The types of Cash Flow and how to do it in practice

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The article discusses the different types of cash flow, such as direct, indirect and mixed. And explains how they play an important role in financial planning. The article also discusses the advantages and disadvantages of each type.

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Types of Cash Flow Statement

Operating cash flow

Operating cash flow tracks the inflows and outflows of money related to the company's operating activities, that is, sales and service activities directly linked to the company's operations.

In operating cash flow, the focus is on analyzing operational movements, such as sales of products or services, payment of suppliers, inventory maintenance, employee salaries, monthly cost of equipment or systems, among others.

This type of cash flow does not include information on the company's other investments, nor costs such as working capital reserves, for example.

Direct cash flow

Direct cash flow monitors the gross inflows and outflows of a business, that is, the amounts without applying any discount.

It is the money that enters and leaves the company directly, without considering other variables, such as accounting information or depreciation of assets, for example.

This metric provides a clearer view of the money obtained.

Indirect cash flow

Indirect cash flow analyzes intermediate accounting information to monitor financial movements and control data from an accounting point of view.

Financial managers who work internally in a business generally use direct cash flow less than accountants do.

In this cash flow category, data from statements such as the Income Statement and the Balance Sheet are used to understand the variation in economic performance according to the cash basis.

Free cash flow

Free cash flow measures the money available after paying all expenses and investments necessary to maintain operating activities. Its main objective is to verify the company's ability to remain active, grow, and generate value for its shareholders or investors.

Projected cash flow

Projected cash flow is used to carry out the company's financial planning for a given future period, allowing managers to work in advance on the necessary actions and be prepared to deal with possible variations in cash flow.

To estimate projected cash flow, it is necessary to evaluate the company's previous cash flows, in addition to considering the months

Discounted cash flow

Discounted cash flow is used to understand the value of a company according to its future projections, also considering the time value of money, that is, inflation and the variation in the values of money, products, and services.

Companies can use this type of cash flow to understand the return on invested capital in the medium or long term, for example.

IFRS Cash Flow

IASB - International Accounting Standards Board, an international entity headquartered in London responsible for issuing international accounting standards, has published the IFRS - International Financial Reporting Standards. In Brazil, regulation for international standards came with Law 11,638/2007, which seeks to standardize financial statements so they can be interpreted in accordance with international standards.

How to Prepare the Cash Flow Statement

In practice and under accounting standards, there are two ways to prepare and present the statement of cash flows: using the direct method and the indirect method.

Direct Method

The direct method, as the name itself says, consists of classifying all cash inflows and outflows (and cash equivalents) that occurred in a given period into operating, investing, and financing groups. In this way of preparing and presenting cash flows, the most complex (and even subjective) part that falls to the administrator is the classification of flows into the three groups. At first it may seem like a trivial issue, but in practice it may not be that simple.

For example, how should dividends paid to shareholders be classified? In the operating group or in financing? Depending on management's point of view, it can be either one or the other. And financial expenses (interest paid)? Operating? Or in the financing group, because they are financing costs? Finance Theory gives clues on how to classify both dividends and interest paid. According to Finance Theory, investment activities are dissociated from the way investments are financed. Both generate risks and benefits for shareholders, but they need to be analyzed separately. The combined effect of investments and financing is enjoyed (or borne) by shareholders.

Therefore, if the company's management deems it correct, both dividends paid and interest paid should be classified in the financing group, as they are cash flows related to the capital structure.

On the other hand, if the interest paid is, for example, due to occasional short-term cash financing needs, the entity's management may deem it more appropriate to classify it as operating in order to have a better notion of operating cash flows after deducting the interest paid arising from the financing of the operation itself (and not from financing investments, since these are distinct). The same reasoning can be applied to dividends. The cash flow from operations, when already net of dividends, can be interpreted as a measure of net operating cash flow, what truly remains from operating activities.

And financial income (interest received)? Operating or in the investing group? It depends! If it is financial income from highly liquid short-term investments, it is neither one nor the other; it is simply amounts to be considered in the reconciliation of opening cash and cash equivalent balances! Now, if it is interest received from long-term or strategic financial investments, it can be classified as cash flows from investments. A tip: when the investments that generated the financial income were made, how were they classified? If in the investing group, the financial income will most likely be classified there as well.

What matters is for management to develop criteria for classifying cash flows, maintain them consistently over time, and make clear to users of the financial statements which criteria were adopted, so that if the user wishes, they can “disassemble and reassemble” the statement of cash flows in whatever way best suits them.

The direct method, by presenting inflows and outflows classified, needs to be analyzed carefully. Without comparisons with past periods, it becomes very difficult to know whether payments and receipts were “good” or “bad.” Measures of payments and receipts, by themselves, do not provide much information. The simplicity of preparing the cash flow statement using the direct method comes at a cost: the loss of relevant information for analysis, especially regarding the operating group.

