13-1 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Statement of Cash Flows Chapter 13 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

13-2 Understanding the Business Positive cash flows permit a company to... Expand its operations. Replace needed assets. Take advantage of market opportunities. Pay dividends to owners. Wall Street analysts consider cash flow an important indicator of a company’s financial health.

13-3 Cash Currency Cash Equivalents Short-term, highly liquid investments. Readily convertible into cash. So near maturity that market value is unaffected by interest rate changes (i.e., original maturities of less than 3 months). Short-term, highly liquid investments. Readily convertible into cash. So near maturity that market value is unaffected by interest rate changes (i.e., original maturities of less than 3 months). Classifications of the Statement of Cash Flows

13-4 Classifications of the Statement of Cash Flows Operating Activities Cash inflows and outflows directly related to earnings from normal operations. Investing Activities Cash inflows and outflows related to the acquisition or sale of productive facilities and investments in the securities of other companies. Financing Activities Cash inflows and outflows related to external sources of financing (owners and creditors) for the enterprise.

13-5 Investing ActivitiesOperating ActivitiesFinancing Activities Sale of operational assets Sale of investments Collections of loans Cash received from revenues Issuance of stock Issuance of bonds and notes CASH INFLOWS Business CASH OUTFLOWS Purchase of operational assets Purchase of investments Loans to others Cash paid for expenses Payment of dividends Repurchase of stock Repayment of debt

13-6 This ending cash balance should agree with the balance sheet.

13-7 Direct Method vs. Indirect Method Two Formats for Reporting Operating Activities Reports the cash effects of each operating activity Direct Method Starts with accrual net income and converts to cash basis Indirect Method Note that no matter which format is used, the same amount of net cash flows from operating activities is generated.

13-8 Cash Flows from Operating Activities Inflows Cash received from: Customers Dividends and interest on investments Inflows Cash received from: Customers Dividends and interest on investments + Outflows Cash paid for: Purchase of goods for resale and services (electricity, etc.) Salaries and wages Income taxes Interest on liabilities Outflows Cash paid for: Purchase of goods for resale and services (electricity, etc.) Salaries and wages Income taxes Interest on liabilities _

13-9 Cash Flows from Investing Activities + Inflows Cash received from: Sale or disposal of property, plant and equipment Sale or maturity of investments in securities Inflows Cash received from: Sale or disposal of property, plant and equipment Sale or maturity of investments in securities _ Outflows Cash paid for: Purchase of property, plant and equipment Purchase of investments in securities Outflows Cash paid for: Purchase of property, plant and equipment Purchase of investments in securities

13-10 Cash Flows from Financing Activities + _ Inflows Cash received from: Borrowings on notes, mortgages, bonds, etc. from creditors Issuing stock to owners Inflows Cash received from: Borrowings on notes, mortgages, bonds, etc. from creditors Issuing stock to owners Outflows Cash paid for: Repayment of principal to creditors (excluding interest, which is an operating activity) Repurchasing stock from owners Dividends to owners Outflows Cash paid for: Repayment of principal to creditors (excluding interest, which is an operating activity) Repurchasing stock from owners Dividends to owners

13-11 Relationships to the Balance Sheet and the Income Statement Information needed to prepare a statement of cash flows: Comparative Balance Sheets. Income Statement. Additional details concerning selected accounts. Information needed to prepare a statement of cash flows: Comparative Balance Sheets. Income Statement. Additional details concerning selected accounts.

13-12 Relationships to the Balance Sheet and the Income Statement  Cash =  Liabilities  Stockholders’ Equity  Noncash Assets Derives from... Assets = Liabilities  Stockholders’ Equity

13-13 Relationships to the Balance Sheet and the Income Statement

13-14 Reporting and Interpreting Cash Flows from Operating Net Income Cash Flows from Operating Activities: Indirect Method +/- Changes in current assets and current liabilities. + Losses and - Gains + Noncash expenses such as depreciation and amortization. The indirect method adjusts net income by eliminating noncash items.

