An In-Depth Look at the Classification of Cash Flows in Business

Classification of Cash Flows

The statement of cash flows, sometimes referred to as the cash flow statement, is classified by activity to provide more detail to help users to assess the ability of a business to generate cash flow from a particular activity. 

Cash flow statements are prepared according to AS-3 (Revised) on CFS. The standard required CFS to be prepared showing cash flow under three heads namely –

1. Cash flow from Operating Activities – (Revenue producing Activities – Buying, Selling, Service Render)
2. Cash flow from Investing Activities – (Investment for Running the Business)
3. Cash flow from Financing Activities – (Fund arrange activities)

The identification and classification of cash flows into business activities is summarized in the illustration shown below.

Cash Flows from Operating Activities

Operating cash flow refers to cash inflows and outflows connected to business activities conducted by the company. It’s essentially a measure to see cash flow related to the business and its day-to-day operation.

Operating activities are the principal revenue producing activities (Buying, Selling, Service Render) of the enterprise and other activities that are not investing or financing activities example – Computer manufacturing, Trading Company, Financing Company etc. generally results from business transaction and events that determine net profit & loss.

Cash flow from operations are calculated using either the direct or indirect method.

1. Direct Method - The direct method of calculating cash flow from operating activities is a straightforward process that involves taking all the cash collections from operations and subtracting all the cash disbursements from operations. This approach lists all the transactions that resulted in cash paid or received during the reporting period. 
2. Indirect Method - The indirect method of calculating cash flow from operating activities requires you to start with net income from the income statement and make adjustments to “undo” the impact of the accruals made during the reporting period. Some of the most common and consistent adjustments include depreciation and amortization. It is comparatively easier to prepare the cash flow statement through indirect method. A lot of loan officers are required to prepare the cash flow statement through direct method and hence, it requires the compilation of additional operating activities.

Both the direct and indirect methods will result in the same number, but the process of calculating cash flow from operations differs. While the direct method is easier to understand, it’s more time-consuming because it requires accounting for every transaction that took place during the reporting period. Most companies prefer the indirect method because it's faster and closely linked to the balance sheet.

1. Non-Financial Companies – 
• Receipts from sales of goods and services 
• Receipts from royalties, fees and commission etc. 
• Receipts from debtors and bills receivable 
• Payment for purchase of goods and service 
• Payment of creditors & bills payables 
• Payment of wages, salaries, and other payments to employee 
• Payment of and refund of income tax unless there are identified with investing or financing activities. 
2. For Financial Companies – 
• Payment for purchase of securities 
• Payment of interest on loans 
• Receipts from sales of securities 
• Dividend Received on Securities 
• Interest Received on loan granted 
• Payment of salaries etc. to employee 
• Payment of and refund of income tax unless these are identified with investing or financing activities.

Cash flow from operating activities indicates the amount of money a company brings in from its ongoing, regular business activities, such as manufacturing and selling goods or providing a service to customers. It is the first section depicted on a company's cash flow statement.

Cash flow from operating activities does not include long-term capital expenditures or investment revenue and expense. CFO focuses only on the core business and is also known as operating cash flow (OCF) or net cash from operating activities.

Formula (short form):

• Operating Cash Flow = Net Income + Non-Cash Expenses – Increase in Working Capital

Formula (long form):

• Operating Cash Flow = Net Income + Depreciation + Stock Based Compensation + Deferred Tax + Other Non-Cash Items – Increase in Accounts Receivable – Increase in Inventory + Increase in Accounts Payable + Increase in Accrued Expenses + Increase in Deferred Revenue

Key takeaways of Cash flow of operating Activities

Cash flow from operating activities is an important benchmark to determine the financial success of a company's core business activities.

1. Cash flow from operating activities is the first section depicted on a cash flow statement, which also includes cash from investing and financing activities.
2. There are two methods for depicting cash from operating activities on a cash flow statement: the indirect method and the direct method.
3. The indirect method begins with net income from the income statement then adds back noncash items to arrive at a cash basis figure.
4. The direct method tracks all transactions in a period on a cash basis and uses actual cash inflows and outflows on the cash flow statement.

Cash flow from Investing Activities 

After calculating cash flows from operating activities, you need to calculate cash flows from investing activities. This section of the cash flow statement details cash flows related to the buying and selling of long-term assets like property, facilities, and equipment. Keep in mind that this section only includes investing activities involving free cash, not debt.

• Activities are the acquisition and disposal of long-term Assets and other investment not included in cash equivalent. 
• These activities include transaction involving purchase and sale of long-term assets, which are not held for resale such as machinery, land & building, investment etc. 

