Statement of Cash Flows Chapters 4 B Statement of Cash Flows

Objectives of this Chapter I. Identify business activities which can generate or use cash and differentiate between income flows (i.e., accrual basis) and cash flows from operating activities. II. The Importance and the usefulness of the statement of cash flows. Statement of Cash Flows

Objectives of this Chapter (contd.) III. Learn how to prepare the statement of cash flows. VI. The “cash burn rate” and the use of this rate in evaluating the financial viability of start-up companies. V. Learn the two alternatives (direct and indirect methods) in preparing net cash flows from operating activities. Statement of Cash Flows

Statement of Cash Flows I. Activities which can either generate cash or use cash for a business entity A. Operating activities. B. Investing activities. C. Financing activities. Statement of Cash Flows

A. Operating Activities (i.e., sales revenue, expenses) All these activities are reported in the I/S (income statement). However, I/S only provides the accrual-basis net income (revenue –expense + gains – losses ) which very often is not the change in cash. Therefore, we need to adjust from net income flows to cash flows in order to report the net cash provided by (or used in) operating activities. Statement of Cash Flows

A. Operating Activities (contd.) There are two approaches to reconcile net income to net cash provided by (or used in) operating activities: 1. Indirect Method ==> Lump-Sum Adjustment 2. Direct Method ==> Individual Account Adjustment Statement of Cash Flows

Statement of Cash Flows 1. Indirect Method Adjust net income (the lump sum amount of all revenues and expenses) for all differences between income flows and cash flows. Statement of Cash Flows

Statement of Cash Flows 2. Direct Method Adjust each revenue account to cash collection and adjust each expense account to cash payment. Subtract total cash payments from total cash collections to derive net cash flows of the operation activities. SFAS No. 95 allows a choice between the direct and indirect approach for the cash flow statement Statement of Cash Flows

Cash flows from operating activities Cash Inflows: 1. Collections from customers including cash received from sales (or services) and collections of A/R. 2. Cash receipts of interests or dividends. 3. Collections of other operating receipts (i.e., unearned revenue, rent revenue). Statement of Cash Flows

Cash Flows from Operating Activities (contd.) Cash Outflows: 1. Payments to suppliers. 2. Payments to employees. 3. Payments for interest expense. 4. Payments for income taxes. 5. Payments for other expenses(i.e., Prepaid expenses; rent expenses). Statement of Cash Flows

Statement of Cash Flows Activities which can either generate cash or use cash for a business entity A. Operating activities. B. Investing activities. C. Financing activities. Statement of Cash Flows

B. Investing Activities In addition to generate cash from or use cash in the operating activities, companies can also generate cash from (or use cash in) investing activities. Statement of Cash Flows

Cash Flows from Investing Activities Transactions involving acquiring (Investing (Cash outflows)) and selling (Disinvesting (Cash inflows)) : a. Property, Plant and Equipment. b. Investments (current and non-current). c. Notes Receivable (current and non-current). Statement of Cash Flows

Statement of Cash Flows Notes Receivable Notes Receivable (current and non-current), including: Lending money (N/R , cash outflow); Collecting of loan (N/R , cash inflow); Selling of N/R (N/R, discounting N/R, cash inflow) Statement of Cash Flows

Statement of Cash Flows Activities which can either generate cash or use cash for a business entity A. Operating activities. B. Investing activities. C. Financing activities. Statement of Cash Flows

C. Financing Activities Companies can also generate cash or use cash through financing activities: Statement of Cash Flows

Cash Flows from Financing Activities Obtaining resources from owners and creditors (cash inflows) and repaying the amount borrowed (cash outflows). Cash inflows: Cash received from issuance of common stock. Cash received from issuance of bonds. Cash received from issuance of N/P (short-term or long term). Statement of Cash Flows

Cash Flows from Financing Activities (contd.) Cash Outflows: Retirement of bonds. Retirement of stock. Payments of N/P. Payments of dividends. Statement of Cash Flows

II. The Importance and Usefulness of the Statement of Cash Flows Possible earnings managements may result in unreliable accrual earnings. Accrual accounting relies on many subjective judgments that may introduce measurement error and uncertainty into reported earnings. One-time write-offs and restructuring charges can reduce the quality of reported earnings. For these reasons, analysts scrutinize a firm’s cash flows—not just its accrual earnings—to evaluate performance and creditworthiness.

