15 &18 FINANCIAL REPORTING: CHAPTERS Part 2: The Statement of Changes in Financial Position, or The Cash Flow Statement, or the Statement of Cash Flows, or that statement that Boulton never taught us way back in grade 11 with eighteen versions of a really, really long damn name that I can’t even be bothered to remember so I’ll just call it whatever comes into my head. CHAPTERS 15 &18

Note: we are only going to learn the “indirect method.” CASH FLOW STATEMENT Purpose To provide information about cash receipts and cash payments during the period Recall that accounting numbers are NOT cash based, they’re accrual based. The Cash Flow Statement reconciles these two values (i.e. it turns accrual Net Income into real Cash Flow). Note: we are only going to learn the “indirect method.”

CASH FLOW STATEMENT Purpose Achtungen! Items that affect PROFIT but not cash Items that affect CASH but not profit Sales on A/R Bad Debt Expense Inventory valuation (FIFO, etc) Revenue from significant investments Amortization (all kinds) LCM write downs Gains/Losses on sale of assets Changes in accounting policies Purchase of assets Investments in securities Redemption of investments Debt acquisition Debt repayment Stock issue (corp.) Dividends (corp.) Owner’s investment (sole prop.) Owner’s Drawings (sole prop.)

CASH FLOW STATEMENT What You Need The cash flow statement is prepared differently from the other financial statements; it is not prepared from the worksheet/trial balance. Instead, you require the following information: 1. Comparative balance sheets (2 years) 2. Current income statement 3. Any additional information

CASH FLOW STATEMENT What You Need Know that there are three sections to the Statement: Operating activities Investing activities Financing activities

CASH FLOW STATEMENT RULE OF THUMB: The Process RULE OF THUMB: If it was subtracted from profit but didn’t use cash, add it back If it was added to profit but didn’t generate cash, deduct it. If it doesn’t affect cash, don’t put it in the Cash Flow Statement!

CASH FLOW STATEMENT The Process Step 1: Go through the comparative balance sheets and determine the value of all differences Step 2: Start the Cash Flow Statement. Begin by listing Net Income. You’ll now convert this number to Net Change in Cash by doing the following: Step 3: Place the differences (from Step 1) into the appropriate section (be sure to list properly as an increase/decrease to cash) Step 4: Complete the statement by taking any additional information into account. This may require adjustments to Step 3.

CASH FLOW STATEMENT Step 2. Start with your NET INCOME figure. All changes will be made to this figure. You’ll be converting it from an ACCRUAL number, into a CASH number. We do it this way so we have at least something to start with, otherwise we’d have to start at zero and adjust for every transaction for the year.

CASH FLOW STATEMENT Step 3: Operating Activities Operating activities include: Regular business operations, i.e. the cash effects of transactions that create revenues and expenses Generally: From the Balance Sheet From the Income Statement Current Assets: Revenue & Expense: An increase is a USE of cash, deduct it. Since we start with the Net Income, revenues and expenses are already accounted for. Only non-cash revenues and costs are a concern. Examples include: Example: Accounts Receivable Why? Current Liabilities: An increase is a SOURCE of cash, add it back. Example: Accounts Payable Why? Amortization Increase: add back Losses Increase: add back Gains Increase: deduct

CASH FLOW STATEMENT Step 3: Investing Activities Investing activities include: Purchasing and disposing of investments and capital (L-T) assets using cash, and Lending others money and collecting on those loans Generally: From the Balance Sheet From the Income Statement Capital Assets Generally, items here are not a concern Additional information should tell you if you need to worry about Dividends Received for significant ownership (>20%), since they’re not recorded as revenue they must be added. Interest Revenue on money lent is already in Net Income. An increase in investments or other long-term assets is a USE of cash, deduct it.

CASH FLOW STATEMENT Step 3: Financing Activities Financing activities include: Borrowing money from others and repaying the amounts borrowed, and Obtaining cash from owners/shareholders and paying them drawings/dividends Generally: From the Balance Sheet From the Income Statement Long-Term Debt and Equity Generally, items here are not a concern. An increase in debt or equity is a SOURCE of cash, add it. Dividends are a USE of cash, deduct. Note: if you’ve issued bonds or shares, you’ve probably used the funds to buy assets, so you’ll have entries under Investing Activities. Note: Interest paid on bonds is an operating item and is already incorporated in the Net Income figure that you start with.