Example of Cash Flow Investing Activities 

• Payment for purchase of fixed assets (including intangible assets) and also payment for capitalized research and development costs and self-constructed fixed assets (including intangible assets) 
• Payment to purchase (acquires) shares, warrant or debt instruments of other enterprise (In the case of non-financial companies) 
• Receipts from sales (disposal) of shares warrants or debts instruments of others enterprise (In the case of non-financial companies) 
• Advance and loan made to third parties (other than advance and loan made by a financial enterprise) 
• Receipts from repayment of advance and loan made to third parties (Other than advance and loan of financial enterprise)

Cash flow from investing activities (CFI) is one of the sections on the cash flow statement that reports how much cash has been generated or spent from various investment-related activities in a specific period. Investing activities include purchases of physical assets, investments in securities, or the sale of securities or assets. 

Negative cash flow is often indicative of a company's poor performance. However, negative cash flow from investing activities might be due to significant amounts of cash being invested in the long-term health of the company, such as research and development.

Key Takeaway’s for Investing Activities

1. Cash flow from investing activities is a section of the cash flow statement that shows the cash generated or spent relating to investment activities.
2. Investing activities include purchases of physical assets, investments in securities, or the sale of securities or assets.
3. Negative cash flow from investing activities might not be a bad sign if management is investing in the long-term health of the company.

Cash flow from Financing Activities 

The third section of the cash flow statement examines cash inflows and outflows related to financing activities. This includes cash flows from both debt and equity financing—cash flows associated with raising cash and paying back debts to investors and creditors.

When using GAAP, this section also includes dividends paid, which may be included in the operating section when using IFRS standards. Interest paid is included in the operating section under GAAP, but sometimes in the financing section under IFRS as well.

Cash flows from financing activities have the transactions related to equity financing and borrowings. It provides a change in cash as a result of obtaining and repayment of loans, buyback of shares, and paying dividend.

Are the activities which result in change in size and composition of owner capital (including preference share capital in case of company) and borrowing of the enterprise from other source. 

Example of cash flow from Financing Activities 

1. Proceeds from the issue of shares on other similar instruments. 
2. Proceeds from the issue of debenture loan bonds and other short-term borrowing 
3. Payment for buy back of equity shares 
4. Repayment of the amount borrowed including redemption of debenture 
5. Payment of dividend both on equity and preference shares 
6. Payment for interest on debenture and loans 
7. Change in bank overdraft and cash credit. 

Cash flow from financing activities (CFF) is a section of a company’s cash flow statement, which shows the net flows of cash that are used to fund the company. Financing activities include transactions involving debt, equity, and dividends. 

Cash flow from financing activities provides investors with insight into a company’s financial strength and how well a company's capital structure is managed. 

Formula and Calculation for CFF

Investors and analyst will use the following formula and calculation to determine if a business is on sound financial footing.

CFF = CED − (CD + RP)

Where:

1. CED = Cash inflows from issuing equity or debt
2. CD = Cash paid as dividends
3. RP = Repurchase of debt and equity

As an example, let's say a company has the following information in the financing activities section of its cash flow statement:

• Repurchase stock: $1,000,000 (cash outflow)
• Proceeds from long-term debt: $3,000,000 (cash inflow)
• Payments to long-term debt: $500,000 (cash outflow)
• Payments of dividends: $400,000 (cash outflow)

Thus, CFF would be as follows: $3,000,000 - ($1,000,000 + $500,000 + $400,000), or $1,100,000

Positive and Negative CFF 

Debt and equity financing are reflected in the cash flow from financing section, which varies with the different capital structures, dividend policies, or debt terms that companies may have. 

Transactions That Cause Positive Cash Flow from Financing Activities 

1. Issuing equity or stock, which is sold to investors 
2. Borrowing debt from a creditor or bank 
3. Issuing bonds, which is debt that investors purchase 

A positive number for cash flow from financing activities means more money is flowing into the company than flowing out, which increases the company’s assets. 

Transactions That Cause Negative Cash Flow from Financing Activities 

1. Stock repurchases 
2. Dividends 
3. Paying down debt 

Negative CFF numbers can mean the company is servicing debt but can also mean the company is retiring debt or making dividend payments and stock repurchases, which investors might be glad to see. 

Transaction not regarded as Cash Flow 

1. The movement in between the items of cash and cash equivalent are not cash flow , For example – cash deposited into bank is not cash flow because cash in hand is reduced on deposit into bank balance is increased. 
2. Both cash and Cash bank are items of Items of cash and cash equivalent. Example – cash withdrawn from Bank. 

Non-Cash Transaction 

Are those transactions in which flow (inflow /outflow) of cash and cash equivalent does not take place? 

Example – 

1. Depreciation and amortization expense 
2. Issue of equity share on debenture for consideration other than cash (for purchase of assets) 
3. Conversion of debenture into new debenture or shares. 
4. Non cash transactions are not considered which preparing Cash flow statement (CFS).

