The Statement of Cash Flows Chapter 6 The Statement of Cash Flows

The Purpose of the Statement of Cash Flows

The Statement of Cash Flows Summarizes cash flows for a period of time “For the year ended...” Explains how cash was generated and used Reflects transactions already reported in the balance sheet income statement Financial Accounting, 7e Stice/Stice, 2006 © Thomson

The Statement of Cash Flows Particularly useful when net income does not accurately reflect the economic performance of a business: Noncash expenses are high Growth companies use more cash than expenses imply Accrual basis accounting assumptions are stretched to the limit Financial Accounting, 7e Stice/Stice, 2006 © Thomson

The Statement of Cash Flows A one-page summary of the results of a company’s operating, investing, and financing activities A pro forma SCF As a forecasting tool Whether future cash activities are consistent and workable Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Information Reported on Statement of Cash Flows

Cash Equivalents The SCF explains the changes in cash and cash equivalents during a period short-term, highly liquid investments i.e., treasury bills, commercial paper, and money market funds Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Three Categories of Cash Flows Cash receipts and disbursements are classified into three main categories: Operating activities Investing activities Financing activities Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Operating Activities Includes all transactions relating to a company delivering or producing its goods for sale and providing its services Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Major Cash Flows: Operating Activities Cash receipts from: Sale of goods or services Sale of trading securities Interest revenue Dividend revenue Cash payments for: Inventory purchases Wages and salaries Taxes Interest expense Other expenses (e.g., utilities, rent) Purchase of trading securities Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Investing Activities Includes cash inflows and outflows from changes in noncurrent assets: Productive assets Investment securities Loans to others Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Major Cash Flows: Investing Activities Cash receipts from: Sale of plant assets Sale of a business segment Sale of nontrading securities Collection of principal on loans Cash payments for: Purchase plant assets Purchase of nontrading securities Making loans to other entities Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Financing Activities Includes obtaining resources from owners and providing them a return on their investment creditors and repaying those borrowings Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Major Cash Flows: Financing Activities Cash receipts from: Issuance of stock Borrowing (e.g., bonds, notes, mortgages) Cash payments for: Cash dividends Repayment of loans Repurchase of stock (treasury stock) Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Relationship of the SCF to the Balance Sheet and Income Statement Stmt of Cash Flows Operating Current Assets Accrual Adjustments Investing Long-term Assets Financing Net Change in Cash Current Liabilities Accts Pay & Accrued Liabil Income Statement Short-term Loans Pay Current Portion Long-term Revenues Expenses Long-term Liabilities Stockholders’ Equity Net Income Financial Accounting, 7e Stice/Stice, 2006 © Thomson

 Cash Flow Pattern or Cash from... Cash flow is typically Inflow (positive) Outflow (negative) Operations  Investing Financing or Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Cash Flow Pattern A company’s cash flow pattern is a general reflection of where the company is in its life cycle ... Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Start-Up, High Growth Company Cash Flow Pattern Start-Up, High Growth Company Investing Financing Operating Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Cash Flow Pattern Investing Financing Operating Steady-State Company Dividends Financing Operating Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Cash Flow Pattern Investing Financing Operating Cash Cow Dividends Share Repurchases Loan Repayment Financing Operating Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Noncash Investing and Financing Activities Activities that affect a company’s financial position but do not result in cash flows Example: Land acquired by issuing stock These activities should be disclosed separately in a schedule or in the notes to the financial statements Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Preparing a SCF A Simple Example

Analysis of Transactions Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Statement of Cash Flows Same as 12/31/05 balance sheet

Analysis of Other Primary Financial Statement for SCF

Alternative Approach Statement of Cash Flows Determine cash inflows and outflows through analysis of changes in Individual income statement accounts Individual balance sheet accounts Financial Accounting, 7e Stice/Stice, 2006 © Thomson

A Six-step Process For Preparing The SCF Compute cash balance change for the year Convert income statement from accrual to cash basis Eliminate non-cash expenses Eliminate gains and losses from investing and financing activities Adjust revenues and expenses for changes in current assets and current liabilities Analyze long-term assets to determine investing activities Analyze long-term debt and stockholders’ equity to determine financing activities Reconcile total of steps 2, 3, & 4 with step 1; prepare statement Disclosure other significant non-cash financing and investing activities

Step #1 Silmaril Inc. Compute the change in the cash balance during the period. Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Step #2 Silmaril Inc. Convert the income statement from accrual basis to cash basis. Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Step #2 Silmaril Inc. 2a) Eliminate noncash expenses Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Step #2 Silmaril Inc. 2b) Eliminate the effects of non-operating activities Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Step #2 Silmaril Inc. 2c) Adjust remaining current assets and liabilities from accrual to cash Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Step #2 Silmaril Inc. Completed worksheet Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Reporting Cash Flows From Operations Two methods Indirect Method Used by most companies because it is easy to construct from the balance sheet and income statement Direct Method Preferred by the FASB and many users because it is easy to understand Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Indirect Method Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Some Rules of Thumb for the Indirect Method DIRECTION OF CHANGE Increase Decrease NECESSARY ADJUSTMENT Subtract the increase Add the decrease Add the increase Subtract the decrease ACCOUNT Current asset Current liability Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Silmaril Inc. Cash Flows from Operations: Indirect Method Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Statement of Cash Flows Direct Method Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Silmaril Inc. Cash Flows from Operations: Direct Method Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Silmaril Inc. Cash from Operations Direct Method Indirect Method Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Step #3 Silmaril Inc. Analyze long-term assets to identify financing transactions Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Step #4 Silmaril Inc. Analyze long-term liabilities and stockholders’ equity to identify financing transactions Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Silmaril Inc. Step 5 SCF Indirect Method

Using Cash Flow Information to Forecast

Using Cash Flow Information To Forecast Financial Position The same six-step process can be used to construct a forecasted statement of cash flows Use a projected balance sheet and income statement The cash flow projection allows a company to plan the timing of new loans, stock issuances, asset acquisitions, etc. Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Using Cash Flow Information To Forecast Financial Position Projected cash flow statements allow Potential lenders to evaluate the debt repaying ability of debtors Potential investors to evaluate the likelihood of receiving cash dividends in the future Financial Accounting, 7e Stice/Stice, 2006 © Thomson

In Summary ... SCF provides information on cash sources and uses SCF describes three types of cash activities Cash flow patterns reflect the life cycle stage of the business SCF can follow either the indirect or direct format Financial Accounting, 7e Stice/Stice, 2006 © Thomson