Financial Accounting A Decision-Making Approach, 2nd Edition King, Lembke, and Smith John Wiley & Sons, Inc. Prepared by Dr. Denise English, Boise State University *

After reading Chapter 13, you should be able to: 1. Describe the type of information included in a cash flow statement, how it is organized, and how it is useful for decision making. 2. Describe the different types of cash flows that are important for decision makers and how these cash flows are reported. 3. Explain the cash flow effects of common types of transactions and describe how they are reported in the cash flow statement. 4. Explain how decision makers analyze cash sources and uses listed in the cash flow statement, and describe ratios often used in analyzing cash flow. CHAPTER THIRTEEN THE CASH FLOW STATEMENT AND DECISIONS

Understanding the Statement of Cash Flows A Statement of Cash Flows is required by generally accepted accounting principles to be included in a complete set of financial statements. The purpose of the cash flow statement is to report how an organization generated and used its cash. Cash and cash equivalents are usually combined and reported as cash.

Purpose: provide information about the sources and uses of cash due to operating, investing, and financing activities for a defined period of time. Presentation Formula: Net cash provided (used) by operating activities + Net cash provided (used) by investing activities + Net cash provided (used) by financing activities Net increase(decrease) in Cash ==================================== Organization of the Statement of Cash Flows

The Statement of Cash Flows is organized into three categories: operating, investing, and financing. 1) Cash flows from operations are generated from normal activities. They are routine and recurring and must be positive over the long run for the company to remain viable. 2) Cash flows related to investing reflect how an organization’s cash is used to provide future benefits, such as through buying equipment and investments in securities. 3) Cash flows related to financing reflect amounts received by borrowing or from issuing stock, as well as payments made to retire debt, repurchase stock, and provide dividends to owners. Organization of the Statement of Cash Flows

Some of the Different Types of Cash Flows Cash Flows Related to Operating Activities: Cash receipts and collections from sales of goods and services Cash receipts from earnings on investments in securities (interest and dividends) Payments to suppliers Payments to employees Payments for interest Payments for taxes Exhibit 13-2 (partial)

Some of the Different Types of Cash Flows Cash Flows Related to Investing Activities: Cash receipts from the sale of securities of other companies Cash receipts from sales of productive assets Payments for the purchase of securities of other companies Payments at the time of purchase for the acquisition of productive assets Exhibit 13-2 (partial)

Some of the Different Types of Cash Flows Cash Flows Related to Financing Activities: Proceeds from issuing capital stock or other equity securities Proceeds from issuing debt securities or obtaining loans (other than trade credit) Payments for reacquisition of capital stock or other equity securities of the entity Payments for the retirement of debt securities (excluding interest) Payments of principal on loans (other than trade payables) Payments of dividends Exhibit 13-2 (partial)

Tying Together Activities and Financial Statements The Statement of Cash Flows ties together the balance sheet, income statement, and statement of changes in stockholders’ equity by reporting the effects of an entity’s operating, investing, and financing activities on the cash balance. More specifically, the cash flow statement reflects the changes in the balances of all balance sheet accounts.

Operating Cash Flows The operating section of the cash flow statement is most important because it deals with cash generated or used by primary activities. Most companies present this information using an indirect approach, starting with accrual- basis net income and adjusting that figure to obtain cash generated or used by operations.

Adjustments to Net Income To determine cash generated by operations, several adjustments to accrual-basis net income are necessary: 1) Add back expenses that reduced net income this period but did not use cash. 2) Deduct cash payments made this period for expenses of other periods. 3) Deduct revenues that did not result in cash inflows during the current period. 4) Add cash collections for revenues earned in other periods. 5) Remove items reported in the income statement that are not directly related to normal operations.

Depreciation and Amortization Under accrual accounting, depreciation reduces income; however, depreciation expense, is not a cash expense. Depreciation is neither a source nor use of cash, but must be added back to convert net income to determine cash generated by operations. The amortization of intangibles and the depletion of natural resources also result in noncash expenses that must be added to net income on the cash flow statement to determine cash generated by operations.

Changes in Deferred Income Taxes If temporary differences exist between the income reported in the income statement and that reported on the tax return, a deferred tax liability or asset is affected. The tax expense reported in the income statement is different from cash tax payments. The cash flow statement must report an adjustment for deferred income taxes to bring net income to the amount of cash generated from operations.

Amortization of Debt Discount or Premium Debt discount arises when debt is issued for less than its maturity value; this results in actual actual interest costs higher than the current cash interest payments. Thus, the amortization amount must be added to net income to determine cash generated by operations. Debt premium arises when debt is issued for more than its maturity value, resulting in actual interest costs lower than current cash interest payments. Thus the amortization amount must be subtracted from net income to determine cash generated by operations.