The Importance and Usefulness of the Statement of Cash Flows (cont.) In order to show cash flows of a company, cash flows of all three activities should be reported. In doing so, investors can also obtain all the information of operating, investing, and financing activities of a company. Moreover, the following questions can also be answered: Statement of Cash Flows

Statement of Cash Flows The Importance and the Usefulness of the Statement of Cash Flows (contd.) 1. What is the relationship between net income and cash provided by operations? 2. Why did cash decreased when net income increased? 3. What expansion (investment) activities took place and how were they financed? Statement of Cash Flows

Statement of Cash Flows The Importance and the Usefulness of the Statement of Cash Flows (contd.) 4. How much is the cash provided by operating activities? 5. What happened to the proceeds received from issuance of bonds or common stock? All of these cannot be answered from either the income statement or the balance sheet statement. Statement of Cash Flows

Statement of Cash Flows SFAS No. 95 To improve the comparability, SFAS No. 95, “Statement of Cash Flows,” requires companies present the statement of cash flows using a specific format. Statement of Cash Flows

Statement of Cash Flows SFAS No. 95 (contd.) Following SFAS No. 95, the statement of cash flows should have three sections: 1. Cash flows from operating activities (using a direct or an indirect method). 2. Cash flows from investing activities. 3. Cash flows from financing activities. Statement of Cash Flows

Cash flow statement: Wal-Mart example Adjustments to accrual earnings 4-25

Cash flow statement: Wal-Mart example 4-26

III. Procedures for Preparation of the Statement of Cash Flows 1. Operating Cash Flows (indirect method). 2. Investing Cash Flows. 3. Financing Cash Flows. Statement of Cash Flows

1. Operating Cash Flows (Indirect Method; Reconciliation Method) Net Income  Adjustments + Any increase in current Liabilities (except for N/P) + Any decrease in current assets (except for cash and N/R) - Any decrease in current liabilities (except for N/P) - Any increase in current assets (except for cash and N/R) Statement of Cash Flows

Statement of Cash Flows 2. Investing Cash Flows Inflows: decrease in noncurrent assets (i.e., long-term investments, P.P.E.) and certain current assets (i.e., trading securities, N/R). Outflows: increases in noncurrent assets and certain current assets Statement of Cash Flows

Statement of Cash Flows 3. Financing Cash Flows Inflows: increases in noncurrent liabilities (i.e., B/P, N/P), stockholders’ equity and certain current liability (i.e., N/P). Outflows: decreases in noncurrent liabilities, stockholders’ equity, certain current liability and dividend payment. Statement of Cash Flows

Statement of Cash Flows Adjustments to Convert Net Income to Net Cash Flow from Operating Activities Net Income Adjustments + Depreciation, depletion and amortization expense, B/D expense + Amortization of discount on B/P + Amortization of premium on investment in bonds + Increase in deferred income tax liability + Loss on disposal of assets or liabilities + Investment loss under the equity method Statement of Cash Flows

Statement of Cash Flows Adjustments to Convert Net Income to Net Cash Flow from Operating Activities (contd.) + Increases in current liabilities other than N/P (i.e., A/P, salaries payable, interest payable, I/T payable, deferred I/T, and any other current liabilities related to operations) + Decreases in current assets other than cash and N/R (i.e., A/R, interest receivable, inventory, prepaids, and any other current assets related to operations) Statement of Cash Flows

