It is an understood fact that the business entities report their earnings, expenses, and financial side of their operations in the financial statements. In the cash-based accounting system, appropriation of cash gone and entered in the business is easy. However, the accrual-based account system requires a more rigorous approach to cater to all aspects.
Therefore, a cash flow statement is also required besides the income statement and the balance sheet. A cash flow statement is a significant financial statement of any business entity. However, it is often overlooked when analyzing the financial results of a company.
Ideally, investors, managers, creditors, auditors, or tax professionals can derive useful insights from the cash flow statement. Analysis of cash flow statement enables the professionals to understand the cash flow management, identify the improvement areas, and act accordingly. Therefore, understanding all dimensions of the cash flow statement is very important.
The cash flow activities are further sub-divided into different categories. In this article, we will analyze the cash flow from financing activities. The article will revolve around appropriation, calculation, interpretation, and practical implication of cash flow from financing activities of any business entity.
What Is A Cash Flow Statement?
The statement of cash flow or Cash flow statement can be defined as,
It is one of the major financial statements prepared by any business entity to record the amount of cash and cash equivalents that entered or left the company during the financial period.
According to IFRS’s IAS 7,
The cash flow statement of any business entity is a central component of financial statements that reflects the information about the company’s financial health and its capacity to generate cash flows.
The IAS 7 further classifies the cash flow statement as,
The cash flow statement tells how a business entity’s cash and cash equivalents changed during a financial period. Cash is defined as cash in hand, bank, and demand deposits. Whereas the cash equivalents are highly volatile and short-term investments that can readily be converted into cash.
The cash flow statement is further sub-divided into the following three categories:
- Cash flow from operating activities
- Cash flow from financing activities
- Cash flow from investing activities
Cash Flow From Operating Activities
Cash flow from operating activities represents all the payments and receipts of the company made during a financial period to execute day-to-day operations. It includes cash expenses, revenues, receipts, etc. The net of receipts and payments is represented as net cash flow from operating activities.
Cash Flow From Financing Activities
Cash flow from financing activities represents the funding that a company generates during a financial period or repayment of the debt finance. The difference between the repayments and generated fundings is shown as the net cash flow from financing activities.
Cash Flow From Investing Activities
Cash flow from investing activities represents the investments made by the company and the income generated from such activities. For instance, a company might have acquired an asset that generates recurring income in several financial periods. The difference between the investment made and cashback is recorded as net cash flow from investing activities.
Cash Flow From Financing Activities
Cash flow from financing activities has already been described in the above section. However, we will attempt to comprehend the concept more elaboratively. Cash flow from financing activities can be defined as,
Cash flow from financing activities is the net balance of funding that a company collects and repayments or distribution of debt and dividends during a financial period. The fundings generated by a business entity can include the share capital raised, debt instruments issued or bank loans. On the other hand, the payments side of financing activities can be the distribution of dividends, repayment of the debt, equity, or capital lease obligations.
What Is Included In Cash Flow From Financing Activities?
The cash flow from financing activities is a very important part of the cash flow statements. The prospective investors, financial analysts, creditors, and external stakeholders can analyze the financing activities to understand the company’s long-term financial health.
It shows how much a company’s debt or equity has generated or been paid back during a financial period. Similarly, the investors can know the information about dividend payouts from the CFF of a company’s cash flow statement.
The financing activities of a company can be summarized as the following activities:
- Issuance of debt
- Issuance of equity
- Payment of dividends
- Repayment of equity
- Repayment of debt
- Capital leases obligations
- Repurchase of debt or equity
Formula For Calculation Of Cash Flow From Financing Activities
The formula for the calculation of cash flow from financing activities can be shown as:
Cash flow from financing activities = CED –(CD + RP)
Where,
CED = cash inflows from issuing equity or debt
CD = cash dividends paid out to shareholders
RP = repurchase of debt or equity/repayment of debt and equity
How To Calculate?
Let’s understand the process of calculating net cash flow from financing activities for any business entity.
- The first step is to collect all the cash generated from the financing activities during a financial period. It will be recorded in cash inflows from the financing activities. For instance, shares issued, debt instruments issued, bank loans, etc.
- The second step is the addition of the repayments of equity or debt and cash dividend paid out to the shareholders. It can include redemption of debentures, calling back the equity, repurchase of debt, etc.
- The net cash flow from the financing activities will be calculated by subtracting the cash outflows from the cash inflows. The balance will either be positive or negative. We will discuss the interpretation of CFF in the next section.
Interpretation
As discussed earlier, cash flow from financing activities is a significant part of the cash flow statement. It exactly measures the cash movement between the shareholders, creditors, and the company. The net balance of the financing activities shows how much money a firm generates in excess of the payments.
Besides, the balance of the CFF also indicates how much the company’s debt has been paid off. The information about how frequently cash dividends are paid out to the shareholders is also reflected. The balance of the net cash flow can be positive or negative. We can understand the interpretation of each case by analyzing them separately.
Positive CFF
If the CFF is positive, it suggests that the company is generating more cash from issuing shares or debt instruments than the cash flowing out. The higher inflows imply an increase in the company’s assets. Besides, it might also reflect the increase in debt.
The positive CFF for consecutive years does not necessarily show the increase of assets. Instead, it suggests that the company has been relying on long-term debt continuously.
Negative CFF
If the CFF of the company is negative, it suggests servicing of debt, cash dividend paid out to the shareholders or repurchase of equity. If the outflows are greater than the inflows, the net CFF will show a negative number. The implications of the negative CFF will be a decrease in assets, a decrease in liabilities, and cash dividends.
The negative CFF is a favorable sign for investors as it suggests the company’s policy of paying cash dividends. It also suggests positive growth as the company has enough resources to retire or service its debt.
Example Of CFF
Let’s take an example of the cash flow from financing activities:
A company, Steward Steel Mills Inc., has the following cash flow from financing activities:
| Steward Steel Inc. Cash Flow Statement For the year ending Dec 31st, 20XX | |
| FINANCING ACTIVITIES | USD(millions) |
| Proceeds from long-term debt and other | 380 |
| Repayments of long-term debt and other | (1500) |
| Principal repayments of capital lease obligations | (2000) |
| Principal repayments of finance lease obligations | (129) |
| Cash Dividends paid out | (0.5) |
| Net cash provided by(used in) financing activities | (3249.5) |
From the above examples, we can interpret the activities as follows:
- Inflow: proceeds from issuing long-term debt
- Outflow: repayment of long-term debt
- Outflow: principal repayments of capital lease obligations
- Outflow: principal repayments of finance lease obligations
Practical Implications
CFF has implications for investors as well as the creditors of the company.
Investors can understand and analyze how often a company raises capital. It also helps investors understand what the main sources of financing for any company are.
Cash dividends are another aspect of CFF that can help investors invest their money in any company’s stocks. The continuous positive balance of CFF might be a warning signal for investors that the company is overly relying on debt financing.
The creditors can also get useful insights into a company’s debt repayment policy. If the company has heavy cash outflows in debt retiring and servicing, it adds to the company’s creditworthiness. Therefore, such companies are a good investment for the creditors.
Conclusion
We have understood the cash flow from financing activities. However, there are some differences when reporting cash flows from financing activities as per IFRS and GAAP. When a company is following GAAP, the dividends paid are recorded in financing activities.
However, dividends paid can be recorded as financing or operating activities under IFRS. Similarly, dividends received and interest received are strictly operating activities in the GAAP, but IFRS allows recording in financing or operating activities. So this difference is also important to understand depending on which firm you are analyzing.
