Chapter 4 Statement of Cash Flows Copyright © 2016 Pearson Education, Inc.

Why Cash Flow is Important: An Example Copyright © 2016 Pearson Education, Inc.

Why Cash Flow is Important: An Example The company reported rising amounts of net income. The company failed to generate any cash from its operations. These deficits were offset by borrowings. The company went bankrupt in 2008. Copyright © 2016 Pearson Education, Inc.

Why Cash Flow is Important: An Example It is possible for a company to post a healthy net income but not have cash needed to pay its employees, suppliers, and bankers. Positive net income on the income statement is ultimately insignificant unless a company can translate its earnings into cash. Copyright © 2016 Pearson Education, Inc.

Why Cash Flow is Important: An Example The statement of cash flows provides information about cash inflows and outflows during an accounting period and over time. It is extremely important as an analytical tool. Copyright © 2016 Pearson Education, Inc.

Why Cash Flow is Important: An Example Cash flows are segregated by: operating activities, investing activities, and financing activities. Copyright © 2016 Pearson Education, Inc.

Statement of Cash Flows: Basic Principle The statement of cash flows is another way of presenting the balance sheet of the company. The balance sheet shows amounts at the end of the accounting period. The statement of cash flows shows changes in the balance sheet accounts between periods. Copyright © 2016 Pearson Education, Inc.

Statement of Cash Flows: Basic Principle Change in cash between periods is explained by changes in all other balance sheet accounts. Each balance sheet account is related either to an operating activity, an investing activity, or a financing activity. Change in cash between periods is equal to cash flow from operating activities, investing activities, or financing activities. Copyright © 2016 Pearson Education, Inc.

Statement of Cash Flows: Basic Principle Copyright © 2016 Pearson Education, Inc.

Statement of Cash Flows: Basic Principle Cash account increased by $1,299 million between November 30, 2006 and 2007. Operations used cash (net outflow) of $45,945 million. Investing activities used cash (net outflow) of $1,698 million. The company borrowed (net inflow) $48,592 million. The company borrowed to cover the cash deficit in operations and capital expenditures. Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Begins with a return to the balance sheet Requires reordering of the information presented on a balance sheet Shows changes over time rather than the absolute dollar amount of the accounts at a point in time Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Four parts of a statement of cash flows Cash Operating activities Investing activities Financing activities Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Highly liquid short-term marketable securities (cash equivalents) Short-term investments Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Operating activities Delivering or producing goods for sale Providing services Cash effects of transactions and other events that enter into the determination of income Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Investing activities Acquiring and selling (or otherwise disposing of) securities that are not cash equivalents or productive assets that are expected to benefit the firm for long periods Lending money and collecting on loans Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Financing activities Borrowing from creditors and repaying principal Obtaining resources from owners and providing them with a return on the investment Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Calculate the changes in all of the balance sheet accounts, including cash. List the changes in all of the accounts except cash as inflows or outflows. Categorize the flows by operating, financing, or investing activities. The inflows less the outflows balance to and explain the change in cash. Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Next, transfer the account changes to the appropriate area of a statement of cash flows. In doing so, a determination must be made of what constitutes an inflow and what constitutes an outflow. Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Exhibit 4.2 – inflows Decrease in other assets Increase in long-term debt Increase in common stock and additional paid-in capital Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Exhibit 4.2 – outflows Increase in inventories Decrease in notes payable Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Accumulated depreciation Appears in the asset section Is actually a contra-asset Reduces the amount of total assets Shown in parentheses on the balance sheet Has the same effect as a liability account Copyright © 2016 Pearson Education, Inc.

Preparing a Statement of Cash Flows Other complications Two transactions in one account Multiple transactions affecting other accounts Copyright © 2016 Pearson Education, Inc.

Calculating Cash Flow from Operating Activities Operating activities represent cash generated internally. Investing and financing activities provide cash from external sources. Copyright © 2016 Pearson Education, Inc.

Calculating Cash Flow from Operating Activities Firms may use one of two methods to calculate cash flow from operating activities: Direct Method Indirect Method Direct and indirect methods yield identical figures for net cash flow from operating activities. Copyright © 2016 Pearson Education, Inc.

Calculating Cash Flow from Operating Activities Direct Method Cash collection from customers Interest and dividends collected Other operating cash receipts Cash paid to suppliers Interest paid Taxes paid Other operating cash payments Copyright © 2016 Pearson Education, Inc.

Calculating Cash Flow from Operating Activities The indirect method starts with net income and adjusts for deferrals accruals noncash items nonoperating items Copyright © 2016 Pearson Education, Inc.

Calculating Cash Flow from Operating Activities Copyright © 2016 Pearson Education, Inc.

Calculating Cash Flow from Operating Activities Copyright © 2016 Pearson Education, Inc.