Gains and Losses Gains and losses included in the income statement not directly related to regular operations (such as on the disposal of investments or fixed assets, or from debt retirements), must be eliminated from the amount of cash flow generated by operations. Gains must be deducted from net income while losses must be added to net income to determine cash generated by operations.

Changes in Current Assets and Liabilities Current assets and current liabilities play an important role in the operating cycle of a business; thus, changes in these must be considered in determining the cash generated from operations. For example, sales generate cash unless they are on credit and the receivable has not yet been collected; in the same way, costs of operations use cash unless they are on credit and have not been paid by period end.

Adjustments Related to Changes in Current Assets and Current Liabilities to Compute Cash Flows Generated from Operations Current Assets Current Liabilities Accounts Receivable : Accounts and Trade Increases--subtract from net Notes Payable: incomeIncreases--add to net income Decreases--add to net income Decreases--subtract from net Inventory: income Increases--subtract from net Other Liabilities (e.g. accruals), income excluding nontrade payables: Decreases--add to net income Increases--add to net income Other Current Assets Decreases--subtract from (e.g. Prepaid Expenses): net income Increases--subtract from net income Decreases--add to net income Exhibit 13-3

Assessing Cash Flows from Operations By examining the elements of the operating section of the cash flow statement, decision makers might be able to identify cash, receivables, and inventory management problems that could affect liquidity A credit crisis could be identified by noting increases in current payables, indicative of not paying bills.

Investing Cash Flows Organizations usually must invest cash so they can conduct the operating activities needed to attain their goals. Analyzing the investing activities section of the cash flow statement can indicate whether the company is expanding or contracting its operating capacity. Examining the cash expended for plant and equipment in comparison with the amount of depreciation expense and the related balance sheet assets can provide insight on rate of growth or contraction.

Financing Cash Flows The financing section of the cash flow statement reports on the cash effects of the following: 1) borrowing (other than trade payables) 2) repaying debt (other than trade payables) 3) issuing stock 4) repurchasing stock, and 5) paying dividends.

Reporting Changes in Financial Position The statement of cash flows provides information about cash inflows and outflows, as well as bridges the gap between one balance sheet and the next. The income statement provides part of the explanation as to why financial position changed during the year. The statement of stockholders’ equity provides another part of the explanation with respect to changes in equity.

Supplemental Cash Flow Information Certain changes in financial position do not affect cash directly, but are important investing or financing activities of which financial statement readers must be informed. For example, the exchange of land for a long-term debt agreement does not affect cash, but represents both investing and financing activity, and must be disclosed. Such disclosures are provided in a separate section of the cash flow statement, or in notes to the cash flow statement or financial statements in general.

The Direct Approach to the Cash Flow Statement The FASB recommends presenting the cash flow statement using the direct approach, focusing on cash flows directly, rather than starting with net income and adjusting for noncash items. Cash received from customers, cash interest or dividends received from investments, and cash received from other income sources, as well as cash payments made to suppliers and employees, and cash paid for interest and for taxes would be directly reported. Noncash revenues and expenses and nonoperating gains and losses are not included because they have no cash effects.

Cash Flow Measures Related to Return A ratio that is useful in determining a company’s ability to pay dividends, and over time, how successful their operations are is Cash Flow per Share, computed as follows: Cash Flow per Share = (Net cash provided by operations - Dividends on preferred stock) Common shares outstanding

Cash Flow Measures Related to Return Another cash measure of return is the ratio of Cash Flow to Total Assets, which provides a measure of cash return on the investment and can be used over time as a measure of profitability. It is computed as follows: Cash Flow to Total = Assets Cash flow from operations Average total assets

Cash Flow Measures Related to Return One other measure of return that is discussed by analysts is Free Cash Flow. This measure indicates the amount of cash that is generated by operations, after maintaining productive capacity. It is computed as follows: Free Cash Flow = Cash generated from operations -- Cash invested to maintain capacity

Cash Flow Measures Related to Safety Cash flow measures related to safety have to do with how cash flows from operations compare with some required or anticipated payment. One such measure is the ratio of Dividends to Operating Cash Flow, calculated as follows: Dividends to Operating Cash = Flow Current dividends paid Cash provided by operations

Cash Flow Measures Related to Safety Another measure of safety is the ratio of Cash Flow to Current Maturities of Debt. This ratio indicates a company’s ability to generate enough cash from its operations to repay debt commitments that mature in the near future, excluding normal trade payables. It is calculated as: Cash Flow to Maturing Debt Cash provided by operations Debt maturing currently =

Cash Flow Measures Related to Safety A similar measure of safety is the ratio of Cash Flow to Total Debt. This ratio takes a longer-run view by comparing current cash flow from operations with total liabilities. The higher the ratio, the better a company’s debt-paying ability and the better the safety margin for creditors. It is calculated as follows: Cash Flow to Total Debt Cash provided by operations Total debt =

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