Tell apart cash flows from operating, investing and financing activities
The idea
The cash flow statement sorts movements in cash into three buckets. Operating covers the cash effects of the transactions that produce net income; investing covers the purchase and sale of long-term assets; financing covers dealings with providers of capital — borrowing, repayment, share issues and dividends. The indirect method starts from net income and reverses out non-cash charges and working capital movements, which is why depreciation is added back without any cash having moved. The statement's value is that cash is far harder to manage than earnings: profit is an opinion about timing, and cash is a fact.
A practice question
Cash paid to buy new equipment is classified as:
- an investing outflow — correct
- an operating outflowWhy not: Operating covers the cash effects of trading. Only the subsequent depreciation touches that section, and then merely as a non-cash add-back.
- a financing outflowWhy not: Financing covers dealings with the providers of capital. The supplier of a machine is not one of them.
Buying or selling long-lived assets is the definition of the investing section.
A harder one
Net income is $100, depreciation $30, and receivables rose by $20. Operating cash flow is:
- $150Why not: 100 + 30 + 20 — the rise in receivables added rather than subtracted. Revenue billed and not yet collected is cash the business does not have.
- $110 — correct
- $90Why not: 100 − 30 + 20, with both adjustments reversed. Depreciation is added back because no cash left; the receivables rise is deducted because cash did not arrive.
Add back the 30 non-cash charge and subtract the 20 of revenue billed but not yet collected.
The hardest tier
Free cash flow to the firm is most closely approximated by operating cash flow minus:
- dividends paidWhy not: Dividends are one of the things free cash flow is available *for*. Deducting them would answer what is left after the distribution, not what was available to make it.
- interest receivedWhy not: An inflow, not a deduction, and one already inside operating cash flow under US GAAP.
- capital expenditure — correct
What remains after keeping the asset base intact is what is genuinely available to providers of capital.
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