The statement of cash flows presents sources and uses of cash in three distinct categories: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Financial statement users are able to assess a company’s strategy and ability to generate a profit and stay in business by assessing how much a company relies on operating, investing, and financing activities to produce its cash flows.
Classification of Cash Flows Makes a Difference
Assume you are the chief financial officer of T-Shirt Pros, a small business that makes custom-printed T-shirts. While reviewing the financial statements that were prepared by company accountants, you discover an error. During this period, the company had purchased a warehouse building, in exchange for a $200,000 note payable. The company’s policy is to report noncash investing and financing activities in a separate statement, after the presentation of the statement of cash flows. This noncash investing and financing transaction was inadvertently included in both the financing section as a source of cash, and the investing section as a use of cash.
T-Shirt Pros’ statement of cash flows, as it was prepared by the company accountants, reported the following for the period, and had no other capital expenditure.
Because of the misplacement of the transaction, the calculation of free cash flow by outside analysts could be affected significantly. Free cash flow is calculated as cash flow from operating activities, reduced by capital expenditures, the value for which is normally obtained from the investing section of the statement of cash flows. As their manager, would you treat the accountants’ error as a harmless misclassification, or as a major blunder on their part? Explain.
Cash Flows from Operating Activities
Cash flows from operating activities arise from the activities a business uses to produce net income. For example, operating cash flows include cash sources from sales and cash used to purchase inventory and to pay for operating expenses such as salaries and utilities. Operating cash flows also include cash flows from interest and dividend revenue interest expense, and income tax.
Cash Flows from Investing Activities
Cash flows from investing activities are cash business transactions related to a business’ investments in long-term assets. They can usually be identified from changes in the Fixed Assets section of the long-term assets section of the balance sheet. Some examples of investing cash flows are payments for the purchase of land, buildings, equipment, and other investment assets and cash receipts from the sale of land, buildings, equipment, and other investment assets.
Cash Flows from Financing Activities
Cash flows from financing activities are cash transactions related to the business
raising money from debt or stock, or repaying that debt. They can be identified
from changes in long-term liabilities and equity. Examples of financing cash flows
include cash proceeds from issuance of debt instruments such as notes or bonds
payable, cash proceeds from issuance of capital stock, cash payments for dividend
distributions, principal repayment or redemption of notes or bonds payable, or
purchase of treasury stock. Cash flows related to changes in equity can be
identified on the Statement of Stockholder’s Equity, and cash flows related to longterm liabilities can be identified by changes in long-term liabilities on the balance