Classifying Cash Flows into Three Categories

August 2005

This month we continue our discussion of the cash flow statement. Last month we likened the cash flow statement to your bank account statement. It tells you what you actually have—not what might come in and might go out, as is accounted for on the income statement.

What the cash flow statement does that your bank statement doesn’t do is categorize the amounts that you collected and the amounts that you paid. Your bank account statement only lists the check numbers and deposit dates; it doesn’t tell you what all of those inflows and outflows were for.

Both the direct and indirect methods divide cash flows into three categories:

• Operations
• Financing
• Investing

Let’s talk about each of these in turn.

Operating Activities

The operations section gives us an idea of how much cash the organization generated in its day-to-day delivery of its products and services. This number can and should be compared with the operating income on the income statement. If operating income and operating cash flow are vastly different, you need to start asking some tough questions. It might mean that the organization is recording sales that will never be collected in cash. Ooh...

Cash inflows from operating activities include:

• Cash receipts for the sale of goods or services
• Cash receipts for the collection or sale of operating receivables (receivables arising from the sale of goods or services)
• Cash interest received
• Cash dividends received
• Other cash receipts not directly identified with financing or investing activities

Cash outflows for operating activities include:

• Cash payments for trade goods purchased for resale or use in manufacturing
• Cash payments for notes to suppliers or trade goods
• Cash payments to other suppliers and to employees
• Cash paid for taxes, fees, and fines
• Interest paid to creditors
• Other cash payments not directly identified with financing or investing activities

Financing Activities

The financing category tells us how much cash was generated by debt or equity financing. Put another way, the financing section details the cash flows between the organization and the folks who help finance the organization through debt and equity.

An interesting twist here is that interest used to repay debt is not included in the financing category; it is included in the operating category. Somewhere along the way I have probably told you that accounting is just a set of rules about how to keep records. Not everything is intuitive or sensible. You are just going to have to accept this one and move on!

• Cash inflows from financing activities include:
• Cash proceeds from the sale of stock
• Cash receipts from borrowing

Cash receipts from contributions and investment income that donors restricted for endowments or for buying, improving, or constructing long-term assets

• Cash outflows from financing activities include:
• Cash disbursed to repay principal on long and short-term debt
• Cash paid to reacquire common and preferred equity instruments
• Dividends paid to common and preferred stockholders

Investing Activities

The last category is investing. And, as you might expect, this section of the cash flow statement details how much cash the entity made and used in making investments in other entities, such as the purchase of stocks or bonds of another entity. What you may not expect is that this category includes the purchase and sale of productive assets, such as manufacturing equipment. This is, per the profession’s view, an investment in the company’s future and should not be classified under either operations or financing.

Cash inflows from investing activities are:

• Collections of principal on debt instruments of other entities
• Cash proceeds from the sale of equity investments
• Cash received from the sale of productive assets

Cash outflows from investing activities are:

• Cash paid to acquire debt instruments of other entities
• Cash payments to buy equity interest in other entities
• Disbursements made to purchase productive assets