Statement of Cash Flows Adjustments to Convert Net Income to Net Cash Flow from Operating Activities (contd.) - Amortization of premium on B/P - Amortization of discount on investment in bonds - Gain on disposal of assets or liabilities - Investment income under the equity method - Decrease in deferred income tax liability - Decreases in current liabilities - Increases in current assets | | Net Cash Flows from Operating Activities Adjustments Statement of Cash Flows

Adjustments: + Amortization of Discount on B/P Example: Issue a 2-year bond, market int. rate = 12%, bond int. rate = 10% P.V. of Bond = $10,000 x 0.797 + 1,000 x 1.690 = 9,600 1. 1/1/x1 Cash 9,660 Discount on B/P 340 B/P 10,000 Statement of Cash Flows

Adjustments: + Amortization of Dis. on B/P (contd.) 2. Payment of Interest on 12/31/x1 Interest Expense (12% x 9660) 1159.2 Cash 1,000.0 Dis. On B/Pa 159.2 a. Amortization of bond discount increase interest expense but does not use cash. Statement of Cash Flows

Adjustments: + Amortization of Dis. on B/P (contd.) 3. Payable of Interest on 12/31/x2 Interest Expense (9660 +159.2)  0.12 1,174.4 Cash 1,000.0 Discount On B/P 174.4 Dis 340 159.2 174.4 Statement of Cash Flows

Adjustments: + Amortization of Premium on Investment in Bonds Example: GEO Corp. purchased $100,000, 10% 5-year bonds on 1/1/x2, with interest payable on 7/1 and 1/1. The bonds sell for $108,111 which results in bond premium of $8,111 and an effective interest rate of 8%. Statement of Cash Flows

+ Amortization of Premium on Investment in Bonds (contd.) Example (contd.) Record the purchase on 1/1/x2: Investments 108,111 Cash 108,111 Record the interest revenue on 7/1/x2: Cash 5,000 Interest Revenue 4,324a Investments 676 a. Interest revenue = $108,111 x 4% = $4,324 Statement of Cash Flows

Adjustments: + Loss on Disposal of PPE or Investments Example: Sale a piece of land with a cost of $7,000 for $5,000 Cash 5,000 Loss on Sale of Landa 2,000 Land 7,000 a. This transaction results in a cash increase of $5,000 reported in the investing activity section, not the operating activity section. Statement of Cash Flows

Adjustments: + Investment Loss under equity method Equity method must be used to account for return on investment in stock when gaining ownership of 20% ~ 50% with significant influence. Example: Obtain 30% of ownership with significant influence on investment in stock of Green Corp. for $40,000 Statement of Cash Flows

+ Investment Loss under equity method (contd.) 2/4/x2 Investment in Stock 40,000 Cash 40,000 12/31/x2 Green’s Loss of Year x2 = 100,000 Loss in Investment 30,000 Investment in Stock 30,000 Statement of Cash Flows

Data needed to prepare statement of cash flows 1. Comparative balance sheet statements. 2. The income statement. 3. The retained earnings statement. 4. Other supplemental information concerning the reasons for the changes in the B/S accounts (other than cash). Statement of Cash Flows

Example 1 Layton Company Balance Sheet (12/31/x2) a. Land was sold at cost for cash during the year. b. A building was purchased for cash during the year and no building or equipment was sold during the year. Statement of Cash Flows

Example 1 (contd.) Layton Company Balance Sheet (12/31/x2) a. Bonds were issued at the end of year. Statement of Cash Flows

Example 1 (contd.) Income Statement (for the year ended 12/31x2) Statement of Cash Flows

Example 1 (contd.) Layton Company Retained Earnings (20x2) Statement of Cash Flows

Statement of Cash Flows Layton Company Statement of Cash Flows For the Year Ended December 31, 20x2 Net cash flow from operating activities: Net Income $7,000 Adjustments to reconcile net income to net cash provided by operating activities: Add: Depreciation expense 2,300 Increase in A/P 1,500 Less: Increase in A/R (2,700) Net cash provided by operating activities $8,100 Statement of Cash Flows

