The Statement of Cash Flows Chapter 5 The Statement of Cash Flows 1

Chapter Outline Understanding Cash Flows The Purpose of the Statement of Cash Flows Sources and Uses of Funds Creating the Statement of Cash Flows Statement of Cash Flows Analysis 2

Learning Outcomes State the reason cash flows are critical to the operation of a successful business. Identify sources and uses of funds to assist in the creation of a statement of cash flows. Create a statement of cash flows using an income statement and two balance sheets. Analyze a statement of cash flows to better manage the cash flows of your own business. 3

Understanding Cash Flows Assume, for example, that you have income from a variety of sources. These sources may include money paid to you from a job, income from parents or other family members, and interest you may earn on savings accounts. In addition, you have living and school expenses that must be paid. You know that you must have enough money on hand to pay your bills as they become due. Having access to cash at the right time (versus having the right amount of cash) is important to individuals. It is also critically important to businesses. 4

The Purpose of the Statement of Cash Flows The statement of cash flow shows (SCF) shows all sources and uses of funds from operating, investing, and financing activities of a business. The SCF is designed to report a business’s inflows and outflows of money affecting the cash position as well as its beginning and ending cash and cash equivalents balances for each accounting period. The cash inflows and outflows of a business are of significant importance to a business’s owners, investors, lenders, creditors, and managers. 5

The Purpose of the Statement of Cash Flows Cash on a balance sheet is considered to be a current asset. Cash, in this case, refers to currency, checks on hand, and deposits in banks. Cash is not synonymous with the term “revenue” or “sales.” Cash equivalents are short-term, temporary investments such as treasury bills, certificates of deposit, or commercial paper that can be quickly and easily converted to cash. 6

Sources and Uses of Funds Sources represent inflows and uses represent outflows of funds for the hospitality business. When comparing assets from last period’s balance sheet to this period’s balance sheet, decreases in assets represent sources of funds and increases in assets represent uses of funds. Accumulated depreciation behaves in an opposite manner to the other assets. This is because depreciation is a contra asset account. 7

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Sources and Uses of Funds Alternatively, increases in liabilities and owners’ equity represent sources of funds and decreases in liabilities and owners’ equity represent uses of funds. 9

Sources and Uses of Funds Up arrows represent “increases” and down arrows represent “decreases.” Assets in each column have opposite arrows from liabilities and owners’ equity. Also, arrows in the left column are opposite of those in the right column. 10

Sources and Uses of Funds If you can remember only one, you can remember all the rest. Once you have that arrow correct, then you can remember the directions of the other arrows. Be careful, though! If you get your one example backwards, then ALL of the others are wrong! Memorize this “trick”; it will help you immensely! You can now put numbers to your sources and uses of funds. These numbers will show you increases and decreases as shown in Figure 5.4. 11

Steps to Calculate Sources and Uses of Funds Draw the chart shown in Figure 5.3 to help you identify sources and uses of funds. Draw up arrows ↑ and down arrows ↓ next to the balance sheets to indicate increases and decreases in the accounts from 2009 to 2010. Calculate the difference in each account from 2009 to 2010. Place the difference in each account under the appropriate Sources or Uses column. Do not calculate subtotals and totals. Add the numbers in the Sources column and then add the number in the Uses column. The totals in each column should equal each other. If they do, you have identified the correct sources and uses of funds, and you are finished! If the totals in each column do not equal each other, calculate the difference between the columns and divide by 2. This is the amount of your mistake. 12

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Creating the Statement of Cash Flows The statement of cash flows should be prepared just as often as you prepare your income statement and balance sheet. In order to build a statement of cash flows, you will need the following: Income statement for this year, including a statement of retained earnings Balance sheet from last year Balance sheet from this year 14

Creating the Statement of Cash Flows The format of a SCF consists of the following: Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities Net changes in cash Supplementary schedules Figure 5.5 is an example of the standard format used to prepare a statement of cash flows. 15

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Cash Flow from Operating Activities Cash flow from operating activities is the result of all of the transactions and events that normally make up a business’s day to day activities. These include cash generated from selling goods or providing services, as well as income from items such as interest and dividends. Operating activities will also include cash payments for items such as inventory, payroll, taxes, interest, utilities, and rent. 17

Cash Flow from Operating Activities The net amount of cash provided (or used) by operating activities is a key figure on a statement of cash flows because it shows cash flows that managers can control the most. The first step in creating a statement of cash flows is to develop a summary of cash inflows and outflows resulting from operating activities, using information provided on the income statement including sales, expenses, and thus, net income. 18

Cash Flow from Operating Activities There are two methods that are used in calculating and reporting the amount of cash flow from operating activities on the statement of cash flows: the indirect method and the direct method. Although both produce identical results, the indirect method is more popular because it more easily reconciles the difference between net income and the net cash flow provided by operations. 19

Cash Flow from Operating Activities When using the indirect method, you start with the figure for net income (taken from your income statement) and then adjust this amount up or down to account for any income statement entries that do not actually provide or use cash. The accrual income statement must be converted to a cash basis in order to report cash flow from operating activities. 20

Cash Flow from Operating Activities The two most common items on the income statement that may need to be adjusted from an accrual basis to a cash basis are Depreciation, and Gains/losses from a sale of investments/equipment. Depreciation is a method of allocating the cost of a fixed asset over the useful life of the asset. More important, however, depreciation is subtracted from the income statement primarily to lower income, and thus lower taxes. 21

