Cash flows, financial statement analysis and capstone: a full accounting cycle

This final lesson completes the set of financial statements with the statement of cash flows, shows how users analyze statements with ratios, and closes the course with a capstone that takes a new small business through a complete accounting cycle. The cash flow statement matters because profit and cash are different things: Birchwood Bikes earned $1,030 of net income in May, yet its operating activities used cash. Ratios matter because a single number, such as $21,500 of profit, means little until it is compared with something: sales, assets, last year, or a competitor.

The statement of cash flows

The statement of cash flows reports cash receipts and payments for a period, classified into three activities. Operating activities are the principal revenue-producing activities: cash from customers, cash paid to suppliers and employees, and other cash flows that are not investing or financing. Investing activities are the purchase and sale of long-term assets and investments not held as cash equivalents: buying equipment, selling a building, making a loan to another business. Financing activities change the size and composition of equity and borrowings: issuing shares, borrowing and repaying loans, and paying dividends.

Under US GAAP, interest paid and received and dividends received are operating activities, and dividends paid are financing activities. Under IFRS, which you will see in Canadian and international statements, companies have some choice about classifying interest and dividends. This course classifies interest paid as operating and dividends paid as financing.

Operating cash flow can be presented by the direct method, which lists the main classes of operating receipts and payments, or by the indirect method, which starts with net income and adjusts it for non-cash items and for changes in working capital. Standards encourage the direct method, but most companies use the indirect method, and it is the one that shows most clearly why profit and cash differ.

The indirect method

Start with net income. Add back expenses that did not use cash, chiefly depreciation and amortization, and remove gains or add losses on the sale of long-term assets (their cash effect belongs in investing). Then adjust for changes in current operating assets and liabilities. An increase in a current asset such as receivables, inventory or prepaid expenses means cash was tied up, so it is subtracted; a decrease is added. An increase in a current liability such as accounts payable, wages payable or unearned revenue means cash was conserved, so it is added; a decrease is subtracted.

# Statement of cash flows for Birchwood Bikes, May (indirect method)
net_income = 1030
noncash = {"Depreciation": 300}
opening = {"Accounts receivable": 0, "Supplies": 0, "Prepaid insurance": 0,
           "Accounts payable": 0, "Wages payable": 0, "Interest payable": 0}
closing = {"Accounts receivable": 2200, "Supplies": 900, "Prepaid insurance": 3300,
           "Accounts payable": 850, "Wages payable": 420, "Interest payable": 100}
current_assets = {"Accounts receivable", "Supplies", "Prepaid insurance"}

operating = net_income + sum(noncash.values())
lines = [("Net income", net_income)] + list(noncash.items())
for k in closing:
    change = closing[k] - opening[k]
    adj = -change if k in current_assets else change
    operating += adj
    lines.append((f"Change in {k.lower()}", adj))
investing = -18000                                  # equipment purchased
financing = 40000 + 20000 - 500                     # shares, note, dividends
for name, amt in lines:
    print(f"  {name:<34}{amt:>8,}")
print(f"Cash from operating activities    {operating:>8,}")
print(f"Cash from investing activities    {investing:>8,}")
print(f"Cash from financing activities    {financing:>8,}")
print(f"Net change in cash                {operating + investing + financing:>8,}")

  Net income                           1,030
  Depreciation                           300
  Change in accounts receivable       -2,200
  Change in supplies                    -900
  Change in prepaid insurance         -3,300
  Change in accounts payable             850
  Change in wages payable                420
  Change in interest payable             100
Cash from operating activities      -3,700
Cash from investing activities     -18,000
Cash from financing activities      59,500
Net change in cash                  37,800

Birchwood's operating activities used $3,700 of cash in May even though net income was $1,030. The main reasons are that it paid a year of insurance in advance ($3,300 still prepaid), bought supplies it had not yet used, and had not yet collected $2,200 of revenue. Those are normal start-up effects, but a business that grows quickly can run out of cash for exactly these reasons while reporting profits. Investing used $18,000 for equipment, and financing provided $59,500. The net increase in cash of $37,800 equals the cash balance on the 31 May balance sheet, since the business started with none.

