1 Financial Accounting: Tools for Business Decision Making Kimmel, Weygandt, Kieso, Trenholm KIMMEL

2 Chapter 13 Statement of Cash Flows After studying Chapter 13, you should be able to: 1.Indicate the primary purpose of the statement of cash flows. 2.Distinguish among operating, investing, and financing activities. 3.Explain the impact of the product life cycle on a company's cash flows. 4.Prepare a statement of cash flows using one of two approaches: (a) the indirect method, or (b) the direct method. 5.Use the statement of cash flows to evaluate a company.

3 Questions the Statement of Cash Flow (SCF) Answers

4 SCF Helps Users Evaluate +Ability to generate future cash flows +Ability to pay dividends and meet obligations +Reasons for the difference between net earnings and net cash provided (used) by operating activities +Investing and financing transactions during the period

5 +Include +Cash effects of transactions that create revenues and expenses and +Enter into determination of net earnings Operating Activities Balance Sheet: Noncash Current Assets and Current Liabilities; Statement of Earnings Items

6 +Include +Purchasing and disposing of investments and productive long-lived assets using cash and +Lending money and collecting the loans Balance Sheet: Investment and Long-Term Asset Items Investing Activities

7 +Include +Obtaining cash from issuing debt and repaying the amounts borrowed and +Obtaining cash from shareholders and paying them dividends Financing Activities Balance Sheet: Long-Term Liability and Shareholders’ Equity Items

8 +If it does not affect cash, do NOT report in body of the statement of cash flows +Report in separate note or supplementary schedule to the financial statements Significant Noncash Activities

9 Format of SCF Cash flows from the three activities - operating, investing, and financing - constitute the general format of the SCF COMPANY NAME Statement of Cash Flows Period Covered Cash flows from operating activities (List of individual items)XX Net cash provided (used) by operating activitiesXXX Cash flows from investing activities (List of individual items) XX Net cash provided (used) by investing activitiesXXX Cash flows from financing activities (List of individual items) XX Net cash provided (used) by financing activitiesXXX Net increase (decrease) in cashXXX Cash at beginning of periodXXX Cash at end of period XXX

10 The Product Life Cycle +Product life cycle phases: +Introductory phase +Growth phase +Maturity phase +Decline phase +The phase a company is in affects its cash flows

Illustration Impact of Product Life Cycle on Cash Flows

Illustration 13-4 Steps (#1) in Preparing SCF

13 Definition of Cash +Define cash and cash equivalents +Can include Cash + Short-Term Investments - Short-Term Borrowings

14 Preparation of the Operating Activities Section +Net earnings must be converted from an accrual basis to a cash basis in the operating activities section +Conversion may be done by two methods: +Indirect +Direct

15 Indirect and Direct Methods +Both methods arrive at the same total amount of cash provided (used) by operating activities +Methods differ in disclosing the items that make up the total amount +Choice of methods affects only the operating activities section; the investing and financing activities sections are the same

16 Indirect Method +Used extensively in practice +Most companies favour the indirect method for the following reasons +Easier to prepare +Focuses on the differences between net earnings and net cash flow from operating activities +Reveals less company information to competitors

17 Direct Method +CICA prefers the direct method but allows the use of either method +Details cash receipts and payments +Easier to understand

18 Operating Activities – Indirect Method Section 4a

Illustration 13-4 Steps (#2) in Preparing SCF

Illustration 13-7 Net Earnings to Net Cash Provided (Used) by Operating Activities

21 Net Earnings to Net Cash Provided (Used) by Operating Activities +SCF prepared by the indirect method starts with net earnings and adds or deducts items not affecting cash to arrive at net cash provided (used) by operating activities +Changes in specific noncash current assets and current liabilities and +Noncash items reported in the statement of earnings

22 Net Earnings to Net Cash Provided (Used) by Operating Activities (B/S: Noncash Current Assets and Current Liabilities) Adjustments to Convert Net Earnings to Net Cash Provided (Used) by Operating Activities Add*Deduct* Change in Current Asset Account Balance Accounts Receivable Decrease Increase Inventory Decrease Increase Prepaid expenses Decrease Increase Other current assets Decrease Increase Change in Current Liability Account Balance Accounts payable Increase Decrease Accrued expenses payable Increase Decrease Other current liabilities Increase Decrease * Add (deduct) change in account balance to net earnings

23 Net Earnings to Net Cash Provided (Used) by Operating Activities (St. of Earnings: Noncash Items) Adjustments to Convert Net Earnings to Net Cash Provided (Used) by Operating Activities Noncash Items on Statement of Earnings Amortization (of capital assets) expenseAdd Amortization of bond discount to interest expenseAdd Amortization of bond premium to interest expense Deduct Loss on sale of assetAdd Gain on sale of asset Deduct Income from long-term equity investment Deduct