Advantages

- Allows receipts and payments to be classified taking technical rather than tax criteria into consideration;

- Establishes a new challenge: managing the company with cash in mind;

- Allows cash information to be available daily.

Disadvantages

- Initially, it adds a new task: classifying receipts and payments;

- The lack of familiarity of those involved in classifying receipts and payments.

Indirect Method

The second method of preparing and presenting cash flows, the indirect method, is a little more complex, as it starts from profit (which is measured on an accrual basis) and adjustments are made to it in order to arrive at cash. And these adjustments are often not well understood. Since net income (or net loss) is formed by operating and financial components (financial income and expenses), and by income and expenses that do not affect cash in the period (depreciation, amortization, equity-accounted results, etc.), qualitative adjustments must be made. On the other hand, however, information is gained. From adjusted net income, we arrive at what we call generated operating cash flow, which is the appropriate measure of cash generation from activities. But the activities themselves generate and consume cash as a result of changes in payment and receipt terms, inventory levels, sales, costs, etc. Therefore, it is necessary to add or deduct changes in current operating assets and liabilities from the generated operating cash flow in order to arrive at cash flow from operations. This cash flow from operations must be exactly the same as the cash flow from operations when prepared using the direct method. This is because the same cash flow is being explained from two points of view. Cash is cash, and there is no way to modify it.

But its explanations may be different. By increasing the complexity of preparing and presenting cash flows using the indirect method, more information is gained. For example, if there is a significant increase in average collection periods, this will be shown in the indirect cash flow statement as a negative change in the customers account (or accounts receivable). Because the company increased the average collection period, the entity failed to collect cash (or “lent” more resources to its customers). And the effect of this change in sales policy is a decrease in operating cash flow. This type of information is impossible to obtain in the direct cash flow statement. Another example: imagine that suppliers increased average payment terms. What is the effect of this on cash flow? Since the terms were extended, the purchasing company has more time to pay suppliers and therefore keeps a higher cash balance. And this will be shown in the indirect cash flow statement as a positive change in the suppliers account. It is as if the company had stopped paying (and effectively gained some cash relief!) part of its debts to suppliers (or as if the suppliers had granted more “loans” to their customers), and therefore there is an increase in cash flow from operations.

Interesting! The indirect cash flow statement is indeed more informative, but more complex. And what about inventories? Imagine that a certain company is expanding its activities by opening a new store. Comparatively, ending inventories will be higher than beginning inventories, because the beginning inventories will be from (for example) a single store and the ending inventories from (for example) two stores. Very good, and what about cash flow? Since inventories increased, in the indirect cash flow statement there will be a negative change in the inventories account, because from the generated operating cash flow, the entity had to use it to increase inventories. Hence, a decrease in operating cash flow.

Correct? No!! Note that this increase in inventories resulted from the initial investments in inventory in a new store and, therefore, is not genuinely operating in nature, but rather investments made in initial inventories! And the most appropriate classification for this increase in inventory level is in the investing group, not the operating group.

Notice that this “detail” can substantially change how cash generation is demonstrated (and especially analyzed). Will this increase in inventories happen again in the future? Most likely not. Only if the company expands again. But if it does not expand and inventories still increase? Then this increase is indeed operating in nature and will be shown as a decrease in the company’s operating cash flow. But why did this happen? That is a good question. Did inventory costs increase? Are they turning over more slowly? Is the company selling less? Are there idle inventories?

Note that the preparation and presentation of cash flows is not as trivial as it may seem. Various strategic issues are involved. And these issues are the most relevant ones to be analyzed.

Advantages

- Its implementation is low-cost, requiring only the use of two balance sheets (the one at the beginning and the one at the end of the period), the income statement, and some additional information obtained from the company’s accounting records;

- Allows the differences between accounting profit and cash flow to be identified through reconciliation.

Disadvantages

- The volume of rework of information, in order to convert information from the accrual accounting basis to the cash basis, in addition to, depending on the time interval for its execution, potentially presenting unpleasant results;

- The fact that tax legislation interferes with the accounting result means that only part of these distortions will be eliminated by this method.

Examples

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Exercises

1) (AOCP - 2016 - Municipality of Juiz de Fora - MG - Administrator) What is the criterion used for the economic-financial evaluation of investments that take into account the time value of money?

A) Accounting cash flow.

B) Economic cash flow.

C) Historical cash flow.

D) Discounted cash flow.

E) Future cash flow.

2) (CESGRANRIO - 2018 - LIQUIGÁS - Junior Professional - Economics) A person bought a property financed according to the following payment flow: They must pay 60 equal and consecutive monthly installments of R$10,000.00, the first beginning one month after the purchase. Suppose the person can invest their financial resources at a positive interest rate.

