to give a complete picture of the financial condition of a business.
Liabilities are also sources of assets. For example, cash increases when a business borrows money. Inventory increases when a business buys products on credit and incurs a liability that will be paid later. Also, typically a business has liabilities for unpaid expenses and has not yet used cash to pay these liabilities. Another reason for reporting liabilities in the balance sheet is to account for the sources of the company’s assets, to answer the question: Where did the company’s total assets come from?
Some part of the total assets of a business comes not from liabilities but from its owners investing capital in the business and from retaining some or all of the profit the business earns that is not distributed to its owners. In this example the business is organized legally as a corporation. Its stockholders’ equity accounts in the balance sheet reveal the sources of the company’s total assets in excess of its total liabilities. Notice in Exhibit 2.2 the two stockholders’ (owners’) equity sources, which are called capital stock and retained earnings.
When owners (stockholders of a business corporation) invest capital in the business, the capital stock account is increased. Net income earned by a business less the amount distributed to owners increases the retained earnings account. The nature of retained earnings can be confusing; therefore, we explain this account in depth at the appropriate places in the book. Just a quick word of advice here: Retained earnings is not—we repeat, not—an asset. Get such a notion out of your head.
3 REPORTING CASH FLOWS
Statement of Cash Flows
Chapter 2 introduces the two hardcore financial statements that are included in the financial report of a business, the income statement (Exhibit 2.1) and the balance sheet (Exhibit 2.2). Both of these provide a comprehensive summary of the financial performance and financial condition of the business; however, this is not the end of the story. Financial reporting standards require that a statement of cash flows also be presented for the same time period as the income statement.
This third financial statement, as its title implies, focuses on the cash flows of the period. The cash flow statement is not more important than the income statement and balance sheet. Rather, it discloses additional information that supplements the income statement and balance sheet.
Exhibit 3.1 presents the statement of cash flows for our business example. This financial statement has three parts, or layers: 1) cash flows from operating activities, 2) cash flows from investing activities, and 3) cash flows from financing activities. Operating activities relate to the profit-making activities of the business. Of course, a business may suffer a loss instead of making profit. On a statement of cash flows, the term “operating activities” refers to revenue and expenses (as well as gains and losses) during the period that culminate in the bottom-line net income or loss for the period.
EXHIBIT 3.1 STATEMENT OF CASH FLOWS FOR YEAR
| Dollar Amounts in Thousands | ||
| Cash Flow from Operating Activities | ||
| Net Income (from Income Statement) | $ 2,642) | |
| Accounts Receivable Increase) | (320) | |
| Inventory Increase) | (935) | |
| Prepaid Expenses Increase) | (275) | |
| Depreciation Expense) | 785) | |
| Accounts Payable Increase) | 645) | |
| Accrued Expenses Payable Increase) | 480) | |
| Income Tax Payable Increase) | 83) | $ 3,105) |
| Cash Flow from Investing Activities) | ||
| Expenditures for Property, Plant, and Equipment) | $ (3,050) | |
| Expenditures for Intangible Assets) | (575) | (3,625) |
| Cash Flow from Financing Activities) | ||
| Increase in Short-Term Debt) | $ 125) | |
| Increase in Long-Term Debt) | 500) | |
| Issuance of Additional Capital Stock Shares) | 175) | |
| Distribution of Cash Dividends from Profit) | (750) | 50) |
| Decrease in Cash During Year) | $0(470) | |
| Cash Balance at Start of Year) | 3,735) | |
| Cash Balance at End of Year) | $ 3,265) | |
The income statement of our business example (Exhibit 2.1) divulges 10 lines of information and its balance sheet has 21 lines. So, already you have 31 items of information, which take time to read. The statement of cash flows adds another 20 lines of information to read. Is this financial statement worth the additional time it takes to read it? What’s the payoff?
For many financial report readers, the main value of the statement of cash flows is that it discloses the cash flow from operating activities. They zero in on this number, and may not read any other line of information in the financial statement. This key metric is commonly called cash flow from profit. In its income statement for the year (Exhibit 2.1), the company reports that it earned $2,642,000 net income, or bottom-line profit. In its statement of cash flows for the year (Exhibit 3.1) the
