Cash Flow Classification

The largest portion of the CFA Level 1 curriculum is the financial reporting and analysis section (the topic makes up 20% of the test).  By studying this section, the candidate learns reporting standards, analysis techniques, and the ins and outs of the major financial statements – the balance sheet, income statement, statement of comprehensive income, statement of changes in equity, and finally the statement of cash flows.

In order to understand the statement of cash flows in its entirety, the candidate should familiarize themselves with the three groups in which business activities are classified. This article details these three types (operating, investing, and financing) and also discusses the reporting differences associated with these three activities between the Financial Account Standards Board’s (FASB) Generally Accepted Accounting Principles (GAAP) and the International Accounting Standards Board’s (IASB) International Financial Reporting Standards (IFRS).

Operating Cash Flows

Operating cash flows are cash flows associated with a business’s daily functions.  Companies should be generating the majority of their cash flows from operating activities. Some examples of operating cash inflows are the sale of food by a restaurant and the sale of cars if you are an auto dealer. Examples of operating cash outflows are payments for inventory, wages, and administrative costs.

It is important to understand all of the operating inflows and outflows of a company because the operating cash flow indicates whether a company is generating enough cash to continue and grow its operations, or if it will require additional sources of income.  If you were deciding whether to invest in a company by purchasing debt, you might want to look at the operating cash flow section of their statement of cash flows to see if the entity is generating enough cash to cover coupon and even principal payments.

Investing Cash Flows

Investing activities are those associated with the acquisition and disposal of long-term assets.   Some examples of investing cash inflows are cash receipts of non-trading securities, and the sale of property, plant, and equipment.   Examples of investing cash outflows are the purchase of any long term assets such as property, plant, and equipment, and long term investments in equity and debt.  Any cash flows related to securities held for the very short-term, which are highly liquid, and securities held for trading purposes, would be classified as operating activities.

Financing Cash Flows

Lastly, financing cash flows are any activity related to obtaining or repaying capital.  Examples of financing cash inflows are cash received from issuing stocks and bonds, and any cash received from borrowing.  Outflows include cash payments to repay bonds, repurchasing stock from shareholders, any cash flows related to paying back borrowings, and also dividends paid.

Differences Between GAAP and IFRS

When analyzing financial statements it is important to know what standards the companies use to report with because standards classify cash flows differently.   In general, IFRS is more flexible when reporting cash flows.

When reporting under IFRS:

• interest received may be classified as either an operating or investing activity
• interest paid may be classified as either an operating or investing activity
• dividends received may be classified as operating or investing activities
• dividends paid may be classified as operating or financing activities.

GAAP is not as flexible as IFRS is when it comes to classifying income.

• interest received and paid must be classified as an operating cash flow
• dividends received must be classified as an operating cash flow
• dividends paid must be classified as a financing cash flow
• interest paid must be classified as an operating activity even though the principal amount of debit is a financing activity.

Summary

Fully understanding the three types of cash flows will be very helpful for anyone in the accounting and finance industry, especially if you are currently studying for a CPA or CFA exam.  Additionally, knowing the differences between how GAAP and IFRS report several cash flows will be a huge help if you are deciding whether to invest in a company and are analyzing their financial statements.