Where did the cash go? Three buckets¶
Chapter 3 showed you that net income and cash can move by different amounts in the same period, because accrual accounting records revenue and expenses when they happen, not when the cash does. Chapter 1 already named the report that tracks cash itself, the statement of cash flows, built from three kinds of activity: financing, investing, and operating. This section puts those ideas together, so you can take any cash payment or receipt a business makes and say which bucket it belongs in, or whether it belongs in none of them.
Costco's other bottom line¶
Every year, Costco Wholesale reports a net income figure to its investors, and every year it also reports a separate cash flow number. The two are never exactly the same, and in some years the gap runs to several billion dollars. Neither number is wrong. Net income measures what Costco earned under accrual accounting, the kind of measurement Chapter 3 built. The statement of cash flows measures something narrower: actual dollars that moved into or out of the business. That's why lenders and investors read the cash number first; it can't be dressed up by the timing choices accrual accounting allows.
The statement of cash flows answers one question: where did the cash come from, and where did it go? It sorts every cash inflow and outflow of the period into exactly one of three buckets, based on what kind of activity caused it.
Three buckets, one question each¶
Operating activities are the cash effects of day-to-day running of the business: the same revenue and expense transactions that drive net income, but counted only when cash actually moves. Collecting cash from customers, paying suppliers and employees, and paying income taxes all belong here. So do two flows that surprise people: interest paid and interest received. Even though interest relates to borrowing or investing, US GAAP classifies the cash interest a company pays or receives as operating, because it flows through net income the same way a routine expense or revenue does.
Investing activities are cash spent on, or collected from, long-term assets: buying or selling equipment, buildings, or land, and buying or selling another company's stock as a long-term investment. Lending money to someone else, and later collecting on that loan, is investing too, since a loan made to another party is itself a long-term asset.
Financing activities are cash flows between the company and the people who fund it: banks and stockholders. Borrowing cash on a note payable, repaying that note's principal, issuing new common stock, repurchasing the company's own stock, and paying cash dividends to stockholders are all financing.
| Bucket | Question it answers | Typical cash in | Typical cash out |
|---|---|---|---|
| Operating | How much cash did day-to-day business generate? | Collections from customers; interest and dividends received | Payments to suppliers and employees; interest paid; income taxes paid |
| Investing | How much cash moved in or out of long-term assets? | Selling equipment, land, or a long-term investment | Buying equipment, land, or a long-term investment; making a loan |
| Financing | How much cash moved between the company and the people who fund it? | Borrowing on a note; issuing stock | Repaying a note; repurchasing stock; paying dividends |
Same cash account, three different reasons
Northstar Moving pays out cash three times in one week: $600 to a mechanic for routine truck maintenance, $18,000 to buy a used moving truck, and $2,000 to repay part of a bank loan. All three payments reduce the same Cash account, but they land in three different sections: the maintenance is operating, the truck purchase is investing, and the loan repayment is financing.
Common mistake: equipment purchases are operating because the equipment is used in operations
It's tempting to think a purchase belongs in operating activities if the thing purchased gets used in daily operations. What matters isn't how the asset is used later, it's what kind of asset it is. Equipment, buildings, and land are long-term assets, so buying or selling them is always investing, no matter how central that asset is to running the business day to day.
The one everyone gets backwards: dividends¶
Dividends look like they should be operating, since they're a routine cash payment. They aren't. A dividend is a distribution of profit to the company's own stockholders, not a cost of running the business, so paying one is financing, the same bucket as issuing or repurchasing stock. Interest paid works differently: US GAAP puts it in operating because it's an expense that reduces net income. Dividends paid never reduce net income, which is one more reason they don't belong in operating.
Dividends received are a separate case. When a company holds another company's stock as a long-term investment and collects a dividend on it, that cash counts as operating, because it's investment income flowing through net income, the same way interest received does.
Common mistake: dividends paid are an operating expense
Dividends paid to stockholders never appear on the income statement and never reduce net income, so they can't be an operating expense. They're a payout to the owners of the business, which is exactly what the financing section reports. Don't confuse this with interest paid, which is operating, or with dividends received, which is also operating because it's investment income.
When cash never moves¶
Some of a company's biggest decisions involve no cash at all. A company might buy a building entirely by signing a note payable, or settle a note payable by handing the lender shares of common stock instead of cash. Both are real investing and financing decisions, too significant to leave out of the financial statements, but they can't sit inside the operating, investing, or financing sections, since those report only actual cash flows. Instead, GAAP requires noncash investing and financing activities to be disclosed separately, usually in a short schedule at the bottom of the statement, so a reader can still see the transaction happened.
Common mistake: if no cash moved, the statement of cash flows has nothing to say about it
A transaction with no cash can't appear inside the three sections, but "not in the three sections" doesn't mean "not reported." Significant noncash investing and financing activities, like buying an asset entirely with a note, are disclosed in their own schedule precisely because they matter to anyone reading the statement.
Every cash flow you'll see for the rest of this chapter sorts into one of these three buckets, or off to the side as a noncash disclosure. The next section builds the biggest of the three buckets, operating activities, starting from the net income number Chapter 3 taught you to compute and working out how to turn it into a cash number.
Pause and work¶
Try sorting a full year of cash activity yourself, one item at a time.
Some categories are filled in below. Work out the rest using the same rules.
Now try a fresh company and a fresh list of transactions, start to finish.