Cash Flow from Operating Activities In order to adjust net income to reflect actual cash, then, depreciation must be added back. A gain on a sale of an investment/equipment occurs when the original cost of the investment/equipment is lower than the price at which it is sold at a later date. Conversely, a loss on a sale of an investment/equipment occurs when the original cost of the investment/equipment is higher than the price at which it is sold at a later date. 22

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Cash Flow from Operating Activities The remaining adjustments to net income when calculating cash flow from operating activities come from the sources and uses of funds calculated from the balance sheets. Sources of funds are shown as a positive number on the statement of cash flows and uses of funds are shown as a negative number of the statement of cash flows. In general, the sources and uses of funds used for cash flow from operating activities will come from current assets and current liabilities. The exceptions to this are marketable securities, which belongs in investing activities, and notes payable (short-term debt), which belongs in financing activities. 24

Cash Flow from Investing Activities An investment can be understood simply as the acquisition of an asset for the purpose of increasing future financial return or benefits. Cash flow from investing activities summarizes this part of a business’s action. A business’s investing activities include those transactions and events involving the purchase and sale of marketable securities, investments, land, buildings, equipment, and other assets not generally purchased for resale. 25

Cash Flow from Investing Activities The cash flow from investing activities comes from the sources and uses of funds that you calculated from your balance sheets. Sources of funds are shown as a positive number on the statement of cash flows and uses of funds are shown as a negative number of the statement of cash flows. In general, the sources and uses of funds used for cash flow from investing activities will come from long-term assets (investments, property and equipment, and other assets). The exception to this is marketable securities, which is a current asset that belongs in investing activities. 26

Cash Flow from Financing Activities The third and final of the three cash inflow and outflow activity summaries that make up a complete SCF relates to the financing activities of a business. Cash flow from financing activities refers to a variety actions including: Obtaining resources (funds) from the owners of a business (e.g. by selling company stocks) Providing owners with a return of their original investment amount (e.g. payment of dividends) Borrowing money Repaying borrowed money 27

Cash Flow from Financing Activities Although repayments of loans are considered a financing activity, interest paid and interest received are classified as operating activities (as part of the income statement). Cash payments made to reduce the principal (the amount borrowed) of a loan would be considered cash flow related to a financing activity, while any interest paid to secure the loan would be considered an operating expense. Loans, notes, and mortgages are all examples of financing activities that affect cash flows. 28

Cash Flow from Financing Activities The cash flow from financing activities comes from the sources and uses of funds calculated from the balance sheets. Sources of funds are shown as a positive number on the statement of cash flows and uses of funds are shown as a negative number of the statement of cash flows. In general, the sources and uses of funds needed for cash flow from financing activities come from long-term debt and equity. The exception to this is notes payable (short-term debt), which is a current liability that belongs in financing activities. 29

Cash Flow from Financing Activities Also, dividends paid must be recorded in financing activities because that is a cash outflow from net income. Additions and subtractions to the statement of cash flows are shown in Figure 5.9. With the exceptions noted, operating activities are developed using current assets and current liabilities, investing activities are developed using long-term assets, and financing activities are developed using long-term debt and owners’ equity. 30

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Net Changes in Cash Net changes in cash represent all cash inflows minus cash outflows from operating, investing, and financing activities. This net change in cash must equal the difference between the cash account at the beginning of the accounting period and the cash account at the end of the accounting period. 32

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Supplementary Schedules Any noncash investing and financing transactions undertaken by a company should be reported in a Supplementary Schedule of Noncash Investing and Finance Activities that is attached as a supplement to the SCF. Also included in the statement of cash flows is the Supplementary Disclosure of Cash Flow Information, which reports cash paid during the year for interest and income taxes. 34

Statement of Cash Flows Summary A complete SCF should include: A summary of cash inflows and outflows resulting from operating activities A summary of cash inflows and outflows resulting from investing activities A summary of cash inflows and outflows resulting from financing activities Net changes in cash from the beginning to the ending of the accounting period A supplementary schedule of noncash investing and financing activities (if applicable) A supplementary disclosure of cash flow information 35

Statement of Cash Flows Example For a complete illustration of building a Statement of Cash Flows for the Blue Lagoon Water Park Resort, see Figures 5.10, 5.11, and 5.12. 36

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Statement of Cash Flows Analysis One way to analyze a statement of cash flows is to first look at the sources and uses of funds identified by comparing last year’s balance sheet with this year’s balance sheet. By matching “like” dollar amounts of sources and uses of funds, you can surmise how funds were spent based on how funds were generated. 40

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Statement of Cash Flows Analysis Another method of analyzing the statement of cash flows is to compare operating, investing, and financing activities from last year to this year. The dollar or percentage variance shows changes from previously experienced levels, and will give you an indication of whether your numbers are improving, declining, or staying the same. 42

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Statement of Cash Flows Analysis For many investors and managers, a business’s free cash flow is an important measure of its economic health. Free cash flow is simply the amount of cash a business generates from its operating activities minus the amount of cash it must spend on its investment activities and capital expenditures. Thus, free cash flow is considered a good measure of a company’s ability to pay its debts, ensure its growth, and pay (if applicable) its investors in the form of dividends. 44

Statement of Cash Flows Analysis A company with a positive free cash flow can grow and invest its excess cash in its own expansion or alternative investments. If a company has a negative free cash flow it will need to supplement its cash from other sources, such as borrowing funds or seeking additional investors. 45

Review of Learning Outcomes State the reason cash flows are critical to the operation of a successful business. Identify sources and uses of funds to assist in the creation of a statement of cash flows. Create a statement of cash flows using an income statement and two balance sheets. Analyze a statement of cash flows to better manage the cash flows of your own business. 46