Layton Company Statement of Cash Flows (contd.) Cash flows from investing activities: Proceeds from sale of land $3,000 Payments for purchase of building (12,000) Net cash used by investing activities (9,000) Cash flows from financing activities: Proceeds from issuance of bonds 7,000 Payments of dividends (3,500) Net cash provided by financing activities 3,500 Statement of Cash Flows

Layton Company Statement of Cash Flows (contd.) Net increase in cash $2,600 Cash, Jan 1, 20x2 $4,000 Cash, Dec 31, 20x2 $6,600 Statement of Cash Flows

Example 2: Green Company Balance Sheet Accounts 1/1/x2 12/31/x2 Difference Cash $3,500 $5,500 A/R 4,400 3,600 800  Inventory 5,000 6,600 1,600  Land 8,200 12,200 4,000c  Building & Equip 35,700 48,700 13,000a,d  Acc. Depr. (6,000) (8,700) Total Assets $50,800 $67,900 Statement of Cash Flows

Green Company Balance Sheet (contd.) A/P $5,100 $3,200 1,900  Salary Payable 1,400 1,800 400  B/P, 10% 7,000 15,000 8,000b  Common Stock, $10 par 8,000 9,000 1,000  Paid-in Capital 16,000 19,000 3,000  R/E 13,300 19,900 Total Liabilities & Equity $50,800 $67,900 Statement of Cash Flows

Statement of Cash Flows Income Statement For the Year Ended 12/31/20x2 Sales Revenue $80,000 CGS (48,600) Gross Profit $31,400 Operating Expenses: Deprecation Expense $3,400 Other Expenses 15,900 (19,300) $12,100 Other Revenues & Expenses Gains on Sale of Equipment $600 Interest Expense (700) (100) Income Before Income Tax $12,000 Income Tax Expense (3,600) Net Income $8,400 . Statement of Cash Flows 52

Statement of Cash Flows Retained Earnings (20x2) Beginning balance of retained earnings $13,300 Add: Net Income 8,400 21,700 Less: Dividends (1,800) Ending balance of retained earning $19,900 Statement of Cash Flows

Supplemental Information for 20x2 (a) Equipment was purchased for cash at a cost of $15,200. (b) Ten-year bonds payable with a face value of $8,000 were issued for $8,000 at the end of the year. (c) Land was acquired through the issuance of 100 shares of $10 par common stock when the stock was selling at a market price of $40 per share. (d) Equipment with a cost of $2,200 and a book value of $1,500 was sold for $2,100 cash. Statement of Cash Flows

Statement of Cash Flows GREEN Company Statement of Cash Flows For the Year Ended December 31, 20x2 Net cash flows from operating activities: Net Income $8,400 Adj. To reconcile net income to net cash provided by operating activities: Add: Depreciation Expense 3,400 Decrease in A/R 800 Increase in S/P 400 Less: Increase in Inventory (1,600) Decrease in A/P (1,900) Gain on sale of Equipment (600) Net cash provided by operating activities $8,900 Statement of Cash Flows

Statement of Cash Flows (contd.) GREEN Company Statement of Cash Flows (contd.) Cash flows from investing activities: Payments for purchase of equip. (15,200) Proceeds from sale of equipment 2,100 Net cash used by investing activities (13,100) Cash flows from financing activities: Proceeds from issuance of bonds 8,000 Payments of dividends (1,800) Net cash provided by financing activities 6,200 Net increase in cash (see Schedule 1) $2,000 Cash, Jan 1, 20x2 $3,500 Cash, Dec 31, 20x2 $5,500 56 Statement of Cash Flows

Statement of Cash Flows (contd.) GREEN Company Statement of Cash Flows (contd.) Schedule 1: Investing & financing activities not affecting cash flows: Investing activities: Acquisition of land by Issuance of common stock ($4,000) Financing Activities: Issuance of common stock for land $4,000 57 Statement of Cash Flows

Statement of Cash Flows Special Topics 1. Direct exchange. 2. Partial cash investing and financing activities. 3. Cash dividends declared. Statement of Cash Flows

