The Statement of Cash Flows Cash, liquidity, and the cash flow cycle The cash flow statement preparing a cash flow statement –It’s as easy as 1,2,3

Cash and Liquidity Cash includes highly liquid marketable securities.  These are items that can be converted to cash quickly without loss of value. ( Treasury bills, notes, negotiable CDs, and commercial paper.) Liquidity refers to a firm’s ability to meet financial obligations when due, and the ability to fund investment opportunities.  A firm’s cash flow cycle significantly impacts its liquidity.

The Cash Flow Cycle The movement of cash through fixed assets and inventory, into accounts receivable, and finally back to cash. Factors affecting the cash flow cycle  inventory turnover, collection period, payable period

THE CASH CONVERSION CYCLE + A/R Period + Inventory Period - A/P Period = Cash Conversion Period The length of time between when we pay cash for inventory and collect cash from our customers A/R Cash Sale Inventory Labor Assets, Taxes, Profits...

The Statement of Cash Flows Focuses on the liquidity of a business, by measuring cash inflows and outflows.  Shows where money comes from and where it goes Three components of cash flow statement: +/- Operating Cash Flows +/- Investing Cash Flows +/- Financing Cash Flows

The Cash Flow Statement - Operating Activities - Investing Activities - Financing Activities Cash flow from operations: Net Income $ 1,000 Depreciation 500 Decrease in Accounts Rec. 100 Increase in Inventory (1,200) Increase in Accounts Payable 600 Decrease in Accruals (100) Operating cash flow 900 Cash flow from investing activities: Purchase Plan & Equipment (2,000) Investing cash flow (2,000) Cash flow from financing activities: Increase in Long-term Debt 1,200 Sale of Common Stock 800 Dividends (500) Financing cash flow 1,500 Change in cash 400 Beginning cash 1,000 Ending cash 1,400

Operating Activities Inflows: Sale of goods Revenue from services Interest income Outflows: Pay wages Purchase inventory Pay other expenses Pay interest Pay taxes

Investing Activities Inflows: Sale of fixed assets Sale of investment securities Outflows: Purchase of fixed assets Purchase of investment securities

Financing Activities Inflows: New loans Sale of stock Outflows: Repayment of loans Repurchase of a firm’s own securities (treasury stock) Payment of dividends

Preparing a Cash Flow Statement (Three easy steps!) 1.Calculate the change in all balance sheet accounts. 2.Identify whether the changes result in increases or decreases in cash flows. 3.Identify the source of the changes: operating, investing, or financing activities. Note: Some changes involve multiple activities.

Use the balance sheet to explain the change in cash! The balance sheet or accounting equation: A = L + E Since the accounting equation must remain in balance:  A =  L +  E The change in cash can be written as:  cash =  L +  E -  (non-cash assets)

The change in cash: The change in cash can be explained in terms of all other balance sheet accounts:  cash =  L +  E -  (non-cash assets)

CASH FLOW RULES Asset Increase=Use Asset Decrease=Source Liability Increase= Source Liability Decrease=Use

BUILDING THE STATEMENT OF CASH FLOWS BUILDING THE STATEMENT OF CASH FLOWS Belfry Company Balance Sheet For the Period Ended 12/31/00 ASSETS12/31/99 12/31/00 Cash $1,000 $1,400 Accts. Receivable 3,000 2,900 Inventory 2,000 3,200 CURRENT ASSETS $6,000 $7,500 Fixed Assets Plant & Equip. $4,000 $6,000 Accum. Depr. (1,000) (1,500) Net $3,000 $4,500 TOTAL ASSETS $9,000 $12,000 LIABILITIES 12/31/99 12/31/00 Accts. Payable $1,500 $2,100 Accruals CURRENT LIABIL. $2,000 $2,500 Long-term debt $5,000 $6,200 Common Stock 500 1,300 Retained Earn 1,500 2,000 TOTAL EQUITY $2,000 $3,300 TOTAL LIABILITIES AND EQUITY $9,000 $12,000 Slide 8 of 9

The change in Retained Earnings Beginning RE$1,500 + Net Income 1,000 - Dividends Ending RE $2,000

BUILDING THE STATEMENT OF CASH FLOWS Belfry Company Income Statement For the Period Ended 12/31/00 Sales$10,000 COGS 6,000 Gross Margin$ 4,000 Expense$ 1,600 Depreciation 500 EBIT$ 1,900 Interest 400 EBT$ 1,500 Tax 500 Net Income$ 1,000

The Cash Flow Statement - Operating Activities - Investing Activities - Financing Activities Cash flow from operations: Net Income $ 1,000 Depreciation 500 Decrease in Accounts Rec. 100 Increase in Inventory (1,200) Increase in Accounts Payable 600 Decrease in Accruals (100) Operating cash flow 900 Cash flow from investing activities: Purchase Plan & Equipment (2,000) Investing cash flow (2,000) Cash flow from financing activities: Increase in Long-term Debt 1,200 Sale of Common Stock 800 Dividends (500) Financing cash flow 1,500 Change in cash 400 Beginning cash 1,000 Ending cash 1,400

CASH COVERAGE A variation on TIE to better get at cash flow Slide 2 of 3

FIXED CHARGE COVERAGE A variation on TIE to include lease payments as fixed financial charges equivalent to interest Interpretation: Failure from excessive debt is due to the inability to pay interest (fixed) charges which depend on the amount of debt and the interest rate. Coverage ratios measure financial charges relative to available income. Slide 3 of 3