16.2: Differentiate between Operating, Investing, and Financing Activities (2024)

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THINK IT THROUGH

Classification of Cash Flows Makes a Difference

Assume you are the chief financial officer of T-Shirt Pros, asmall business that makes custom-printed T-shirts. While reviewingthe financial statements that were prepared by company accountants,you discover an error. During this period, the company hadpurchased a warehouse building, in exchange for a $200,000 notepayable. The company’s policy is to report noncash investing andfinancing activities in a separate statement, after thepresentation of the statement of cash flows. This noncash investingand financing transaction was inadvertently included in both thefinancing section as a source of cash, and the investing section asa use of cash.

T-Shirt Pros’ statement of cash flows, as it was prepared by thecompany accountants, reported the following for the period, and hadno other capital expenditures.

Because of the misplacement of the transaction, the calculationof free cash flow by outside analysts could be affectedsignificantly. Free cash flow is calculated as cash flow fromoperating activities, reduced by capital expenditures, the valuefor which is normally obtained from the investing section of thestatement of cash flows. As their manager, would you treat theaccountants’ error as a harmless misclassification, or as a majorblunder on their part? Explain.

Cash Flows from Operating Activities

Cash flows from operating activities arise fromthe activities a business uses to produce net income. For example,operating cash flows include cash sources from sales and cash usedto purchase inventory and to pay for operating expenses such assalaries and utilities. Operating cash flows also include cashflows from interest and dividend revenue interest expense, andincome tax.

Cash Flows from Investing Activities

Cash flows from investing activities are cashbusiness transactions related to a business’ investments inlong-term assets. They can usually be identified from changes inthe Fixed Assets section of the long-term assets section of thebalance sheet. Some examples of investing cash flows are paymentsfor the purchase of land, buildings, equipment, and otherinvestment assets and cash receipts from the sale of land,buildings, equipment, and other investment assets.

Cash Flows from Financing Activities

Cash flows from financing activities are cashtransactions related to the business raising money from debt orstock, or repaying that debt. They can be identified from changesin long-term liabilities and equity. Examples of financing cashflows include cash proceeds from issuance of debt instruments suchas notes or bonds payable, cash proceeds from issuance of capitalstock, cash payments for dividend distributions, principalrepayment or redemption of notes or bonds payable, or purchase oftreasury stock. Cash flows related to changes in equity can beidentified on the Statement of Stockholder’s Equity, and cash flowsrelated to long-term liabilities can be identified by changes inlong-term liabilities on the balance sheet.

CONCEPTS IN PRACTICE

Can a Negative Be Positive?

Investors do not always take a negative cash flow as a negative.For example, assume in 2018Amazon showed a loss of $124billion and a net cash outflow of $262 billion from investingactivities. Yet during the same year,Amazon was able to raise a net$254 billion through financing. Why would investors and lenders bewilling to place money withAmazon? For one thing, despitehaving a net loss, Amazonproduced $31 billion cash from operating activities. Much of thiswas through delaying payment on inventories.Amazon’s accounts payableincreased by $78 billion, while its inventory increased by $20billion.

Another reason lenders and investors were willing to fundAmazon is that investing paymentsare often signs of a company growing. Assume that in 2018Amazon paid almost $50 billion topurchase fixed assets and to acquire other businesses; this is asignal of a company that is growing. Lenders and investorsinterpreted Amazon’s cash flowsas evidence that Amazon would beable to produce positive net income in the future. In fact,Amazon had net income of $19billion in 2017. Furthermore,Amazon is still showing growththrough its statement of cash flows; it spent about $26 billion infixed equipment and acquisitions.