Calculating Cash Flow from Operating Activities Copyright © 2016 Pearson Education, Inc.

Calculating Cash Flow from Operating Activities Indirect method – Sage Inc. Depreciation and amortization are added to net income. Increase in deferred tax liability account is added to net income. Increase in accounts receivable is deducted. Increase in inventory is deducted. Copyright © 2016 Pearson Education, Inc.

Calculating Cash Flow from Operating Activities Indirect method – Sage Inc. Decrease in prepaid expenses is added. Increase in accounts payable is added. Decrease in accrued liabilities is subtracted. Increase in income taxes payable is added. Copyright © 2016 Pearson Education, Inc.

Cash Flow from Investing Activities Copyright © 2016 Pearson Education, Inc.

Cash Flow from Investing Activities Additions to property, plant, and equipment represent a cash outflow of $14.1 million. Decrease in other assets represents a cash inflow of $295 thousand. Copyright © 2016 Pearson Education, Inc.

Cash Flow from Financing Activities Copyright © 2016 Pearson Education, Inc.

Cash Flow from Financing Activities Sage Inc. issued new shares of stock during 2016. The total cash generated from stock sales amounted to $256 thousand. Copyright © 2016 Pearson Education, Inc.

Cash Flow from Financing Activities Short-term debt and current maturities of long-term debt jointly explain Sage Inc.’s net reduction in short-term borrowings: Copyright © 2016 Pearson Education, Inc.

Cash Flow from Financing Activities Long-term borrowings should be segregated into two components: Additions to long-term borrowings Reduction of long-term borrowings Copyright © 2016 Pearson Education, Inc.

Cash Flow from Financing Activities Additions to long-term borrowings and reductions of long-term borrowings on the Sage Inc. statement of cash flows reconcile the change in the long-term debt account on the balance sheet. Copyright © 2016 Pearson Education, Inc.

Cash Flow from Financing Activities Change in retained earnings results from net income recognition and the payment of cash dividends. Payment of cash dividends is financing outflow. Declaration of a cash dividend would not affect cash. Copyright © 2016 Pearson Education, Inc.

Cash Flow from Financing Activities This information is provided in the Sage Inc. Statement of Stockholders’ Equity. Copyright © 2016 Pearson Education, Inc.

Change in Cash Net cash provided by operating activities, less the net cash used by investing activities, plus the net cash provided by financing activities produced a net decrease in cash and cash equivalents for Sage Inc.: Copyright © 2016 Pearson Education, Inc.

Change in Cash The cash flows provided (used) by operating, investing, and financing activities vary considerably depending on the company, its performance, its ability to generate cash, its financing and investing strategies, and its success in implementing financing and investing strategies. Copyright © 2016 Pearson Education, Inc.

Change in Cash Copyright © 2016 Pearson Education, Inc.

Analyzing the Statement of Cash Flows The statement of cash flows helps the analyst determine the following: Ability to generate cash flows in the future Capacity to meet cash obligations Future external financing needs Success in productively managing investing activities Effectiveness in implementing financing and investing strategies. Copyright © 2016 Pearson Education, Inc.

Analyzing the Statement of Cash Flows Cash Flow from Operations It is possible for a firm to be highly profitable and not be able to pay dividends not be able to invest in new equipment not be able to service debt go bankrupt Copyright © 2016 Pearson Education, Inc.

Analyzing the Statement of Cash Flows Cash Flow from Operations Ongoing operation depends on success in generating cash from operations. Firms need cash to satisfy creditors and investors. Copyright © 2016 Pearson Education, Inc.

Analyzing the Statement of Cash Flows Cash Flow from Operations Temporary shortfalls of cash can be satisfied by borrowing or other means, but ultimately a firm must generate cash. Periods of high interest rates and inflation contributed to the enhanced attention paid to cash flow by investors and creditors. Copyright © 2016 Pearson Education, Inc.

Analyzing the Statement of Cash Flows Nocash Corporation Nocash Corporation had sales of $50,000 in its first year of operations. Nocash Corporation had sales of $100,000 in its second year of operations. Nocash Corporation had expenses of $40,000 in its first year of operations. Nocash Corporation had expenses of $70,000 in its second year of operations. Copyright © 2016 Pearson Education, Inc.

Analyzing the Statement of Cash Flows Copyright © 2016 Pearson Education, Inc.

Analyzing the Statement of Cash Flows Nocash Corporation The income statement does not show several relevant facts. Nocash eased its credit policies and attracted lower quality customers. Nocash purchased a new line of inventory near the end of Year 1 and had to sell it below cost. Rumors regarding problems with accounts receivable and inventory management prompted some suppliers to refuse the sale of goods on credit to Nocash. Copyright © 2016 Pearson Education, Inc.

