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

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

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, Ltd.

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, Ltd.

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, Ltd.

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

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, Ltd.

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, Ltd.

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

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, Ltd.

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, Ltd.

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, Ltd.

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, Ltd.

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, Ltd.

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, Ltd.

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

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, Ltd.

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

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, Ltd.

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, Ltd.

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, Ltd.

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

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, Ltd.

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, Ltd.

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

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

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, Ltd.

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, Ltd.

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, Ltd.

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, Ltd.

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, Ltd.

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, Ltd.

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, Ltd.

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, Ltd.

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, Ltd.

Practice Question Copyright © 2016 Pearson Education, Ltd.

Assignment Deadline 03/11/2018 (Friday) till 11:00 PM Save your file with your name and surname Upload it through the link given on my webpage 10 % weightage in the final score Copied Assignments may get zero in the final score Copyright © 2016 Pearson Education, Ltd.