Principles of Financial Accounting: Statement of Cash Flows - Analysis of Cash, Flows Free Cash Flow Cash Flow Ratios

What It Is

Analysis of cash flows is a crucial aspect of financial accounting that helps investors and creditors understand a company's ability to generate cash and meet its financial obligations. It involves analyzing a company's inflows and outflows of cash to determine its free cash flow and cash flow ratios. For example, if a company buys $10,000 of inventory and pays $5,000 in cash, its cash outflow for inventory is $5,000.

Key Concepts & Formulas

• Free Cash Flow (FCF): The cash generated by a company's operations after deducting capital expenditures. FCF = Net Income + Depreciation - Capital Expenditures Example: A company has net income of $100,000, depreciation of $20,000, and capital expenditures of $30,000. Its FCF is $90,000 ($100,000 + $20,000 - $30,000).
• Cash Flow from Operations (CFO): The cash generated by a company's operations, including cash received from customers and cash paid to suppliers. CFO = Net Income + Depreciation + Amortization - Changes in Working Capital Example: A company has net income of $100,000, depreciation of $20,000, and amortization of $10,000. Its CFO is $130,000 ($100,000 + $20,000 + $10,000).
• Cash Flow from Investing (CFI): The cash generated by a company's investments, including cash received from the sale of assets and cash paid for new investments. CFI = Cash Received from Sale of Assets - Cash Paid for New Investments Example: A company sells an asset for $50,000 and pays $30,000 for a new investment. Its CFI is $20,000 ($50,000 - $30,000).
• Cash Flow from Financing (CFF): The cash generated by a company's financing activities, including cash received from borrowing and cash paid for debt repayment. CFF = Cash Received from Borrowing - Cash Paid for Debt Repayment Example: A company borrows $100,000 and pays $50,000 for debt repayment. Its CFF is $50,000 ($100,000 - $50,000).
• Cash Flow Ratio: A ratio that measures a company's ability to generate cash from its operations. Common cash flow ratios include the cash flow to debt ratio and the cash flow to equity ratio.
• Cash Flow to Debt Ratio: A ratio that measures a company's ability to generate cash from its operations relative to its debt. Cash Flow to Debt Ratio = CFO / Total Debt Example: A company has CFO of $100,000 and total debt of $500,000. Its cash flow to debt ratio is 0.20 ($100,000 / $500,000).
• Cash Flow to Equity Ratio: A ratio that measures a company's ability to generate cash from its operations relative to its equity. Cash Flow to Equity Ratio = CFO / Total Equity Example: A company has CFO of $100,000 and total equity of $500,000. Its cash flow to equity ratio is 0.20 ($100,000 / $500,000).

Journal Entry Examples

1. Dr. Cash $5,000 Cr. Inventory $5,000 Explanation: This journal entry records the purchase of inventory for $5,000.
2. Dr. Accounts Payable $10,000 Cr. Cash $10,000 Explanation: This journal entry records the payment of accounts payable for $10,000.
3. Dr. Cash $20,000 Cr. Sales Revenue $20,000 Explanation: This journal entry records the collection of cash from customers for $20,000.

Common Mistakes

1. Mistake: Confusing debits and credits for expense accounts. Correction: Remember that debits increase assets, expenses, and losses, while credits increase liabilities, equity, and revenues.
2. Mistake: Not considering the impact of depreciation on cash flow. Correction: Depreciation is a non-cash expense that reduces net income but does not affect cash flow.
3. Mistake: Not analyzing the cash flow statement for trends and anomalies. Correction: Review the cash flow statement to identify trends and anomalies that may indicate financial distress or opportunities for improvement.

Exam Tips

1. Tip: Remember that cash flow is a function of net income, depreciation, and changes in working capital.
2. Tip: Be careful when analyzing the cash flow statement, as it may not always match the income statement.
3. Tip: Consider the impact of financing activities on cash flow, including borrowing and debt repayment.

Quick Practice

1. A company has net income of $100,000, depreciation of $20,000, and capital expenditures of $30,000. What is its free cash flow? Answer: $90,000 ($100,000 + $20,000 - $30,000) Explanation: This question requires the application of the free cash flow formula.
2. A company has cash received from customers of $50,000 and cash paid to suppliers of $30,000. What is its cash flow from operations? Answer: $20,000 ($50,000 - $30,000) Explanation: This question requires the application of the cash flow from operations formula.
3. A company has cash received from the sale of assets of $50,000 and cash paid for new investments of $30,000. What is its cash flow from investing? Answer: $20,000 ($50,000 - $30,000) Explanation: This question requires the application of the cash flow from investing formula.

Last-Minute Cram Sheet

1. Cash Flow Statement: A statement that summarizes a company's inflows and outflows of cash.
2. Free Cash Flow: The cash generated by a company's operations after deducting capital expenditures.
3. Cash Flow to Debt Ratio: A ratio that measures a company's ability to generate cash from its operations relative to its debt.
4. Cash Flow to Equity Ratio: A ratio that measures a company's ability to generate cash from its operations relative to its equity.
5. Depreciation: A non-cash expense that reduces net income but does not affect cash flow.
6. Dividends: Not an expense, but a distribution of cash to shareholders.
7. Cash Flow Statement: May not always match the income statement.
8. Financing Activities: Can have a significant impact on cash flow.
9. Working Capital: Can have a significant impact on cash flow.
10. Cash Flow Ratios: Can be used to evaluate a company's liquidity and solvency.