Statement of Cash Flows 1. Direct Exchange Direct exchange: An example of a direct exchange is issuing bonds to acquire a building. This transaction should appear in the supplementary schedule of the cash flow statement as an investing activity (i.e., acquisition of building) and as a financing activity (i.e., issue bonds for building). Statement of Cash Flows

2. Partial Cash Investing and Financing Activities Example: acquiring land costing $10,000 by paying $1,000 down and signing a $9,000 notes payable. Statement of Cash Flows

2. Partial Cash Investing and Financing Activities (contd.) Presentation on Cash Flow Statement for Partial Investing & Financing Activities: Cash Flows from Investing Activities: Purchase of land by issuance of note and cash ($10,000) Less: issuance of note 9,000 Cash payment for purchase of land ($1,000) Statement of Cash Flows

Other examples of Direct Exchange Other examples of significant noncash investing and financing activities include (required disclosure in the supplementary schedule of the cash flow statement): conversion of bonds to stock. purchase of assets with issue of stock. purchase of assets with debt. declaration (but not payment) of cash dividend. stock dividends and stock splits.

3. Cash Dividends Declared (Stock dividends not reported on statement of cash flows.) a. Cash dividends declared and paid in the same year: Reported as a cash outflow of financing activities Statement of Cash Flows

3. Cash Dividends Declared (contd.) b. Cash dividends declared in the current year but paid in the next year: (1)No impact on cash of the current year; only increase dividends payable (D/P). (2)When D/P decrease next year, reported as a cash outflow of financing activity. Statement of Cash Flows

IV. Cash Burn Rate (Source: RCJ textbook) The ability to generate positive operating cash flow is critical to the survival and success of any company. This is particularly true for start-up companies: Cash is essential for establishing the business and for growth. Investment outlays are often large. Operating cash flows are negative. Cash burn rate is a popular metric for assessing how quickly a start-up firm will consume its cash reserves: Cash used for operations Cash used for capital expenditures or acquisitions + Cash burn rate = # of months covered by cash flow statement

Cash burn rate: Amazon.com illustration Months to burnout: = - ($119,782 + $50,321 +$6,198)/12 months = -$14,692 per month = $996,585/14,692 = 67.8 months

Cash burn rate: Selected companies

V. Cash Flows from the Operating Activities ( the Direct Method) Activities can be presented using: a. Indirect Method (as used in examples 1,2,and 3): N/I  Adjustments to reconcile net income to cash flows. b. Direct Method: The operating cash outflows are deducted from the operating cash inflows to determine the net cash provided by (or used in) operating activities. Statement of Cash Flows

Cash Flows from the Operating Activities (contd.) SFAS No. 95 allows the use of both methods, but encourages the use of the direct method. However, if the direct method is used, a reconcile of net income and cash using the indirect method must also be provided in the supplementary statement. Statement of Cash Flows

Using The Direct Method in Preparing The Operating Cash Flows Cash inflows from operating activities: 1. Collections from customers. 2. Interest & dividends collected. 3. Other operating receipts. Statement of Cash Flows

Using The Direct Method in Preparing The Operating Cash Flows (contd.) Cash outflows from operating activities: 1. Payments to suppliers. 2. Payments to employees. 3. Payments of interest. 4. Other operating payments. 5. Payments of income taxes. Statement of Cash Flows

Statement of Cash Flows Adjustments to Convert I/S Amount to Operating Cash Flows -- A Direct Approach I/S Cash Flows from Amounts Adjustments Operating Activities Net Collections Sales +Dec. in A/R; or = from Revenue -Inc. in A/R Customers Cash +Dec. in Int. Rec.; or Inflows -Inc. in Int. Rec. from Operating Interest +Amort. Of Interest Activities Premium on = Collected Revenue Invest in Bonds; or -Amort. Of Discount on Invest in Bonds Statement of Cash Flows

