Statement of Cash Flows Chapter 12 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Slide 2 The statement of cash flows reports the entity’s cash flows (cash receipts and cash payments) for the period. Basic Concept

McGraw-Hill/Irwin Slide 3 Timing of the Financial Statements December 31, 20x1 (a point in time) Balance Sheet December 31, 20x2 (a point in time) Balance Sheet For the Year Ended December 31, 20x2 (a period of time) Income Statement Statement of Cash Flows Statement of Stockholders’ Equity

McGraw-Hill/Irwin Slide 4 Understanding the Business Positive cash flows permit a company to... Expand its operations. Replace needed assets. Take advantage of market opportunities. Pay dividends to owners. Wall Street analysts consider cash flow an important indicator of a company’s financial health.

McGraw-Hill/Irwin Slide 5 Cash Currency Cash Equivalents Short-term, highly liquid investments. Readily convertible into cash. So near maturity that market value is unaffected by interest rate changes (i.e., less than 3 months to maturity). Short-term, highly liquid investments. Readily convertible into cash. So near maturity that market value is unaffected by interest rate changes (i.e., less than 3 months to maturity). Classifications of the Statement of Cash Flows

Relationships to the Balance Sheet and the Income Statement Information needed to prepare a statement of cash flows: Comparative Balance Sheets. Income Statement. Additional details concerning selected accounts. Information needed to prepare a statement of cash flows: Comparative Balance Sheets. Income Statement. Additional details concerning selected accounts.

McGraw-Hill/Irwin Slide 7 Relationships to the Balance Sheet and the Income Statement  Cash =  Liabilities  Stockholders’ Equity  Noncash Assets Derives from... Assets = Liabilities  Stockholders’ Equity

This ending cash balance should agree with the balance sheet

McGraw-Hill/Irwin Slide 9 Classifications of the Statement of Cash Flows Operating Activities Cash inflows and outflows directly related to earnings from normal operations. Investing Activities Cash inflows and outflows related to the acquisition or sale of productive facilities and investments in the securities of other companies. Financing Activities Cash inflows and outflows related to external sources of financing (owners and creditors) for the enterprise.

McGraw-Hill/Irwin Slide 10 Direct Method vs. Indirect Method Two Formats for Reporting Operating Activities Reports the cash effects of each operating activity Direct Method Starts with accrual net income and converts to cash basis Indirect Method Note that no matter which format is used, the same amount of net cash flows from operating activities is generated.

McGraw-Hill/Irwin Slide 11 Reporting Cash Flows from Operating Activities- Direct Method Cash Flows from Operating Activities Inflows Cash received from: Customers Dividends and interest on investments Inflows Cash received from: Customers Dividends and interest on investments + Outflows Cash paid for: Purchase of goods for resale and services (electricity, etc.) Salaries and wages Income taxes Interest on liabilities Outflows Cash paid for: Purchase of goods for resale and services (electricity, etc.) Salaries and wages Income taxes Interest on liabilities _

McGraw-Hill/Irwin Slide 12 Reporting Cash Flows from Operating Activities- Indirect Method Net Income Cash Flows from Operating Activities - Indirect Method +/- Changes in current assets and current liabilities. + Losses and - Gains + Noncash expenses such as depreciation and amortization. The indirect method adjusts net income by eliminating noncash items.

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12-14 The Statement of Cash Flows will begin with net income from the Income Statement.

Step 1 Adjust net income for depreciation and amortization expense

12-16 Step 2 Adjust net income for changes in current assets and current liabilities.

McGraw-Hill/Irwin Slide 17 Use this table when adjusting Net Income to Operating Cash Flows using the indirect method. Reporting Cash Flows from Operating Activities—Indirect Method

McGraw-Hill/Irwin Slide 18 Adjustment for Gains and Losses Gains Gains must be subtracted from net income to avoid double counting the gain. Losses Losses must be added to net income to avoid double counting the loss. Transactions that cause gains and losses should be classified on the cash flow statement as operating, investing, or financing activities, depending on their dominate characteristics. For example, if the sale of equipment produced a gain, it would be classified as an investing activity.

McGraw-Hill/Irwin Slide 19 Quality of Income Ratio In general, this ratio measures the portion of income that was generated in cash. All other things equal, a higher quality of income ratio indicates greater ability to finance operating and other cash needs from operating cash inflows. Cash Flow from Operating Activities Net Income Quality of Income Ratio =

McGraw-Hill/Irwin Slide 20 Cash Flows from Investing Activities + Inflows Cash received from: Sale or disposal of property, plant and equipment Sale or maturity of investments in securities Inflows Cash received from: Sale or disposal of property, plant and equipment Sale or maturity of investments in securities _ Outflows Cash paid for: Purchase of property, plant and equipment Purchase of investments in securities Outflows Cash paid for: Purchase of property, plant and equipment Purchase of investments in securities

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Although short- term investments is a current asset, it is reported in the investing section on the statement of cash flows.

We must report individually the cash used to purchase equipment and the cash proceeds received from the sale of equipment

McGraw-Hill/Irwin Slide 24 In general, this ratio reflects the portion of purchases of property, plant and equipment financed from operating activities. A high ratio indicates less need for outside financing for current and future expansions. Capital Acquisitions Ratio Cash Flow from Operating Activities Cash Paid for Property, Plant, and Equipment Capital Acquisitions Ratio =

McGraw-Hill/Irwin Slide 25 Cash Flows from Financing Activities + _ Inflows Cash received from: Borrowings on notes, mortgages, bonds, etc. from creditors Issuing stock to owners Inflows Cash received from: Borrowings on notes, mortgages, bonds, etc. from creditors Issuing stock to owners Outflows Cash paid for: Repayment of principal to creditors (excluding interest, which is an operating activity) Repurchasing stock from owners Dividends to owners Outflows Cash paid for: Repayment of principal to creditors (excluding interest, which is an operating activity) Repurchasing stock from owners Dividends to owners

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McGraw-Hill/Irwin Slide Cash used to repay long-term debt.

McGraw-Hill/Irwin Slide Cash proceeds from the issuance of common stock to employees.

Retained earnings decreased by $65,560 due to the combined effect of $40,754 of income and $106,314 in dividends.

McGraw-Hill/Irwin Slide 30 Required Supplemental Information 1. Reconciliation of net income to cash flow from operations (for direct method). 2. Cash paid for income taxes and interest. 3. Significant noncash investing and financing activities. Required Supplemental Information 1. Reconciliation of net income to cash flow from operations (for direct method). 2. Cash paid for income taxes and interest. 3. Significant noncash investing and financing activities. Additional Cash Flow Disclosures Example: Purchase of a building with a mortgage.

McGraw-Hill/Irwin Slide 31 In general, this measures a firm’s ability to pursue long-term investment opportunities. Free Cash Flow Free Cash Flow = Cash Flow from Operating Activities – Dividends – Capital Expenditures

© 2008 The McGraw-Hill Companies, Inc. End of Chapter 12