Key Takeaways of Financing Activities (CFF)

1. Cash flow from financing activities is a section of a company’s cash flow statement, which shows the net flows of cash that are used to fund the company.
2. Financing activities include transactions involving debt, equity, and dividends.
3. Debt and equity financing are reflected in the cash flow from financing section, which varies with the different capital structures, dividend policies, or debt terms that companies may have.

Cash Flow Statement Format

Cash flow statement format (direct method)

In the direct method, the cash flows from operating activities are to be prepared as under:

Cash Flow Statement XYZ Ltd for the year ended xxx
Particulars	Details	Amount
Cash flow from operating activities
Cash Sales
Cash receipts from debtors
Less: Cash Purchase
Cash paid to creditors and other expenses
Cash generated from operating activities
Less: Income tax paid
Cash flow before extra-ordinary items
Add/Less: extraordinary items
Net cash flow from operating activities

Format of cash flow statement (indirect method)

Cash Flow Statement XYZ Ltd for the year ended xxx
Particulars	Details	Amount
A. Cash flow from operating activities
Net profit before tax
Adjustment for non-cash and non-operating items
Add: Depreciation
Preliminary expenses/ discount on issue of debenture w-off
Goodwill, patents, and trademarks amortized
Interest paid on short term and long-term borrowings
Interest paid on bank overdraft
Loss on sale of fixed assets
Increase in provision of doubtful debts
Less: Interest income
Dividend income
Rental Income
(Gain) Profit on sale of fixed assets
Decrease in provision for doubtful debts
Operating profit before working capital changes
Add: decrease in current assets
Increase in current liabilities
Less: Increase in current assets
Decrease in current liabilities
Cash generated from operation
B. Cash flow from investing activities:
Proceeds from sale of tangible fixed assets
Proceeds from sale of intangible fixed assets like goodwill
Proceeds from sale of non-current investment
Interest and dividend received
Rent received
Less: Purchase of tangible fixed assets
Purchase of intangible fixed assets like goodwill
Purchase of non-current investments
Net Cash from investing activities
C. Cash flow from financing activities:
Proceeds from issue of share and debentures
Proceeds from other long-term borrowings
Proceeds from short term borrowing
Less: Decrease in bank overdraft balance
Payment of interim dividend
Payment of proposed dividend of previous year
interest paid on short term and long-term borrowing
Interest Paid on Bank Overdraft
Repayments of loans
Redemption of debenture / preference shares
Net cash flow from financing activities:
Net increase in cash and cash equivalent (A+B+C)
Add: cash and cash equivalent at the beginning
Cash and cash equivalent at the end of the year

Benefits of Cash Flow Forecasts 

1. Cash Flow Statements can be used to predict the future cash flow of companies. This statement reflects the financial health of a company. 
2. A cash flow statement tells you if you’re running out of money even when you’re profitable. You can also see how your bank loan payments are affecting your cash. Thus, it very important for a company to prepare and review Cash Flow Statements. 
3. Cash Flow Statements help to the actual cash position which cannot be derived from the P&L statement. Thus, being aware of the cash liquidity, you can arrange for any cash shortfalls. Or you can use the excess cash for growth purposes. 
4. Furthermore, it enables the management to plan and control the financial operations properly. You can measure the profitability and financial position by doing cash flow analysis along with ratio analysis. Moreover, it is a great tool for internal financial management. 

Limitations of Cash Flow Forecasts 

1. The cash flow cannot project the profits as it shows only the cash position of a company. 
2. Moreover, for any cash flow projections, we need to use the Balance Sheet as well as the P&L statement. 
3. The cash flow statement displays actual cash activities. Hence, it cannot be used as a substitute for the P&L account. 
4. By making some adjustments in purchases and other payments, the cash position can be manipulated. Thus, sometimes the cash flow statement doesn’t display the real liquidity position.

FAQ's

What is Cash Flow in the Financial Statement?

The cash flow statement is one of the three main financial statements that show the state of a company's financial health. The other two important statements are the balance sheet and income statement. The balance sheet shows the assets and liabilities as well as shareholder equity at a particular date. Also known as the profit and loss statement, the income statement focuses on business income and expenses. The cash flow statement measures the cash generated or used by a company during a given period.

The three sections of cash flow statement?

Cash flow from operating (CFO) indicates the amount of cash that a company brings in from its regular business activities or operations. This section includes accounts receivable, accounts payable, amortization, depreciation, and other items. 

Cash flow from investing (CFI) reflects a company's purchases and sales of capital assets. CFI reports the aggregate change in the business cash position as a result of profits and losses from investments in items like plant and equipment. These items are considered long-term investments in the business. 

Cash flow from financing activities (CFF) measures the movement of cash between a firm and its owners, investors, and creditors. This report shows the net flow of funds used to run the company including debt, equity, and dividends.

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