Adjustments to Convert I/S Amount to Operating Cash Flows (contd.) I/S Cash Flows from Amounts Adjustments Operating Activities Net Dividend +Dec. in Dividend Rec. = Dividend Revenue -Inc. in Dividend Rec. Collected Cash +Inc. in Unearned Rev.; Inflows or from Other -Dec. in Unearned Rev. Operating -Gain on Disposal of Other Activities Revenue Assets & Liabilities = Operating Receipts -Investment Income* (Equity Method) +Dec. (-Inc.) in Other Receivable Accounts * Unless listed as separate items on Income Statement (I/S). 73 Statement of Cash Flows

Adjustments to Convert I/S Amount to Operating Cash Flows (contd.) I/S Cash Flows from Amounts Adjustments Operating Activities Net +Inc. in Inventory; Cost of or Payments Goods -Dec. in Inventory = to Sold +Dec. in A/P; or Suppliers Cash -Inc. in A/P Outflows from Salary +Dec. in Sal. Payable; Payments Operating or = to Activities Expense -Inc. in Sal. Payable Employees 74 Statement of Cash Flows

Adjustments to Convert I/S Amount to Operating Cash Flows (contd.) I/S Cash Flows from Amounts Adjustments Operating Activities Net +Dec. in Int. Payable Interest -Inc. in Int. Payable = Payments Expense +Amort. of Prem. on B/P of Interest or Cash -Amort. of Dis. on B/P Outflows from +Inc. in Prepaids Operating -Dec. in Prepaids Activities -Depre., Depletion exp. Other Amort. Exp.*, B/D exp. Other -Losses on disposal of = Operating Expense Assets and Liabilities Payments -Investment lossa (Equity method) a. Unless listed as +Dec. (-Inc.) in Other separate items on the Payable Accounts Income Statement 75 Statement of Cash Flows

Adjustments to Convert I/S Amount to Operating Cash Flows (contd.) I/S Cash Flows from Amounts Adjustments Operating Activities Net +Dec. in I/T Payable; or Income -Inc. in I/T Payable Payments Cash Tax +Dec. in Deferred I/T = of Income Outflows Expense Liability; or Tax from -Inc. in Deferred I/T Operating Liability Activities 76 Statement of Cash Flows

Green Company Statement of Cash Flows (Using the direct method in preparing the operating activities section of a cash flow statement.Information as provided in Example 2.) Cash flows from Operating Activities: Cash inflows: Collections from customers $80,800 1 Cash inflows from operating activities $80,800 1. 80,000 + 800 = 80,800. Statement of Cash Flows

Green Company Statement of Cash Flows (contd.) Cash outflows: Payments to suppliers $(52,100) 1 Payments of interest (700) Other operating payments (15,500) 2 Payments of income tax (3,600) Cash outflows from operating activities (71,900) 1. 48,600 + 1600 + 1900 = 52,100. 2. 15,900 - 400 = 15,500. Statement of Cash Flows

Green Company Statement of Cash Flows (contd.) Net cash inflow from operating activities $8,900 Cash flows from investing activities : Cash flows from Financing Activities * A reconciliation of net income and cash flows using indirect method must also be presented. Statement of Cash Flows

Statement of Cash Flows Information as provided in Example 3 (direct method) Statement of Cash Flows Cash flows from Operating Activities: Cash inflows: Collections from customers $86,0201 Cash inflows from operating activities $86,020 Cash outflows: Payments to suppliers (53,200)2 1. 88,020 - 2,000 = 86,020. 2. 52,200 - 300 + 1300 = 53,200. Statement of Cash Flows

Statement of Cash Flows (contd.) Payments of other expenses (16,000)1 Payments of interest expense (500)2 Payments if Income Tax (2,820)3 Cash outflows from operating activities (72,520) Net cash inflows from operating activities $13,500 1. 15,800 + 200 = 16,000. 2. 1100 - 500 - 100 = 500. 3 3,630 - 630 -180 = 2,820. Statement of Cash Flows