Categories of Cash Flows Inflows and outflows that result from transactions Cash account must increase or decrease Operating activities Cash receipts and cash disbursements from revenues and expenses Involve current assets and current liabilities Investing activities Cash receipts and disbursements that result from purchasing or selling long-term assets or investments in other firms Financing activities Cash receipts and disbursements from long-term debt and equity transactions

Categories of Cash Flows Financing activities Debt Issuing debt Repaying debt Interest expense results from financing activities because it arises from debt financing. Why is it reported in the operating section? Equity Receiving contributions from owners Paying dividends to owners

Accrual-basis vs. Cash-basis Must convert from accrual-basis accounting (GAAP) to cash-basis accounting to prepare statement of cash flows Accrual-basis accounting Revenues recorded when earned and expenses recorded when incurred Timing of cash receipt is irrelevant Cash-basis accounting Revenues recorded when cash received and expenses recorded cash paid Timing of revenue and expense recognition is irrelevant Convert from accrual basis to cash basis Accounts payable (assume for inventory) Beg bal $1,200; End bal $400; purch $36,300 Compute cash paid

Operating activities Direct method Indirect method Cash inflows and outflows explicitly identified Analyzes every item on income statement Indirect method Reconciles net income and cash flow Starts with net income Makes adjustments for income statement items that do not affect cash Adjust for changes in current assets and current liabilities Ends with net cash flow

Investing and financing activities Same presentation for both direct and indirect methods Cash flows for each activity directly identified Used by 90% of companies. Financial statements needed Current year income statement Beginning and ending balance sheet

Steps to Calculate Operating Cash Flows Start with net income Add back non-cash expenses such as depreciation Undo the effect of non-cash expenses Adjust for changes in current assets Increase (decrease) in account should be subtracted from (added to) net income to arrive at cash balance. Adjust for changes in current liabilities Increase (decrease) in account should be added to (subtracted from) net income to arrive at cash balance.

Cash Flow Indirect Method

Cash Flow Indirect Method

Cash Flow Indirect Method

Cash Flow Indirect Method

Operating Activities—Direct Method Changing revenues from accrual basis to cash basis Accounts receivable Beginning balance (balance sheet) + Sales (income statement) - Cash collected from customers (compute) Ending balance (balance sheet)

Changing expenses from accrual basis to cash basis Cost of goods sold Inventory account Beginning inventory (balance sheet) + Purchases (compute) - Cost of goods sold (income statement) Ending balance (balance sheet) Accounts payable Beginning balance (balance sheet) + Purchases (from inventory computation) - Cash paid to vendors (compute)

Changing expenses from accrual basis to cash basis Rent expense Prepaid rent Beginning balance (balance sheet) + Cash paid for rent (compute) - Rent expense (income statement) Ending balance (balance sheet) Interest expense Interest payable + Interest expense (income statement) - Cash paid for interest (compute)

Investing and Financing Activities Investing cash flows Equipment purchases/disposals require the following accounts Asset account (beg & end) Accumulated depreciation (beg & end) Depreciation expense (current) Financing cash flows Debt financing Need to analyze changes in long-term liability accounts Equity financing Additional capital contributions Common and preferred stock accounts Dividends Retained earnings and current net income

Preparing the Statement of Cash Flows Prepare operating, investing, and financing sections Supplementary disclosures Noncash financing and investing activities Cash paid for interest expense and income taxes Broken out in supplementary disclosures because usually part of subtotals

Preparing the Statement of Cash Flows

Free Cash Flow Net cash from operating activities - Cash dividends - Capital expenditures _ Free cash flow

Cash Flow Adequacy Ratio Measures the firm’s ability to generate enough cash from operating activities to pay for its capital expenditures Net cash from operating activities _ Cash required for investing activities Cash paid for capital expenditures and acquisitions minus cash proceeds from disposal of capital assets

Cash Needed to Pay Current Liabilities Current cash debt coverage ratio Measures a firm’s ability to generate the cash it needs in the short-run A liquidity measure Net Cash Provided by Operations Average Current Liabilities

Business Risk, Control, and Ethics Investors’ risks associated with statement of cash flows Investors look for positive cash flows from operations How could a company manipulate operating cash flows?

Assign #7: pg. 594-595, E1A, E5A; Assign #8: P11-1A, P11-9A