CASH FLOW STATEMENT Step 4: Additional Information Remember: You must take additional information into account (provided in question) Why? Example: value of Land may change by $10,000 over the course of the year However, this may be due to a purchase of $20,000 of new land, and a sale of $10,000 of old land. Both activities need to be shown, not just the net change of $10,000

CASH FLOW STATEMENT What’s It Look Like? COMPUTER SERVICES COMPANY Cash Flow Statement — Indirect Method For the Year Ended December 31, 2002

CASH FLOW STATEMENT A Cash Flow Statement tells you many things What’s It Mean? A Cash Flow Statement tells you many things You need to learn how to spot red flags and understand their significance

What’s It Mean? – The Operating Section CASH FLOW STATEMENT What’s It Mean? – The Operating Section Meaning of Significant USE of Cash in: Accounts Receivable Giving credit to risky customers – bad debt Not collecting quickly enough – week credit policies Poor management of A/R department Incompetence in A/R department Inventory & other Short-Term Assets Purchasing too much inventory Could be poor sales, bad forecasts, management incompetence May be a result of lax controls in purchasing, or a sudden change in demand Building up inventory in anticipation of business expansion

CASH FLOW STATEMENT What’s It Mean? – The Operating Section Meaning of Significant USE of Cash in: Accounts Payable You’re paying of debt too quickly Not taking advantage of credit granted Not having a good credit rating and not being granted credit Poor management in A/P department

CASH FLOW STATEMENT What’s It Mean? – The Investing Section Meaning of Significant USE of Cash in: Capital Assets May signal a business restructuring May indicate that many assets are old and need to be replaced May signal an up-coming change in product lines or business focus May be an indication of over zealous ambitions: buying far too expensive equipment, unnecessary purchases, etc. Investments If investments rise, may be an indication that the company has very healthy cash flows, and can afford to invest in stocks/bonds Increase in equity investments may indicate an intention of a takeover

CASH FLOW STATEMENT What’s It Mean? – The Financing Section Meaning of Significant USE of Cash in: Debt & Equity Looking to purchase new assets or a new business Indication of intention to expand in some way Indication of a need to refinance debt (current loans have interest that is too high)…(look to see what’s going on in the investing section) May be showing that company is short on funds and needs loans to keep itself a float (look at other areas of statement for clues) Dividends May be paying out too much in dividends, drain on cash Could be a result of poor decisions, demands/expectations of shareholders

These ratios are cash-based instead of accrual-based CASH FLOW STATEMENT What’s It Mean? Liquidity Cash current debt coverage ratio Profitability Cash return on sales ratio Cash flow per share Solvency Cash total debt coverage These ratios are cash-based instead of accrual-based

CASH CURRENT DEBT COVERAGE Cash current debt coverage indicates the amount of cash to pay off current debt that is generated from operating activities. The ratio provides a better picture of liquidity than using the current ratio because it uses cash provided by operating activities rather than the year-end asset balance. Cash Provided by Operating Activities Average Current Liabilities Cash Current Debt Coverage 

Cash Provided by Operating Activities CASH RETURN ON SALES Cash return on sales indicates how quickly sales are turned into cash. The company is efficient at turning sales into cash when its cash return on sales is greater than its accrual-based counterpart, the profit margin. Cash Provided by Operating Activities Net Sales Cash Return on Sales 

CASH FLOW PER SHARE Cash flow per share indicates the cash flow generated for each common share. Cash Flow from Operating, Investing, and Financing Activities Number of Common Shares Cash Flow per Share 

CASH TOTAL DEBT COVERAGE Cash total debt coverage indicates the amount of cash to pay off total debt that is generated from operating activities. The ratio is the cash based counterpart to the debt to total assets ratio. Cash Provided by Operating Activities Average Total Liabilities Cash Total Debt Coverage 