13-15 Use this table when adjusting Net Income to Operating Cash Flows using the indirect method. Reporting and Interpreting Cash Flows from Operating

13-16 Adjustment for Gains and Losses Gains Gains must be subtracted from net income to avoid double counting the gain. Losses Losses must be added to net income to avoid double counting the loss. Transactions that cause gains and losses should be classified on the statement of cash flows as operating, investing, or financing activities, depending on their dominate characteristics. For example, if the sale of equipment produced a gain, it would be classified as an investing activity.

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13-18 The Statement of Cash Flows will begin with net income from the Income Statement.

13-19 Step 1 Adjust net income for depreciation and amortization expense.

13-20 Step 2 Adjust net income for changes in current assets and current liabilities.

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13-22 Interpreting Cash Flows from Operating Activities Investors will not invest in a company if they do not believe that cash generated from operations will be available to pay them dividends or expand the company. Creditors will not lend money if they do not believe that cash generated from operations will be available to pay back the loan. A common rule of thumb followed by financial and credit analysts is to avoid firms with rising net income but falling cash flow from operations.

13-23 International Perspective—IFRS Classification of Interest on the Cash Flow Statement U.S. GAAP and IFRS differ in the cash flow statement treatment of interest received and interest paid. These differences are currently on the agenda of the joint FASB/IASB financial statement presentation project.

13-24 Quality of Income Ratio In general, this ratio measures the portion of income that was generated in cash. All other things equal, a higher quality of income ratio indicates greater ability to finance operating and other cash needs from operating cash inflows. Cash Flow from Operating Activities Net Income Quality of Income Ratio =

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13-26 We must report individually the cash used to purchase equipment and the cash proceeds received from the sale of equipment.

13-27 Although short-term investments is a current asset, it is reported in the investing section on the statement of cash flows.

13-28 In general, this ratio reflects the portion of purchases of property, plant and equipment financed from operating activities. A high ratio indicates less need for outside financing for current and future expansions. Capital Acquisitions Ratio Cash Flow from Operating Activities Cash Paid for Property, Plant, and Equipment Capital Acquisitions Ratio =

13-29 In general, this measures a firm’s ability to pursue long-term investment opportunities. Free Cash Flow Free Cash Flow = Cash Flow from Operating Activities – Dividends – Capital Expenditures

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13-31 The net increase in Contributed Capital of was caused by two transactions: Repurchase of outstanding stock and Proceeds from the issuance of common stock. The net increase in Contributed Capital of was caused by two transactions: Repurchase of outstanding stock and Proceeds from the issuance of common stock.

13-32 Interpreting Cash Flows from Financing Activities The long-term growth of a company is normally financed from three sources: internally generated funds, the issuance of stock, and money borrowed on a long-term basis. The statement of cash flows shows how management has elected to fund its growth. This information is used by analysts who wish to evaluate the capital structure and growth potential of a business.

13-33 Completing the Statement and Additional Disclosures Three Required Disclosures 1.Reconciliation of net income to cash flow from operations 2.Noncash investing and financing activities 3.Cash paid for interest and income taxes

13-34 Supplement A: Reporting Cash Flows from Operating Activities—Direct Method

13-35 Remember that when we prepared the operating section using the indirect method, we also arrived at net cash inflow of $35,489.

13-36 Supplement B: Adjustments for Gains and Losses on Sale of Long-term Assets: Indirect Method Property, plant, and equipment with an original cost of $10,000 and accumulated depreciation of $4,000 is sold for $8,000 cash. Because the gain was included in the computation of income, it is necessary to remove (subtract) the $2,000 gain from the Operating Activities section of the statement to avoid double counting.

13-37 Supplement C: Spreadsheet Approach The spreadsheet approach offers a systematic way to keep track of data. A spreadsheet is organized as follows: 1.Four columns to record dollar amounts are established (beginning balance, debit changes, credit changes, and ending balance). 2.On the far left of the top half of the spreadsheet, each account name from the balance sheet is entered. 3.On the far left of the bottom half of the spreadsheet, the name of each item that will be reported on the statement of cash flows is entered.

13-38 After entering all the transactions illustrated in the textbook, this is what the spreadsheet looks like.

13-39 End of Chapter 13