Newsletter

By: Stanley Tsang, CPA

This is the third and final part of a three part article series on how to read the financial statements of a nonprofit. In part one and part two of this article, we discussed the statement of financial position (SFP) and the statement of activities (SOA). In part 3, we will be discussing the statement of cash flows (SCF). Remember, a complete set of financial statements according to Generally Accepted Accounting Principles (GAAP) used in the U.S., comprises the SFP, the SOA, the SCF, and the related footnotes.

Statement of Cash Flows

The statement of cash flows (SCF) is essentially a financial statement reporting the effects of operating, investing, and financing activities of a company on cash flows over a period of time, usually between two SFP dates. The change in cash flows is combined with the beginning balance of the total cash flows to show the ending balance in the statement. Cash, being the most liquid of financial assets, is critical to a company’s ability to meet immediate financial needs; hence, a proper understanding of the SCF is important to both financial and non-financial managers using SCF.

Components of a SCF

The three major categories of cash flow activities to be reported in a SCF are: operating activities, investing activities, and financing activities. Each category addresses different aspects of impact on cash flows of a company, as discussed further below.

(1) Operating Activities: Cash flows from operating activities are cash activities resulting from the operations of a company such as cash receipts from contributions, membership dues, grants, etc.; cash disbursements of invoice payments, payroll, supplies, etc.; and all other non-investing and non-financing cash activities to be accounted for as part of the change in net assets such as unrestricted interest and dividend income.

The cash flows from operations can be reported by using either the direct or indirect method. The direct method simply reports the total cash receipts from operations less the total cash disbursements. The indirect method begins with the change in net assets with various adjustments to convert the accrual basis revenue and expenses to cash receipts and disbursements respectively. While the direct method is much easier to understand and less complicated than the indirect method, the latter is nevertheless, the most widely used method in a SCF due to its long history of being prepared by accountants and used by companies.

(2) Investing Activities: Cash flows from investing activities are cash activities from acquiring and disposing of investments such as equity and bond investments and fixed assets such as furniture and equipment.

(3) Financing Activities: Cash flows from financing activities are cash activities resulting from borrowing from and repayment to a third party of financial obligation such as bank and cash receipts from donor-restricted contribution for long-term purposes.

Usefulness of the Statement of Cash Flows

(1) Understanding Sources and Uses of Cash

One of the most common questions a statement user asks regarding cash flows is why a company’s cash balance is decreased while the SOA is showing a significant increase in the net assets for the same period. The answer to this puzzling question lays not only in the fact that both the SFP and SOA are reported according to the accrual accounting with non-cash items (discussed in part one of this article), but also that the SOA does not report the sources and uses of cash flows affected by non-operating activities, namely the investing and financing activities of the company. For example, a company may have an increase in cash flows of $750,000 from its operations reflected by a significantly comparable increase in the net assets reported in the SOA in a given year, but the cash flows can actually be decreased by $250,000 if the company spends $1,000,000 to purchase a new office or pay off an existing debt. Hence, a careful analysis of all sources and uses of cash flows in the SCF always helps the company’s management understand where cash comes from and where cash goes to better manage its cash flows and help meet its business objectives.

(2) Discretionary Cash Flows for Financial Flexibility

In order for a company to grow or increase its reserve for future designated projects, consistent positive operating cash flows over time is critical to achieving such a goal. Discretionary cash flows are the residual positive cash flows after subtracting the cash used for investing and financing activities from the cash flows generated by operations. The SCF is the only financial statement that provides such critical cash flows information for management and the board of directors to assess the extent of possible discretionary cash flows for additional reserve build-up or enhancing existing programs or developing new programs.

(3) Liquidity and Solvency Assessment

When properly used, a SCF can help shed some light on the impact of the operations on a company’s liquidity and its solvency. For example, by adjusting the cash flows balance in the SCF with the projected minimum cash need for a non-operating purpose, management can get an idea of the unrestricted liquidity assets for operations. Also, by dividing the current maturities of loan principal and interest payments into the total operating cash in the SCF, management and creditors can quickly calculate the debt service coverage ratio to assess the company’s current ability to pay back its debt.

Conclusion

Although each of the three financial statements are discussed separately in this article series, they are all very closely related. The assets and payables in the SFP are used to pay bills and generate revenue in the SOA and, in turn, cash receipts from revenue then go back to the bank account in the SFP. The change in net assets in SOA is reported in both the net assets section of the SFP and operating cash flows of the SCF. The SCF reflects all the changes of the assets and liabilities of the SFP and presents them in terms of cash flows which at the end ties back to the cash and cash equivalents in the SFP. In order to make effective and prudent financial and operational decisions, a non-financial manager will need to know how to read all the financial statements and their related components properly to see the entire picture of the financial situation of a company.