Introduction to Financial Statement Analysis. Chapter 2: System of Flows

Financial statements record economic transactions. Economic transactions create a cycle of cash flows through the business. First, creditors and investors contribute invested capital. Second, the invested captial is recorded as debt and equity on the right-hand side of the balance sheet; the right-hand capital holders own (or have claims on) the left-hand side assets. Third, the assets are used to produce cash flows. Cash flows in (sources) and out (uses) over an annual or quarterly period, for example. The statement of cash flows records these period sources/uses of cash into three buckets: operating, investing, and financing. Fourth, the net (or excess) cash flow is either "returned" or "retained." Net cash flow is returned to debt holders with principal paydown; it is returned to shareholders through either dividends or buybacks. Net cash flow is retained when the company simply keeps it (increasing assets and equity).

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