The Statement of Cash Flows

Learning Objectives Describe the circumstances in which the cash flow statement is a particularly important companion of the income statement. Outline the structure of and information reported in the three main categories of the cash flow statement: operating, investing, and financing.

Learning Objectives Appreciate the historical process involved in the development of the modern statement of cash flows. Compute cash flow from operations using either the direct or the indirect method. Prepare a complete statement of cash flows and provide the required supplemental disclosures.

Learning Objectives Understand the differences among cash flow statements prepared according to U.S. GAAP, U.K. GAAP, and International Accounting Standards. Assess a firm’s financial strength by analyzing the relationships among cash flows from operating, investing, and financing activities and by computing financial ratios based on cash flow data.

Learning Objectives Use knowledge of how the three primary financial statements tie together in order to prepare a forecasted statement of cash flows. EXPANDED MATERIAL Use a T-account or work sheet approach to prepare a statement of cash flows.

What Good Is a Cash Flow Statement? Does a statement of cash flows tell us anything we don’t already know from other statements?

What Good Is a Cash Flow Statement? Finally, a statement of cash flows is an excellent forecasting tool. Yes, because there are situations where net income does not give us an accurate picture. Also, everything you want to know about a company is summarized in this one statement.

Purposes of Cash Flow Statement Statement of Cash Flows--The primary financial statement that summarizes an entity’s cash receipts and payments during a period. Predicts an entity’s ability to: generate positive future cash flows. meet current and long-term obligations. pay future dividends. 3 2

Cash Equivalent It must be readily convertible to cash and it must be so near to maturity that there is insignificant risks of changes in value due to changes in interest rate. It is a short-term, highly liquid investment. What is a cash equivalent?

Three Categories of Cash Flows Cash Inflows Operating Activities Investing Financing 35

Cash Flow Categories Operating Activities--Transactions and events that enter into the determination of net income. Investing Activities--Transactions and events that involve the purchase and sale of securities, property, plant, equipment, and other assets not generally held for resale, and the making and collecting of loans. Financing Activities--Transactions and events whereby cash is obtained from or repaid to owners and creditors. 6 5

General Format of a Statement of Cash Flows Cash Provided by or Used in: Operating Activities $XXX Investing Activities XXX Financing Activities XXX Net Increase (Decrease) in Cash $XXX Cash--Beginning of Year XXX Cash--End of Year $XXX 12 6

Operating Activities Cash Inflow Cash Outflow Cash Receipt of Sales Collection of Receivables Interest Revenue Dividend Revenue Cash Outflow Inventory Payments Interest Payments Wages Utilities Rent 13 7

Investing Activities Cash Inflow Cash Outflow Sale of plant assets Sale of securities, other than trading securities Collection of principal on loans Cash Outflow Purchase of plant assets Purchase of securities, other than trading securities Making of loans with other entities 15 9

Financing Activities Cash Inflow Cash Outflow Issuance of own stock Borrowings Cash Outflow Dividend payments Repayment of loans Treasury stock purchase 17 11

Noncash Transactions Noncash Transactions--Investing and financing activities that do not affect an entity’s cash flow. Significant transactions should be disclosed separately. These transactions do not affect the statement of cash flows. 19 13

Reporting Operating Cash Flows Direct Method--A method of reporting net cash flows from operations that shows cash receipts and payments for a period of time. This method is more straight forward. Indirect Method--A method of reporting net cash flow from operations that involves reconciling net income to a cash basis. It shows how noncash flows affect net income. 20 14

The Direct Method This method reports directly the major classes of operating cash receipts and payments of an entity during a period. Accrual-basis revenues and expenses must be converted to equivalent cash receipts and payments. The amount of cash actually collected or paid is determined. 33 21

Example: Cash Receipts Sales and Cash Collected from Customers: Beginning accounts receivable $140 + Sales 150 = Cash available for collection $190 - Ending accounts receivable 60 = Cash collected from customers $130 64 37

Example: Inventory Cost of Goods Sold and Cash Paid for Inventory: Ending inventory $ 75 + Cost of goods sold 80 = Required inventory $155 - Beginning inventory 100 = Cash paid for inventory this year $ 55

Example: Wages Wages Expense and Cash Paid for Wages: Beginning wages payable $ 7 + Wages expense 25 = Total obligation to employee $32 - Ending wages payable 10 = Cash paid for wages $22

Indirect Method The indirect method makes the following adjustments: Adjustments for receivables and other current operating assets. Adjustments for payables and other current liabilities. Adjustments for depreciation and other noncash items. Adjustments for gains and losses. 21 15

Adjustments for Gains and Losses Gains or losses do not represent the cash effect of the transaction. Adjustment to Account Net Income Losses Gains These adjustments are made to net income since the sale of an investment is an investing activity, not an operating activity. 32 20

Adjustments for Receivables Changes in accounts directly affect revenues recorded on an accrual basis. Account Adjustment to Account Change Net Income Accounts Receivable 25 17

Adjustments for Payables Changes in liabilities mean the reverse of changes in current operating asset accounts. Account Adjustment to Account Change Net Income Accounts Payable 28 18