As a check, the direct method gives the same operating total: cash received from customers $6,000 ($4,200 + $1,800), less cash paid to suppliers $1,000, for insurance $3,600, and for rent and wages $5,100, equals −$3,700. Significant non-cash investing and financing activities, such as buying equipment by issuing a note, are not in the statement but are disclosed in the notes.

Analyzing financial statements

Analysts compare a company's figures over time (horizontal or trend analysis), express each item as a percentage of a base such as sales or total assets (vertical or common-size analysis), and compute ratios that link related figures. Ratios are grouped by the question they answer: liquidity (can the business pay its short-term obligations?), activity or efficiency (how well does it use its assets?), profitability (how much does it earn?) and solvency (can it survive in the long run and service its debt?). A ratio is only meaningful in context: compared with the business's own history, with budgets, or with similar businesses.

Here are Birchwood's illustrative results for its first eight months, to 31 December. Because this is the first year, the ratios use year-end balances instead of averages; with two years of data, average balances should be used for turnover and return ratios.

# Key ratios for Birchwood Bikes at 31 December (illustrative, year-end balances)
f = dict(sales=190000, service=58000, cogs=112000, net_income=21500,
         cash=14400, ar=14600, inventory=31800, other_ca=4000,
         total_assets=101000, current_liab=28000, total_liab=44000,
         equity=57000)
revenue = f["sales"] + f["service"]
current_assets = f["cash"] + f["ar"] + f["inventory"] + f["other_ca"]
ratios = {
    "Current ratio": current_assets / f["current_liab"],
    "Quick ratio": (f["cash"] + f["ar"]) / f["current_liab"],
    "Receivables turnover (all revenue on credit)": revenue / f["ar"],
    "Days sales outstanding": 365 / (revenue / f["ar"]),
    "Inventory turnover": f["cogs"] / f["inventory"],
    "Days in inventory": 365 / (f["cogs"] / f["inventory"]),
    "Gross margin on merchandise": (f["sales"] - f["cogs"]) / f["sales"],
    "Net profit margin": f["net_income"] / revenue,
    "Return on assets": f["net_income"] / f["total_assets"],
    "Debt-to-equity": f["total_liab"] / f["equity"],
}
pct = {"Gross margin on merchandise", "Net profit margin", "Return on assets"}
for name, v in ratios.items():
    print(f"{name:<46}{v:>8.1%}" if name in pct else f"{name:<46}{v:>8.2f}")

Current ratio                                     2.31
Quick ratio                                       1.04
Receivables turnover (all revenue on credit)     16.99
Days sales outstanding                           21.49
Inventory turnover                                3.52
Days in inventory                               103.63
Gross margin on merchandise                      41.1%
Net profit margin                                 8.7%
Return on assets                                 21.3%
Debt-to-equity                                    0.77

The ratios tell a reasonable story: Birchwood is liquid, collects promptly, prices well and is profitable. The weak spot is inventory: 104 days of stock is a lot of cash tied up, which matters for a business that must also pay for spring stock in late winter. A lender reviewing these figures would likely ask about seasonal cash needs and might offer a line of credit secured on receivables and inventory. Ratios also have limits: they depend on accounting choices such as inventory method and depreciation estimates, a single year can be unusual, and year-end figures may not represent the rest of the year.

Capstone: a full accounting cycle

Lakeshore Paddle Co. is a new corporation in a lakeside town in a state with an illustrative combined sales tax rate of 7 %. It rents and sells kayaks. The following is a compact version of the cycle you have practiced; the full capstone exercise in the practice section asks you to prepare every schedule yourself.

Work through the capstone in full by journalizing each transaction, posting to T-accounts or a spreadsheet, preparing the unadjusted trial balance, recording the two adjustments, preparing the adjusted trial balance, the income statement, the statement of changes in equity, the balance sheet and the statement of cash flows, and finally closing the books. Then compute three ratios and write two sentences on what they show. That is the whole of this course in one exercise, and it is the foundation for every accounting course that follows: ACCT-102 for managerial accounting, ACCT-211 and 212 for intermediate financial accounting, and ACCT-240 for systems and controls.