AP Business with Personal Finance · Lesson 3

Cash flow and honest reporting

Know Know it

The cash flow statement shows where cash came from and where it went during a period. It has three sections.

Operating activities: cash from running the business, such as cash collected from customers and cash paid to suppliers, workers, landlords and tax authorities. Investing activities: cash spent on or received from long-term assets, such as buying equipment or selling an old truck. Financing activities: cash from or to lenders and owners, such as a new loan, repaying loan principal, owners putting money in, or paying money out to owners.

The three sections add up to the net change in cash, and beginning cash + net change in cash = ending cash, the cash figure on the balance sheet.

Profit and cash are not the same. Under accrual accounting, the method behind these statements, revenue counts when a sale is earned, even if the customer pays later. Depreciation is an expense that uses no cash in the year it is recorded. Repaying the principal of a loan uses cash but is not an expense. That is why a profitable business can run short of cash, and why lenders read the cash flow statement next to the income statement.

Owners, lenders, investors and tax authorities make decisions from financial statements, so the statements must be honest. U.S. companies that sell stock to the public must follow generally accepted accounting principles (GAAP), a shared set of rules for recording and reporting, and many other businesses use them too. Misleading reporting includes leaving debts off the balance sheet, counting more inventory than the business really has, and inventing sales that never happened.

Three safeguards help. Internal controls are a business's own rules and checks, so that no one person handles a whole money task alone. An independent audit is a review in which outside accountants test the records and give an opinion on whether the statements are presented fairly. And employees need safe ways to report wrongdoing. In the United States, the Sarbanes-Oxley Act of 2002 requires the chief executive and chief financial officers of public companies to certify their financial reports.

Trap Depreciation does not drain cash

Depreciation lowers net income, but no cash leaves the business when it is recorded; the cash left when the asset was bought. So depreciation by itself never makes cash fall. When cash falls while profit is positive, look for sales not yet collected, inventory bought, assets purchased or loans repaid.

Worked example Easy

Where on its cash flow statement does a fictional café report the cash it paid for a new espresso machine?

  1. Operating activities
  2. Investing activitiesAnswer
  3. Financing activities
  4. Nowhere, since buying a machine is not an expense

How to solve it

  1. Ask what kind of thing the cash bought: the machine will be used for years.
  2. Cash spent on long-term assets is an investing activity.

Why each choice is right or wrong

  • A. Incorrect. Operating activities cover day-to-day cash such as coffee sales and wages, not the purchase of a long-term asset.
  • B. Correct. Buying a long-term asset such as an espresso machine is an investing activity.
  • C. Incorrect. Financing activities are cash from or to lenders and owners, such as loans, not equipment purchases.
  • D. Incorrect. The purchase is not an expense right away, but cash still left the café, so it must appear on the cash flow statement.

Explain Explain it

Task verbs: calculate, explain

To calculate ending cash, add the three sections, keeping the sign of each: inflows are positive and outflows are negative. Then add the net change to beginning cash.

To explain why a report misleads, say which figure is wrong, in which direction, and who could be hurt by relying on it.

Worked example Medium

Cash flow summary, Mesa Tile Works (fictional), one year

ItemAmount (dollars)
Cash at the start of the year15,000
Net cash from operating activities48,000 in
Net cash from investing activities30,000 out
Net cash from financing activities10,000 out

How much cash does Mesa Tile Works have at the end of the year?

  1. 8,000 dollars
  2. 23,000 dollarsAnswer
  3. 63,000 dollars
  4. 103,000 dollars

How to solve it

  1. Net change in cash: 48,000 - 30,000 - 10,000 = 8,000 dollars.
  2. Ending cash: 15,000 + 8,000 = 23,000 dollars.

Why each choice is right or wrong

  • A. Incorrect. 8,000 dollars is the net change in cash for the year; it still has to be added to the 15,000 dollars at the start.
  • B. Correct. The net change is 48,000 - 30,000 - 10,000 = 8,000 dollars, and 15,000 + 8,000 = 23,000 dollars.
  • C. Incorrect. 63,000 dollars adds only the operating inflow to beginning cash and leaves out the two outflows.
  • D. Incorrect. 103,000 dollars adds every figure, treating the investing and financing outflows as if cash came in.

Explain Your turn

Before showing her financial statements to an investor, the owner of a fictional bakery has her ovens, bought three years ago, listed at the full price she paid for them, with no depreciation ever recorded. Explain how this makes the statements misleading to the investor, and describe one check that could catch the problem.

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A full answer does this

  • Explains that a figure on the statements is too high because the depreciation was never recorded
  • Explains how the overstated figure could mislead the investor's decision
  • Describes a specific check that could catch the missing depreciation

Model answer

The ovens have been used for three years, so part of their cost should already have been recorded as depreciation. Listing them at full price makes their book value, total assets and the owner's equity too high, and because no depreciation expense was ever recorded, past profits were overstated too. The investor could think the bakery is worth more and earns more than it really does, and so pay too much for a share of it. An outside audit would catch this, because the auditors would compare the ovens' recorded value with their purchase date and expected useful life.

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