Analyzing a Statement of Cash Flows: How it’s Organized and What May be Changing

When borrowers need to restate financial results, cash flow reporting is frequently the culprit. The statement of cash flows is arguably the most misunderstood and underappreciated part of companies’ annual reports — but it can also provide valuable insight to lenders who understand its uses and potential weaknesses. Here’s an overview of how this statement is organized and what the Financial Accounting Standards Board (FASB) is doing to make it more user-friendly.

Organizing cash flows

The statement of cash flows customarily shows the sources and uses of cash and its equivalents. Under Generally Accepted Accounting Principles (GAAP), it’s typically organized into three sections:

1. Cash flows from operations. This section 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, depreciation and amortization, income taxes and net changes in accounts receivable, inventory, prepaid assets, accrued expenses and payables. This end result is cash-basis net income, which is the cash provided (or used) in the process of producing and delivering goods or providing services. Beware of borrowers with several successive years of negative operating cash flows.
2. 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 borrower is reinvesting in its future operations — or divesting assets for emergency funds.
3. Cash flows from financing activities. This third section shows the company’s ability to obtain cash via either debt from lenders or equity from investors. It includes new loan proceeds, principal repayments, dividends paid, issuances of securities or bonds, and additional capital contributions by owners.

Capital leases and 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 borrower purchases equipment directly using loan proceeds, the transaction would typically appear at the bottom of the statement, rather than as a cash outflow from investing activities and an inflow from financing activities.

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.

Making cash flows clearer  

Guidance on this topic is provided by Statement of Financial Accounting Standards No. 95, Statement of Cash Flows (Topic 230). Although this statement was issued in 1987, classification among operating, investing, and financing activities remains a gray area.

Managers are 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. External accounting advisors can provide guidance when borrowers are uncertain.

To make matters worse, in-house accounting personnel tend to treat the statement of cash flows as an afterthought, often waiting until late in the reporting cycle to prepare it. This lack of attention makes the statement prone to simple mathematical errors that may require restatement.

Currently, FASB is trying to reduce some of the inconsistencies that are often found in cash flow reporting. Additionally, it’s trying to determine if it should add some disclosure requirements to make the statement more relevant. The cash flow project is in the initial deliberations stage while FASB gathers feedback from companies and auditors.

Drawing more attention

The statement of cash flows has received increasing attention from lenders and other stakeholders in recent years, in part because of a disproportionate number of restatements that have to do with reporting cash flows. When you review a borrower’s financial statements, it’s important to analyze the statement of cash flows — and understand where potential missteps are likely to take place. In some cases, restatements, adjustments or clearer disclosures may be needed to obtain more meaningful information about a borrower’s cash flows.

Have questions about analyzing a statement of cash flows? Or, are you looking for more information on our commercial lender services? Contact Paul Atkinson at 404-874-6244 or fill out our form for more information.