When you compare this to
the Income Statement, you can see that each line relates
to one of the expense types. Cash paid to suppliers relates to
cost of sales, cash paid to employees relates to
the salaries expense, interest paid relates to the
interest expense and income taxes paid
relates to the income tax expense. There is no depreciation in
this Cash Flow Statement because depreciation is a
non-cash transaction. So that's the three sections
of the Cash Flow Statement and when we subtotal these we get
$70k of Cash in from Operating Activities,
$55k of Cash out through Investing Activities,
and finally… $20k of Cash in from
Financing Activities. If we add all these together
we get a net increase in Cash of $35,000,
which reconciles back to the movement of the cash balance
in the Balance Sheet. A closing balance of $185k,
less the opening balance of $150k is also $35,000.
That's the Statement of Cash Flows
prepared under the Direct Method.
It's a really handy report for investors to read over because you can
easily identify where cash flowed in and where it
flowed out. We can see that $76k was
given out to suppliers which was our biggest cash outflow.
It's intuitive so it’s the preferred method of producing a
Cash Flow Statement. However, at the start I said that
many people go for the Indirect Method instead…
Now why is that? The thing is the
Cash Flow from Operating Activities can be tough to work out
using the Direct Method. Particularly for large companies using
the Accrual Basis of Accounting. It can be costly and time-consuming
to go through all the information you need to put it together.
The Indirect Method is an easier alternative.
Which is why most corporations favour it,
even though it's harder for investors to understand.
Both methods are allowed under GAAP and IFRS
and although the Direct Method is preferred,
most companies opt for the Indirect Method instead.
How did you guys find that? The Cash Flow Statement
can be a hard nut to crack, but I think we packed a lot in there.
I think this topic is deserving of two more videos,
which I'll put up shortly. In the next one we'll get
our hands dirty as we reproduce this Cash Flow Statement
with the Direct Method, from scratch,
using only the Income Statement,
the Balance Sheet and the help of some T Accounts.
If you want to fully understand this topic then I highly recommend
you check that one out because seeing everything
getting pieced together will make things much clearer.
Thanks for watching! If you found this video useful,
give it a like, share it,
comment, subscribe if you haven't already.
I put out new videos every Monday here on Accounting Stuff
see you in the next one!
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