Inventory is defined as the goods that the Company holds for resale. When an accounting year ends, companies mostly have inventory on hand that is supposed to be sold in the coming year.
This inventory is kept in the warehouses, and they are then declared on the financial statements as closing inventory of the Company.
Inventory impacts all the three different types of financial statements, i.e., the Income Statement, the Balance Sheet, and the Cash Flow Statement.
In the Income Statement, closing inventory calculates the cost of goods sold. It is subtracted from the sum of opening inventory and Purchases to calculate the cost incurred on the cost of goods sold.
In the Company’s Balance Sheet, closing inventory is recorded as a Current Asset. However, the treatment of inventory in the Cash Flow Statement is slightly different.
What is a Statement of Cash Flow?
The Cash Flow Statement is prepared on an annual basis. It is an official document that is audited along with the Income Statement and the Statement of Financial Position. It represents the Cash Inflow and Outflow of the Company over the given course of time.
The main rationale behind creating a Cash Flow Statement is for the shareholders and the general public to understand the Company’s liquidity position. It also gives stakeholders an idea regarding the management of cash and cash equivalents over the course of years.
Format of Statement of Cash Flow
A Cash Flow Statement is formatted and classified into three different categories:
- Operating Activities: Operating Activities refer to the cash inflows and outflows that happen as a result of operating activities of the business. Therefore, these are the activities that occur in the normal routine of the business.
- Investing Activities: Investing Activities are cash inflows and cash outflows that are undertaken by the business as a result of investment-related opportunities of the business. Examples of investing activities include purchase or sale of assets, loans made to the vendors or received from customers, or any other payments related to mergers and acquisitions.
- Financing Activities: Financing Activities involve movements in share capital, and other long-term sources of finance that the company has raised in order to fund operations. Examples of cash flow from financing activities include dividends, payments for stock repurchases, as well as repayment of debt principal.
All these three amounts are calculated and then summed up together to calculate the net amount of cash present with the Company over time. Therefore, the cash flow statement summarizes and subsequently identifies every cash transaction that has taken place over time.
As far as the change or movement in inventory is concerned during the period, it is presented under the cash flow statement under the operating activities. Specifically, it is mentioned under the changes in working capital.
Impact of inventory on Cash Flow Statement
Inventory is a current asset on the balance sheet of the Company. Therefore, it impacts operating activities on the cash flow statement. This is primarily because of the fact inventory-related movements result in cash inflows, as well as outflows of the Company.
Like in the case of other Current Assets, the Company needs cash resources to acquire inventory. Therefore, when the Company purchases inventory, it implies that the Company spends more cash in order to purchase the inventory.
On the contrary, when inventory is sold, i.e., it decreases, it is similar to a cash inflow in the Company. This is because when sales are made, inventory decreases, and cash increases. Hence, sales are synonymous with cash inflows in the Company.
Based on the rules mentioned above, the impact of inventory movement in the cash flow can be summarized as follows:
- Increase in inventory – Cash Outflow (Negative Cash Outflow)
- Decrease in inventory – Cash Inflow (Positive Cash Inflow)
In case inventory is purchased on credit and/or sold on credit, there is no impact on the Company’s cash flow.
However, it does impact accounts receivable and Accounts Payable. Since this is the amount that needs to be received (or paid) by the Company regardless, it is still mentioned in the Cash Flow Statement.
Example of Inventory Movement in the Cash Flow Statement
In order to understand the concept of inventory movement in the cash flow statement, the following illustration is presented:
Boson Co. purchases 10,000 units of inventory at a cost of $5 each. During the year, they sold around 6,000 units at a price of $10. Boson Co. only deals in credit. The Company had a beginning balance of inventory equivalent to 1000 units at a cost of $5 each.
In the example mentioned above, it can be seen that the impact of inventory movement in the cash flow statement can be summarized as follows:
- Purchase of inventory – Boson Co. purchased 10,000 units of inventory, worth $5 each. This represents a cash outflow of $50,000.
- Sale of inventory – Boson Co. sold 6,000 units of inventory, worth $10 each. This represents a cash inflow of $60,000.
- Therefore, the company had a total cash inflow of $10,000 ($60,000 – $50,000).
The closing inventory of Boson Co. can be calculated as follows:
- Closing Inventory = Opening Inventory + Purchases – Sales
- Closing Inventory = 1000 + 10,000 – 6,000 = 5000 units
- The value of closing inventory would be $5 x 5000 units = $25,000
- The beginning value of inventory was $5,000.
- Therefore, inventory increased by an amount of $20,000 across the years ($25,000 – $5,000).
This change in the value of closing inventory would be reflected in the cash flow statement. On the other hand, the cash inflow as a result of sales and purchases of inventory is already included in the financial statements; therefore, this means that only the change in inventory would be included in the Cash Flow under Operating Activities.
This is going to be represented in the cash flow statement as follows:
|Cash Flow Statement (Boson Co.)||2018|
|Change in working capital|
|Decrease in Accounts Receivable||xxx|
|Increase in inventory||$20,000|
|Net Cash from Operating Activities||xxx|
Therefore, it can be seen that inventory movements are reflected in the Cash Flow Statements only equivalent to the amount that has changed in terms of inventory.
Cash purchases, or credit purchases, are already accounted for in the Income Statement, and therefore, they are not included explicitly in the Company’s Cash Flow Statement. Even in the case of credit purchases, or sales, the change in inventory is still recorded in the cash flow statements.