Noncash Adjustments Depreciation and similar noncash items do not affect cash and are not reported on the statement of cash flows. Any noncash item that reduces net income should be added back to net income in the indirect method. Any noncash item that increases net income should be subtracted from net income in the indirect method. 29 19

Relationship Between Net Income and Operating Cash Flow Business engages in operating activities Cash is received and disbursed Operating cash flow Net income Apply accrual accounting rules “Undo” accrual accounting to get back to cash flow 16

Steps for Preparing a Cash Flow Statement Compute how much the cash balance changed during the year. Convert the income statement from an accrual-basis to a cash-basis summary of operations. a. Eliminate expenses that do not involve the outflow of cash, such as depreciation. b. Eliminate gains and losses associated with investing or financing activities. c. Adjust for changes in the balances of current assets and current liabilities. 49 22

Steps for Preparing a Cash Flow Statement Analyze the long-term assets to identify the cash flow effects of investing activities. Analyze the long-term debt and stockholders’ equity accounts to determine the cash flow effects of any financing transactions. Make sure that the total net cash flow from operating, investing, and financing activities is equal to the net increase or decrease in cash as computed in Step 1. Then, prepare a formal statement of cash flows. Prepare supplement disclosure of significant noncash transactions.

Example: Comparative Balance Sheet Assets Cash and Cash Equivalents Accounts Receivable Inventory Equipment Accumulated Depreciation Total Assets $ 82 180 170 200 (72) $560 $ 40 150 200 140 (60) $470 Liabilities and Equity Accounts Payable Long-Term Notes Payable Common Stock Retained Earnings Total Liabilities and Equity $100 100 250 110 $560 $ 80 50 250 90 $470 50 23

Income Statement, 20X1 Sales Expenses: Cost of Goods Sold Selling and General Expense Depreciation Interest Expense Operating Income Gain from Sale of Equipment Income before Income Taxes Income Tax Expense Net Income $345 $120 58 20 2 200 $145 5 $140 30 $110 51 24

Step 1 Determine change in cash and cash equivalents: Cash 20X1........................... $ 40 Cash 20X2........................... 82 Change in Cash................... $ 42 53 26

(T-account or work sheet entry) Step 2 Convert from an accrual-basis to a cash-basis summary of operations: EXAMPLE: Eliminate depreciation expense, $44, because it does not require the use of cash. Cash Provided by Operations 44 Accumulated Depreciation 44 (T-account or work sheet entry)

Add back $5 to cash provided by operations. Step 2 Convert from an accrual-basis to a cash-basis summary of operations: EXAMPLE: Eliminate the $5 gain from selling equipment. Cash 33 Accumulated Depreciation 32 Equipment 60 Gain on Sale of Equipment 5 Add back $5 to cash provided by operations.

Step 3 Analyze the long-term assets to identify the cash flow effects of investing activities. Expenditures for Property, Plant, and Equipment: Beginning equipment $140 - Equipment sold during the year 60 = $ 80 - Ending equipment 200 = Expenditures for equipment during year $120

Step 4 Analyze the long-term debt and stockholders’ equity accounts to determine the cash flow effects of any financing transactions: Expenditures for Long-Term Debt: Beginning L-T notes payable balance $ 50 - Notes reacquired during the year 0 = $ 50 - Ending L-T notes payable balance 100 = L-T notes payable issued during year $ 50

Step 4 Analyze the long-term debt and stockholders’ equity accounts to determine the cash flow effects of any financing transactions: Payment of Dividends: Beginning retained earnings balance $ 90 + Net income 110 = $200 - Ending retained earnings balance 110 = Dividends paid $ 90

Steps 5 and 6 Steps 5 and 6 relate to actually preparing the formal and supplementary statements.

Operating Activities Section: Indirect Method Cash Flows from Operating Activities: Net Income $110 Adjustments: Depreciation Expense 44 Gain on Sale of Equipment (5) Increase in Accounts Receivable (30) Decrease in Inventory 30 Increase in Accounts Payable 20 Net Cash Provided by Operating Activities $169 Continued on slide 42 61 34

Operating Activities Section: Direct Method 4040 Cash Flows from Operating Activities: Cash Collected from Customers $ 414 Cash Payments for: Inventory (155) Selling & General Expenses (58) Interest (2) Income Taxes (30) $(245) Net Cash Provided by Operating Activities $169 Continued on slide 42 68 41

Investing and Financing Activities Sections The investing and financing sections are the same whether the direct or indirect approach is used.

Investing and Financing Activities Sections Cash Flows from Investing Activities: Proceeds from Sale of Equipment $ 33 Purchase of equipment (120) Net Cash Provided by Investing Activities $(87) Cash Flows from Financing Activities: Issuance of Long-Term Notes Payable 50 Payment of Cash Dividends (90) Net Cash Used for Financing Activities $(40) Net Increase in Cash $ 42 Cash, January 1, 2001 40 Cash, December 31, 2001 $ 82 Continued from either slide 39 or 40

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