Analyzing the Statement of Cash Flows Nocash Corporation The effects of these factors can be found on the balance sheet: Copyright © 2016 Pearson Education, Inc.

Analyzing the Statement of Cash Flows Nocash Corporation If Nocash’s net income is recalculated on a cash basis, the following adjustments would be made: Copyright © 2016 Pearson Education, Inc.

Analyzing the Statement of Cash Flows Nocash Corporation More sales revenue was recognized in computing net income than was collected in cash. The increase in accounts receivable is subtracted. Copyright © 2016 Pearson Education, Inc.

Analyzing the Statement of Cash Flows Nocash Corporation The increase in inventory is deducted, reflecting the cash outflow for inventory purchases in excess of the expense recognized through cost of goods sold. Copyright © 2016 Pearson Education, Inc.

Analyzing the Statement of Cash Flows Nocash Corporation Cash payments to suppliers in Year 2 were greater than the amount of expense recorded. The decrease in accounts payable is deducted. Copyright © 2016 Pearson Education, Inc.

Analyzing the Statement of Cash Flows Nocash Corporation Appearance of $10,000 note payable indicates that borrowing has enabled Nocash to operate. Unless Nocash can generate cash, its problems will compound. Bankers refer to this problem as a company’s “selling itself out of business.” Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows An analysis of the statement of cash flows should cover the following areas: Analysis of cash flow from operating activities Analysis of cash inflows Analysis of cash outflows Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows Cash Flow from Operating Activities The statement of cash flows provides the net cash flow from operating activities. The analyst should be concerned with the success or failure of generating cash from operations, the underlying causes of operating cash flow, the magnitude of operating cash flow, and fluctuations in cash flow from operations. Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows Cash Flow from Operating Activities – Sage Inc. Negative cash flow from operations in 2015 Positive net income in 2015 Apparent cause was substantial growth in accounts receivable and inventories. Positive cash flow in 2016 It will be necessary to monitor cash flow operations and the management of inventories. Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows Summary Analysis of the Statement of Cash Flows Provides an approach to analyzing the statement of cash flows Provides comparative cash flow data Underlines the importance of internal cash generation from operations Highlights the implications for investing and financing activities when cash is not generated from operations Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows Analysis of Cash Inflows – Sage Inc. Operations supplied 62% of needed cash in 2016 and 73% in 2014. The firm had to borrow heavily in 2015, with debt accounting for 98% of cash inflows. Sage Inc. also borrowed in 2016 and 2014 to obtain needed cash not supplied by operations. Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows Analysis of Cash Inflows Generating cash from operations is the preferred method for obtaining cash. Using external sources to generate the majority of cash year after year should be further investigated. Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows Analysis of Cash Outflows – Sage Inc. Purchases of property, plant, and equipment decreased in 2015 compared to 2014. Capital expenditures increased in dollars from 2015 to 2014 but not in percentage due to negative cash flow from operations. Dividends paid increased from 2014 to 2015 and decreased from 2015 to 2016, but percentages declined each year due to cash outflows. Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows Analysis of Cash Outflows – Sage Inc. Capital expenditures in 2014 were covered by cash from operations. Capital expenditures in 2015 were covered by borrowing. Capital expenditures in 2016 were covered by both cash from operations and borrowing. Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows Analysis of Cash Outflows When analyzing cash outflows, the analyst should consider the necessity of the outflow and how the outflow was financed. Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows Analysis of Cash Outflows Generally, it is best to finance short-term assets with short-term debt and long-term assets with long-term debt or issuance of stock. Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows Analysis of Cash Outflows Repayment of debt is a necessary outflow. Notes to the financial statements are useful in assessing how much cash will be needed in upcoming years to repay outstanding debt. Copyright © 2016 Pearson Education, Inc.

Sage Inc.: Analysis of the Statement of Cash Flows Firms should only pay dividends if the company has excess cash not needed for expansion, property, plant, or equipment, or repayment of debt. Copyright © 2016 Pearson Education, Inc.

Qualitative Issues Relating to the Statement of Cash Flows Recording operating expenses as capital expenditures Management of current asset and liability accounts Accounting for vendor financing transactions Recording of purchases and sales of trading securities for nonfinancial companies Copyright © 2016 Pearson Education, Inc.

Appendix 4A: Statement of Cash Flows – Direct Method Copyright © 2016 Pearson Education, Inc.

Appendix 4A: Statement of Cash Flows – Direct Method Copyright © 2016 Pearson Education, Inc.

Appendix 4A: Statement of Cash Flows – Direct Method Copyright © 2016 Pearson Education, Inc.

Copyright Notice All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2016 Pearson Education, Inc.