Developing a Basic Financial Model – Part III: The Cash Flow Statement

Excel is probably the most popular spreadsheet in use today, and certainly a mainstay of investment banks, private equity firms and hedge funds. It offers a tremendous amount of flexibility to develop a wide array of financial computations, ranging from simple, static calculations to complex, dynamic analyses. In order to effectively develop financial models for use in valuation analyses or forecasting, it is important to understand how companies show their information. This article continues the overview of the link between the basic components of a full financial spreadsheet by discussing the last of the three main components: the cash flow statement. Because these financial statements are based on accounting rules, there will be some accounting theory used in this article but only very high level, basic elements to allow the reader to follow along.

The Cash Flow Statement

The cash flow statement (or statement of cash flows) provides an accounting (in the literal and financial sense) of how a company generates cash. Since generally accepted accounting principals (also known as "GAAP") are based on accruing revenues and expenses, understanding how a company earned the cash recorded on its books at the end of a reporting period would be very difficult. The following numerical example will shed some light on this issue.

For the sake of simplicity, let us assume that the only components on a company's balance sheet at December 31, 2007 is cash of $100, accounts receivable of $200, accounts payable of $100, and equity of $200. At the end of December 31, 2008, the company shows accounts receivable of $350, accounts payable of $150 and equity remained $200. What would the cash balance be? First, you look at the change in accounts receivable, and if that balance increases, that is a use of cash (and vice versa for a decrease in the balance). So, given the information above, it is clear that there was a use of cash of $150, meaning that the cash from the balance from the year prior would be decreased by that amount. Why does this happen?

GAAP requires companies to record sales of products or services but the company will usually offer terms, say 30 days for the purchaser to pay for those products or services. During this period, a company does not have the cash from the sales and will not get the cash until the purchasers pay. During this period, the company is effectively lending money to the purchaser, or tying up the company cash. This is why some companies will get bank lines or other credit facilities to finance receivables so the cash in the business does not get used. In short, building receivables (or other assets, like inventories) uses cash.

A similar process occurs for payables, except in an opposite process. The accounts payable have increased by $50, so that increases the cash amount. Think of this as deferring a payment due today until some time in the future, and in keeping with the financing discussion above, a third party is providing financing for you, and thus, this becomes a source of cash. In this example, the $150 increase in accounts receivable offset against the $50 increase in accounts payable nets to a cash use of $100. With equity remaining the same, cash from the prior period would be reduced by $100. In short, cash balance would be zero at December 31, 2008.

The cash flow statement will include all changes in assets and liabilities, including the aforementioned receivables and payables. There will also be expenditures for building up the physical property of a company, changes in bank borrowings and changes in the shareholder equity account (like dividends paid or issuance of new stock). Just like its name, the cash flow statement provides a way to track how cash is generated for a business by "unwinding" the accrual methods of accounting. In conjunction with the income statement and balance sheet, the cash flow statement provides a way to analyze the operations of any company and show how business generate or lose cash.

This is the final part of the basic understanding of financial statements. It is now time to talk a bit more in detail about setting up these statements to do financial modeling. The next several articles will cover a series of steps to walk through building a financial forecast and how to use the historical data to provide guidance to projected information.