Businesses worldwide maintain three crucial financial statements. These statements include the balance sheet, income statement, and cash flow.
Such financial statements objectively give an insight into such business aspects as financial performance, the level of management success, expansion and optimization prospects, etc. So, these aspects are critical to business analysts and potential investors.
A cash flow statement, in this case, provides the company’s management with a substantial understanding of a business’s financial health. It consists of three parts:
- cash flow from operations;
- cash flow from investing;
- cash flow from financing activities.
The cash flow from financing activities (CFF) section is critical to the business since it reflects the cash inflows and outflows from a business’s financing activities. In this article, readers will learn about the importance of CFF and how to calculate CFF.
Understanding Cash Flow From Financing Activities
As mentioned, cash flow from financing activities (CFF) is one of three main sections of a business’s cash flow statement. The CFF section shows the cash net flow used to finance the company.
Financial activities include:
- transactions involving debt;
Thanks to this section of the cash flow statement, the company’s management gets valuable insight into the business’s financial strength. It also tells whether the company uses its resources wisely and whether they need to enforce changes.
The obvious answer is financing activities. But what is meant by financial activities? In accounting, financial activities refer to the transactions involved in raising and retiring a company’s resources (money). The raising part is related to cash inflow and retiring means cash outflows.
Typically, the list of cash inflow items from financing activities consists of the following:
- issuance of bonds or/and debentures;
- issuance of ordinary shares;
- issuance of preference shares;
- the usage of loans from financial institutions to increase short-term and long-term loans.
The list of cash outflow items from financing activities consists of the following:
- shares buyback;
- payments of dividends;
- interest on debts payments;
- returning all debts;
- returning any financial lease obligations;
- dividend distribution tax.
This section provides accountants with data that indicates whether the cash inflow exceeds cash outflow. That’s why it’s critical to pay close attention to this section of the cash flow statement.
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The CFF formula allows investors, creditors, or management to determine the business’s financial health.
CED − (CD + RP) = CFF
Parts of this equation mean:
- CED = cash inflows from issuing equity or debt;
- CD = cash paid as dividends;
- RP = repurchasing debt or/and equity.
According to this formula, investors can tell whether it’s a sound idea to buy a company’s stock.
Calculating Cash Flow From Financing Activities
The first step to calculating cash flow financing activities is to examine the balance sheet and differentiate cash outflows from cash inflows. The increase of equity capital over a specific period indicates an issuance of shares, which indicates cash inflow. Similarly, if there is a decrease in equity capital over a specific period, the company is repurchasing its shares, which indicates a cash outflow.
If short-term and long-term borrowings decrease over a period, the company is repaying its debts, which indicates cash outflow. If there is an increase in short-term or long-term debts, the company gains liabilities resulting in cash inflow.
Note: CFF formula doesn’t consider changes in retained income since it isn’t related to financing activities. Apart from changes within the capital structure, accountants calculating CFF should also include payments made for interest and dividends. Take a look at the company’s income statement, the debit section, to find interest and debit transactions.
As soon as an accountant finds all these details, they can use the formula above. If that formula isn’t detailed enough, use the following equation:
Cash flows from equities and debts issuance – (interest + dividends + stock repurchasing + lease obligations repayment + debt repayment + dividend distribution tax) = CFF.
To calculate cash from financial activities, one must subtract cash outflow from cash inflow.
Positive and Negative CFF
The financing section of the cash flow statement shows equity and debt financing. Financing varies depending on a capital structure, debt terms a company has, and dividend policies.
The following transactions cause a positive cash flow:
- The issuance of stock or equity that a company is selling to investors.
- The issuance of bonds. Bonds are debts bought by investors.
- Borrowing debt from a financial institution.
If a cash flow from financing activities is positive, it means a company has more inflow than outflow, and thus these activities increase the business’s assets.
The following transactions cause a negative cash flow:
- Paying dividends to stakeholders.
- Repaying the company’s debt.
- Repurchase of stock.
A negative cash flow from financing activities is not necessarily a bad occurrence. For example, if the company is paying dividends, it’s a sign for investors that the company is worthy of its investments.
Negative CFF numbers can also mean a business is repaying its debt, so its liabilities are decreasing. Let’s dive into the details of how to interpret CFF numbers.
How to Interpret CFF
Accountants or other responsible employees in the company must look at the company’s CFF to get valuable insight. CFF calculation is also critical for investors investing in the company. But it’s also crucial to learn how to interpret the results.
Capital Financing Options
Take a look at the company’s preferred financing options. If the business prefers selling stock to increase its capital, it will eventually result in the company’s stock falling in price. It’s not a good option if someone considers investing in the stock.
If a business relies too much on debt, it may have problems with short-term or long-term obligations. It may be a risky venture to invest in such a firm. A perfect option is when the company maintains a balance that minimizes the cost of capital.
Cash Inflow Frequency
One option for investors to determine a business’s operational efficiency is to check the frequency of cash inflow from financing activities during several periods. Here’s an example: if a business is issuing new stocks and uses additional debts quite often, it could be a bad sign.
This company may have difficulties with generating income to finance business operations. Even though the company has sufficient cash flow on paper, it may have difficulties in selling goods or services. It’s a warning sign, and investors should investigate whether the company they plan to invest in frequently engages in additional borrowings.
Stock Repurchase And Dividends Distribution
If a firm is generating significant net income consistently and repurchasing stocks, it’s a great indication for investors. Stock’s value increases since there is a lower number of stocks on the market to purchase. If the company has an outflow due to dividend distribution, it’s a tolerable cash outflow since it is sharing profit with investors.
A dividend distribution or buyback isn’t a good sign if the company’s income decreases or could be higher. This situation demonstrates the business’s desire to support its stock price to compensate for low revenue.
The cash flow from financing activities section provides the management and investors with the necessary data. But it’s worth mentioning that no one should make conclusions based only on CFF calculation. Other critical indicators must be considered, and investors should also feel free to ask for additional information.
Author: Charles Lutwidge