Investing and financing¶
The indirect method fixed net income for accounting's timing games, but it only touched the accounts a company uses to run its day-to-day business. It said nothing about the delivery van the company bought, the note it signed to help pay for it, or the dividend check it mailed to its stockholders. Those cash flows live in the investing and financing sections, and you cannot pull them from the income statement the way you pulled net income and depreciation. You get them by comparing the balance sheet at the start of the year to the end of the year and reconstructing what happened to each account in between.
What changed in long-term assets¶
Every investing cash flow starts the same way: pick the account, and rebuild everything that happened to it this year. Equipment is the one you will use most. You know its beginning balance, its ending balance, and the cost of anything sold. Purchases are whatever is left over once you back those out.
Beginning balance + purchases − cost of items sold = ending balance.
Brightline Cleaning's Equipment account went from $46,100 to $57,600 during the year, and it sold equipment that had originally cost $3,000.
| Equipment | Amount |
|---|---|
| Beginning balance | $46,100 |
| + Purchases | ? |
| − Cost of equipment sold | $3,000 |
| = Ending balance | $57,600 |
Solving for the missing piece: $57,600 − $46,100 + $3,000 = $14,500 of purchases. But Brightline financed $3,000 of that with a note payable instead of cash, so only $11,500 actually left the bank. That $11,500, not the full $14,500, is the number that belongs in investing activities, entered as a negative because cash went out. Accumulated Depreciation rolls forward the same way: beginning balance + depreciation expense − accumulated depreciation removed with the equipment sold = ending balance.
Common mistake: treating equipment purchases as operating
Equipment is used to run the business, but buying it is not a routine operating cost. It is the purchase of a long-term asset, so the cash goes in investing activities every time, no matter what the equipment is used for afterward. Brightline's $11,500 cash purchase never touches the operating section.
Selling equipment: back out the gain or loss¶
When equipment is sold, the cash received almost never equals its book value, because book value is an accounting estimate and the sale price is whatever the market pays. The gap between the two is the gain or loss you already met in the operating section, where it got subtracted or added back so it would not be counted twice.
Sale proceeds = (cost − accumulated depreciation of the item sold) ± gain or loss.
Brightline's equipment that was sold had cost $3,000 and had accumulated depreciation of $800, so its book value was $3,000 − $800 = $2,200. The sale produced a gain of $1,200, so proceeds were $2,200 + $1,200 = $3,400. A loss subtracts instead of adds: cost minus accumulated depreciation minus the loss.
Why the whole proceeds, not just the gain
The $1,200 gain is not a cash flow by itself. It is the difference between the $3,400 Brightline actually collected and the $2,200 book value it gave up. The full $3,400 is the investing inflow; the gain already did its job back in the operating section.
Financing activities: debt, stock, and dividends¶
Financing activities are cash flows with the people who supply the company's capital: lenders and stockholders. Notes Payable rolls forward just like Equipment did, except a new note is a cash inflow and a repayment is a cash outflow.
Beginning balance + cash borrowed − cash repaid = ending balance.
Sometimes only one of the two flows is given, and you solve for the other from the beginning and ending balances, the same way you solved for purchases above. Common Stock is simpler: assuming no buybacks, the entire change from beginning to ending is cash raised by issuing new stock. Dividends paid take one more step, through Retained Earnings.
Beginning Retained Earnings + net income − dividends paid = ending Retained Earnings (true whenever every dollar declared is also paid by year-end).
Brightline's Retained Earnings went from $10,000 to $15,500, and net income was $11,000: $10,000 + $11,000 − dividends = $15,500, so dividends paid were $5,500, an outflow.
Common mistake: putting dividends in operating activities
Dividends do not run the business the way salaries or rent do; they are a payment to the owners who supplied the company's capital, so they belong in financing. Interest paid, by contrast, is operating under US GAAP even though it also relates to financing, so do not use that as a reason to move dividends there too.
Noncash activities: what never shows up as a cash flow¶
Some investing and financing transactions involve no cash at all. Brightline also bought $3,000 of equipment by signing a note payable instead of paying cash. That $3,000 shows up in both the Equipment purchases and the Notes Payable ending balance above, but it never appears inside the investing or financing sections, because no cash moved either way. It gets disclosed separately, in a short schedule next to the statement, so a real transaction is not missed just because it never touched cash.
That is also why you read the activity in an account, not just its net change. Northstar Moving's Notes Payable started and ended the year at $10,000, unchanged. Read only the net change and you would assume nothing happened. In fact Northstar borrowed $2,000 and repaid $2,000, two real financing cash flows that happened to cancel out. Land can sit at an unchanged balance because genuinely nothing happened to it. Either way, the roll-forward, not the net change, is the method you trust.
Common mistake: assuming no cash means nothing to report
A significant noncash transaction, like buying equipment entirely with a note, still gets disclosed. Skipping it would hide a real investing-and-financing event from anyone reading the statement, even though neither of the three cash sections includes it.
Pause and work¶
Rebuild an investing and financing section from comparative balances, the same way you just did above.
This one hides one of the two Notes Payable cash flows and holds its balance flat, so you have to solve for both the loss on sale and the missing financing flow from the roll-forward.
With investing and financing built, the only piece left is putting all three sections together into one statement that reconciles to the exact change in cash, which is where Section 4 picks up.