In this situation, it would be better for them, financially, if they paid for the property in

A) a single installment of R$600,000.00 at the time of purchase.

B) 10 equal and consecutive monthly installments of R$60,000.00, beginning one month after the purchase.

C) 20 equal and consecutive monthly installments of R$30,000.00, beginning one month after the purchase.

D) 40 equal and consecutive monthly installments of R$15,000.00, beginning one month after the purchase.

E) 80 equal and consecutive monthly installments of R$7,500.00, beginning one month after the purchase.

3) (FUMARC - 2018 - COPASA - Sanitation Analyst - Administrator) Analyze the statements below regarding the topic of Risks and Rates of Return in Financial Administration, identifying them with T or F, according to whether they are true or false:

( ) All financial assets are expected to produce cash flows, and the degree of risk of an asset is assessed according to the degree of risk of its cash flows.

( ) An asset with a high degree of relevant (market) risk needs to have a relatively low expected rate of return to attract investors.

( ) Standalone risk is the risk to which an investor would be exposed if he or she had only a single asset.

( ) The relationship between risk and return is such that no investment will be made unless the expected rate of return is sufficiently low to compensate the investor for the reduced risk of the investment.

The CORRECT sequence, from top to bottom, is:

A) F – F – T – T

B) F – T – F – T

C) T – T – F – F

D) T – F – T – F

4) (INSTITUTO AOCP - 2017 - EBSERH - Administrative Analyst - Administration (HRL - UFS)) There are several company valuation models, all of them incorporating certain assumptions and varying levels of subjectivity. Due to greater conceptual rigor and consistency with modern finance theory, priority is given to valuation models based on

A) historical cost.

B) market value.

C) adjusted current cost.

D) equity value.

E) discounted cash flow.

5) (FGV - 2015 - CODEMIG - Business Analyst) A company that calculates its Income Tax – IR and its Social Contribution on Net Profit – CSLL according to the tax regime known as “Actual Profit” is evaluating an investment project that involves the acquisition of fixed assets that will cost R$50 million and have a useful life of 10 years, immediately after which such assets will have zero accounting and market residual values. Considering that the depreciation method allowed by the Federal Revenue Service is the Straight-Line Method and that the “IR + CSLL” rate is 34% p.a., the annual nominal cash flow saved by the company due to this government tax incentive is, in millions of reais, equal to:

A) 0.1;

B) 1.7;

C) 3.3;

D) 5.0;

E) 6.6.

6) (FGV - 2015 - CODEMIG - Business Analyst) A model that can be used to project free cash flows to the firm for a given investment project is one in which such flows are subdivided into three components, generating the following equality: free cash flow to the firm = operating cash flow (-) change in net operating working capital (-) net capital expenditures. Therefore, the negative cash flows that most negatively impact the free cash flow to the firm are:

A) financial amortization and short-term investments;

B) amortization of intangible assets and long-term investments;

C) depreciation of fixed assets and short-term investments;

D) depreciation of fixed assets and long-term investments;

E) operating cycle payments and long-term investments.

7) (CESPE / CEBRASPE - 2022 - ANP - Regulator of New Assignments II - Position 5) A company wishes to measure the economic viability of a project for a new production plant. Considering this hypothetical situation, judge the following item: "Adequate financial planning will allow the company to size the project's cash flow needs and mitigate its liquidity risk."

A) Correct

B) Incorrect

8) (FGV - 2023 - DPE-RS - Analyst - Specialized Support Area - Accounting) The Statement of Cash Flows (SCF) was introduced as part of the complete set of accounting statements applied to the public sector in the context of convergence with international standards. One point of the common structure of the SCF is the need to disclose cash flows associated with three activities: operating, investing, and financing.

When preparing the SCF in light of the provisions of the Manual of Accounting Applied to the Public Sector (MCASP), it is necessary to observe that:

A) it is possible to choose between the direct or indirect method;

B) the sum of the three cash flows must correspond to the difference between the opening and closing cash balances for the fiscal year;

C) the cash flow from financing activities must be aligned with debt limits;

D) the result for the fiscal year must be reconciled in determining the cash flow from operating activities;

E) the balances for its preparation are associated with the accounts of a patrimonial nature in the PCASP.

9) (INSTITUTO AOCP - 2023 - MPE-MS - Analyst - Accounting) According to the Manual of Accounting Applied to the Public Sector – 9th edition, the Statement of Cash Flows (SCF)

A) may be prepared using either the direct method or the indirect method.

B) must be prepared using the indirect method.

C) must be prepared using the direct method.

D) should only be prepared by independent public companies.

E) does not need to be prepared or disclosed.

Resolution

1) D

2) E

3) D

4) E

5) B

6) E

7) A

8) B

9) C

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