What’s it: Cash flow from financing activities refers to the inflows and outflows of company money related to long-term financing. It consists of various transactions with suppliers of capital to get capital and pay back the capital.
Cash flow statement in brief
The cash flow statement is the central part of the financial statements besides the balance sheet and income statement.
In the operations activities section, you will see how companies make and spend money from their core business.
Next, the investing activities section shows you how the company grows its business in the long run. The key component in this section is the purchase and sale of fixed assets (capital expenditures).
Lastly, cash inflows from financing activities tell you how companies finance long-term investments using external funding sources. The cash outflows in this section provide details of the refund (such as principal payments and dividends).
Cash flows from financing activities summarize the various transactions that affect the capital structure of a company. In general, capital structures fall into two groups: equity and debt.
Equity represents ownership in a company, so that the suppliers are referred to as shareholders. The potential returns to shareholders are the capital gains from increases in share prices and dividends.
Meanwhile, debt takes various forms, including bank loans, medium-term notes, and bonds. When taking debt, companies must make regular payments. For bank loans, they have to pay installments. Meanwhile, for bonds or medium-term notes, they must pay regular coupons and loan principal at maturity.
Components of cash flow from financing activities
In the financial statements, cash flow from financing activities is one of the three parts of the cash flow statement besides cash flows from operating activities and cash flows from investing activities.
Cash flow from financing activities shows you the flow of money between the business and its suppliers of capital (shareholders and creditors). From this section, you will see how a business finances its long-term operations.
If the cash flow from financing activities is positive, it indicates that the business is receiving cash. It increases the company’s capital, as well as its assets.
Conversely, if the number is negative, it shows the business is paying for capital. For example, a company pays dividends or pays off long-term debt.
Examples of sources of cash inflows from financing activities are:
- Issuance of common stock and preferred stock
- Sale of treasury stock
- Issuance of debt securities such as medium-term notes and bonds
- Loan from bank
Those transactions increase the company’s cash. When issuing stocks or debt securities, for example, money from investors goes to the company.
Meanwhile, examples of sources of cash outflows from financing activities are:
- Share buyback
- Repayment of debt securities
- Bank loan installments
- Payment of cash dividends to shareholders
Several investing and financing activities may affect a company’s capital structure but do not involve cash. We call them non-cash transactions.
The company does not report non-cash transactions in the cash flow statement because they do not involve cash receipt or payment. Examples of non-cash transactions are:
- A barter transaction in which one non-monetary asset is exchanged for another
- Conversion of preferred stock, share dividends, or convertible bonds into common stock
- Real estate acquisition with financing provided by the seller
Why is cash flow from financing activities important
Financing activities provide insight into financial health and business goals. In general, positive cash flow from financing activities can indicate business expansion and growth intentions.
More money flows to the company, so assets increase. Companies can use them to finance the purchase of capital assets or build new production facilities. So, financing activity tells you how companies finance their business, using external sources in the long run.
Furthermore, cash flow from financing activities does not include expansion financing using internal funds because the equity and liability accounts have not changed.
Both investors and creditors look to this section to determine how a company is funding its long-term growth. If a company relies on debt more than equity, it increases financial leverage.
Too aggressive levels of leverage increase financial risk and default. Companies spend money regularly to pay debts. If, their income weakens, it reduces the ability to repay the loan and can lead to default.
Therefore, companies usually take on debt when they have a steady and large enough cash flow. So debt may not be suitable for some newer or developing companies.
New companies usually have a relatively small customer base. Their income is relatively limited, so they have a weak cash inflow from their core business. Therefore, equity funding is a safe route to give them the cash to thrive.
The issuance of shares does not have regular payment consequences. It only has an impact on changes in the composition of company ownership.