24 ANY CORPORATION Statement of Cash Flows (partial) — Indirect Method For the Year Ended December 31, 2001 Cash flows from operating activities Net earnings$ 139,000 Adjustments to reconcile net earnings to net cash provided by operating activities: Amortization expense$ 15,000 Loss on sale of equipment 3,000 Decrease in accounts receivable 10,000 Increase in prepaid expenses ( 4,000) Increase in accrued expenses payable 55,000 79,000 Net cash provided by operating activities $ 218,000 Net Cash Provided (Used) by Operating Activities Indirect Method – Sample Format Indirect Method – Sample Format

25 Operating Activities – Direct Method Section 4b

Illustration 13-4 Steps (#2) in Preparing SCF

Illustration Cash Receipts and Cash Payments (Direct Method)

28 Cash Receipts from Customers +The relationships among cash receipts from customers, revenues from sales, and changes in accounts receivable is: Cash receipts from customers = Revenues from sales { + Decrease in accounts receivable or – Increase in accounts receivable

29 Cash payments to suppliers = Cost of goods sold { + Increase in inventory or – Decrease in inventory { + Decrease in accounts payable or – Increase in accounts payable Cash Payments to Suppliers +The relationship among cash payments to suppliers, cost of goods sold, changes in inventory, and changes in accounts payable is:

30 Cash payments for services + Increase in Prepaid Expenses or – Decrease in Prepaid Expenses + Decrease in accrued expenses payable or – Increase in accrued expenses payable { Operating Expenses { = Cash Payments for Operating Expenses +The relationship among cash payments for operating expenses, changes in prepaid expenses, and changes in accrued expenses payable is:

31 Cash payments for income taxes { = Income tax expense + Decrease in income tax payable or – Increase in income tax payable Cash Payments for Income Taxes +The relationships among cash payments for income taxes, income tax expense, and changes in income taxes payable is:

32 Cash flows from operating activities Cash receipts from customers$517,000 Cash payments: For operating expenses $(210,000) For income taxes (89,000)(299,000) Net cash provided by operating activities 218,000 ANY CORPORATION Statement of Cash Flows (Partial) – Direct Method For the Year Ended December 31, 2001 Net Cash Provided (Used) by Operating Activities Direct Method – Sample Format Direct Method – Sample Format

Illustration 13-4 Steps (#3) in Preparing SCF

34 +Study the balance sheet to determine changes in investments and long-term assets +Changes in each short-term investment (unless incorporated as part of cash definition) and long-term account are analysed using selected transaction data to determine the effect, if any, the changes had on cash Net Cash Provided (Used) by Investing Activities

35 Net Cash Provided (Used) By Financing Activities +Study the balance sheet to determine changes in noncurrent liabilities and shareholders’ equity +Changes in each noncurrent account are analysed using selected transaction data to determine the effect, if any, the changes had on cash

Net cash provided by operating 218,000 activities - continued Cash flows from investing activities Purchase of building ($160,000) Purchase of equipment ( 25,000) Sale of equipment 4,000 Net cash used by investing activities (181,000) Cash flows from financing activities Payment of cash dividends $ 15,000 Net cash used by financing activities ( 15,000) Net increase in cash 22,000 Cash at beginning of period 34,000 Cash at end of period $56,000 ANY CORPORATION Statement of Cash Flows (Partial) For the Year Ended December 31, 2001 Sample Format

37 Using Cash Flows to Evaluate Company +Liquidity +Cash current debt coverage ratio +Solvency +Free cash flow +Capital expenditure ratio +Cash total debt coverage ratio +Profitability +Cash return on sales ratio These ratios are cash-based instead of accrual-based

38 Cash-Based Measures + Accrual-based measures allow management discretion + Cash-based measures have no readily available published industry averages for comparison

39 Cash Current Debt Coverage Ratio +Since cash from operating activities involves the entire year rather than a balance at one point in time, the cash current debt coverage ratio is a better representation of liquidity than the current ratio Cash current debt coverage ratio = Cash provided by operating activities Average current liabilities

40 Free Cash Flow Cash provided by operating activities - Capital expenditures - Dividends paid = Free cash flow

41 Capital Expenditure Ratio +Indicator of company’s ability to generate sufficient cash to finance new capital assets Capital expenditure ratio = Cash provided by operating activities Capital expenditures

42 Cash Total Debt Coverage Ratio +Measures a company’s ability to repay its liabilities from cash generated from operating activities Cash total debt coverage ratio = Cash provided by operating activities Average total liabilities

43 Cash Return on Sales Ratio +Indicates ability to turn sales into cash Cash return on sales = Cash provided by operating activities Net sales

44 Decision Checkpoints +How much cash did the company generate to either expand operations or pay dividends? +Can the company finance its capital expenditures with cash provided by operating activities? + Free cash flow + Capital expenditure ratio

45 Decision Checkpoints (continued) +Is the company generating sufficient cash provided by operating activities to meet its current obligations? +Is the company generating sufficient cash provided by operating activities to meet its long-term obligations? +Are differences between cash and accrual accounting reasonable? + Cash current debt coverage ratio + Cash total debt coverage ratio + Cash return on sales ratio

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