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Wednesday, March, 31, 2010

Financial report in which companies classify cash receipts and payments as having stemmed from operating, investing or financing activities.

Another earnings season has come and gone, just in time to start the next one. Or as PMBA likes to put it, every season is earnings season. By this time of the quarter, most companies have reported their recent results and produced financial statements. In looking at financial statements, and in particular the statement of cash flows, it struck Pocket MBA how much they look like the scribbling that Pocket MBA does when trying to determine what purchases it can make in the coming months. For instance, Pocket MBA was thinking of buying a condo, and to see if it was affordable, started to write down a list of monthly inflows and outflows of cash, potential gains from investment portfolios and recurring debt. Roughly speaking, these correspond to a company's statement of cash flows. Company statements of cash flow are that easy; it's all about how much excess cash (or not) you have at the end of whatever period you're dealing with. Back in Volume 1, No. 18, PMBA addressed the concept of free cash flow and its importance in determining a company's true liquidity. It is the statement of cash flows from whence a determination of free cash emanates.

The statement of cash flows is a relatively new creature of the accounting world, having been born of FASB's implementation of SFAS 95 in 1987 and today resides in FASB Accounting Standards Codification Topic 230 (ASC 230). Until 1987, Accounting Principals Board (APB) Opinion 19 reigned over the ledgers and required that companies report only changes in financial position. APB permitted, but did not require, companies to report cash flow information. In mandating official statements of cash flow, FASB's intent was to require companies "to provide relevant information about the cash receipts and cash payments of an enterprise during a period," ASC 230-10-10-1, to enable investors, creditors and others to better assess

The enterprise's ability to generate positive future net cash flows
The enterprise's ability to meet its obligation, its ability to pay dividends, and its needs for external financing
The reasons for differences between net income and associated cash receipts and payments
The effects on an enterprise's financial position of both its cash and non-cash investing and financing transactions during the period.

See ASC 230-10-10-2. The bottom line is that whereas a company's balance sheet gives you "the bottom line" at a point in time (the end of the period) and an income statement includes all manner of non-cash esoterica that can exasperate a non-expert, a statement of cash flows includes only inflows and outflows of cash (something anyone can understand) over the entire period. It is derived from the income statement and its bottom-line numbers are reflected in the annual increase or decrease of the cash and cash equivalents portion of the company's balance sheet. In fact, the periodic change in cash and cash equivalents is what the statement of cash flows is all about. See ASC 230-10-45-4. When the number is positive, that's free cash flow.

A statement of cash flows is reported in three sections:

Cash flows from operating activities - this includes how much money a company's actual business generated in a period
Cash flows from investing activities - this shows the money a company earned or lost investing cash in various instruments or in buying and selling subsidiaries, plant and equipment
Cash flows from financing activities - this is where the company records activity related to its issuance of stocks and bonds, including dividends paid out and stock buybacks

If you think back to PMBA's scribbling, or your own for that matter, you will recognize all of these sections from your own budgetary process. That's why the statement of cash flows is not just useful, but easy to read. Everyone does something like it in their everyday existence. And that's the kind of accounting term Pocket MBA likes the most.

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