6. Classifying Cash Flows

Classifying Cash Flows

Presented by S. Levkoff, PhD, CAP® from UC San Diego's Department of Economics & Rady School of ManagementIntroduction to Bill’s Internet Security ServicesDate: December 1st, 2017

Cash Inflows:

  • Receives $50,000 cash from issuing common stock, which provides funds to support the company's operations and growth.

  • Borrows $80,000 from the bank to buy $100,000 in hardware, demonstrating leveraging external financing to invest in essential technology.

Hardware Investment:

  • Hardware is expected to be used for 48 months and has a $4,000 salvage value. This reflects a strategic investment in assets that are crucial for service delivery.

Cash Outflows:

  • Pays $12,000 in cash upfront to rent office space for one year, securing a physical location necessary for operational activities.

  • Service Operations:

    • Performs services for two clients, expecting a $40,000 cash inflow within 30 days, indicating a growth in customer base and revenue.

    • Pays employees $10,000 in wages, an essential cost to ensure personnel are compensated for their work, fostering morale and productivity.

Expectation:

  • The bank requires financial statements by December 31st, 2017, indicating the importance of maintaining financial transparency and responsibility to secure ongoing funding.

Financial Inquiry

Key Question: Did Bill "make money" during December?

Cash Flow Summary

Cash Inflows:

  • Stock Sale: $50,000

  • Bank Loan: $80,000

Cash Outflows:

  • Hardware Investment: ($100,000)

  • Rent Payment: ($12,000)

  • Wages Paid: ($10,000)

Total Cash Flow Calculation:

  • Total Cash Inflow: $50,000 + $80,000 = $130,000

  • Total Cash Outflow: ($100,000 + $12,000 + $10,000) = ($122,000)

  • Net Cash Inflow for December: $8,000

Organized Cash Flow Categories

Classification of Cash Flows:

  • Operating Activities:

    • Cash outflows: Rent ($12,000) + Wages ($10,000)

    • Total Cash Flows from Operations: ($22,000)

  • Investing Activities:

    • Cash outflow for Hardware: ($100,000)

  • Financing Activities:

    • Cash inflows from Stock ($50,000) + Bank ($80,000)

    • Total Cash Flows from Financing: $130,000

Net Overview:

  • Net Cash Inflow for December is $8,000, suggesting a healthy cash position despite significant investments.

Income Perspective

  • Revenue recognized even before cash collection due to accrual accounting practices, allowing for a better matching of revenues and expenses.

Expense Calculation Method:

  • Hardware Expense = (Cost - Salvage Value) / Useful Life

  • Rent Expense = Annual Rent / 12

Accounting Income (December):

  • Revenue: $40,000

  • Expenses:

    • Hardware: ($2,000)

    • Rent: ($1,000)

    • Wages: ($10,000)

  • Net Income: $27,000, indicating profitability on an accrual basis.

Financial Statements Overview

  • Importance of looking at all three key financial statements for a comprehensive understanding of financial health:

    • Balance Sheet (December 31, 2017):

      • Assets:

        • Cash: $8,000

        • Accounts Receivable: $40,000

        • Prepaid Rent: $11,000

        • Hardware: $98,000

      • Liabilities & Stockholder's Equity:

        • Bank Debt: $80,000

        • Common Stock: $50,000

        • Retained Earnings: $27,000

      • Total: $157,000

      • Ensures the equation of Total Assets = Total Liabilities + Equity holds.

  • Statement of Cash Flows:

    • Purpose: Reports cash inflows and outflows from operating, investing, and financing activities over a specified period.

    • Structure Overview: Must disclose non-cash transactions at the bottom of the statement to ensure transparency, including cashless transactions and cash obligations like taxes or interest.

Operating Activities Overview

  • Cash Inflows: Collections from customers, receipts of dividends, interest earned.

  • Cash Outflows: Payments to suppliers, employees, tax obligations, and other business-related payments.

  • Operating Cash Summary: Represents cash flows directly tied to core business operations (goods/services).

Investing Activities Overview

  • Cash Inflows: Sale of property, businesses, or investments.

  • Cash Outflows: Purchase of long-term assets that provide benefits beyond one year, integral for expansion or maintaining operational capacity.

  • Advisory: Ensure all transactions are appropriately classified in financial statements for accurate reporting.

Financing Activities Overview

  • Cash Inflows: Issuance of stock, loans taken from creditors, which help finance operations and development.

  • Cash Outflows: Payments of dividends and principal obligations.

  • Insight: Focus solely on owners' and creditors’ transactions, excluding interest payments to maintain clarity on financing activities.

Examples of Cash Flow Classifications

  • Example 1: Alice purchases inventory on account: No cash flow.

  • Example 2: Alice purchases inventory for cash: Classified under Operating Activities.

  • Example 3: Bill sells stock to raise capital: Classified as Financing Activity.

  • Example 4: Bill pays accountant: Classified under Operating Activities.

  • Example 5: Charlie purchases warehouse with cash: Classified under Investing Activities.

  • Example 6: Daniel trades land for warehouse: No cash flow but must be disclosed for full transparency.

Lifecycle Cash Flow Picture

  • Cash flows consolidated across lifecycle stages: Start-Up, Early Growth, Mature, Declining.

  • Operating Activities: Varying cash inflow/outflow at different lifecycle stages, impacting strategic planning and resource allocation.

  • Investing and Financing Activities: Track capital structure and operational capital management critical for sustainability and growth.

Conclusion

  • Understanding the classification and flow of cash is crucial for evaluating a business’s financial health.

  • Monitoring cash flows from operating, investing, and financing activities paints a complete picture of financial operations, essential for stakeholders' decision-making.