Chapter 6 The Statement of Cash Flows

The Purpose of the Statement of Cash Flows

3 Financial Accounting, 7e Stice/Stice, 2006 © Thomson The Statement of Cash Flows Summarizes cash flows for a period of time –“For the year ended...” Explains how cash was generated and used –Reflects transactions already reported in the balance sheet income statement

4 Financial Accounting, 7e Stice/Stice, 2006 © Thomson The Statement of Cash Flows Particularly useful when net income does not accurately reflect the economic performance of a business: –Noncash expenses are high –Growth companies use more cash than expenses imply –Accrual basis accounting assumptions are stretched to the limit

5 Financial Accounting, 7e Stice/Stice, 2006 © Thomson The Statement of Cash Flows A one-page summary of the results of a company’s operating, investing, and financing activities A pro forma SCF –As a forecasting tool –Whether future cash activities are consistent and workable

Information Reported on Statement of Cash Flows

7 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Cash Equivalents The SCF explains the changes in cash and cash equivalents during a period –short-term, highly liquid investments –i.e., treasury bills, commercial paper, and money market funds

8 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Three Categories of Cash Flows Cash receipts and disbursements are classified into three main categories: – Operating activities – Investing activities – Financing activities

9 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Operating Activities Includes all transactions relating to a company delivering or producing its goods for sale and providing its services

10 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Major Cash Flows: Operating Activities Cash receipts from: –Sale of goods or services –Sale of trading securities –Interest revenue –Dividend revenue Cash payments for: –Inventory purchases –Wages and salaries –Taxes –Interest expense –Other expenses (e.g., utilities, rent) –Purchase of trading securities

11 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Investing Activities Includes cash inflows and outflows from changes in noncurrent assets: –Productive assets –Investment securities –Loans to others

12 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Major Cash Flows: Investing Activities Cash receipts from: –Sale of plant assets –Sale of a business segment –Sale of nontrading securities –Collection of principal on loans Cash payments for: –Purchase plant assets –Purchase of nontrading securities –Making loans to other entities

13 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Financing Activities Includes obtaining resources from – owners and providing them a return on their investment – creditors and repaying those borrowings

14 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Major Cash Flows: Financing Activities Cash receipts from: –Issuance of stock –Borrowing (e.g., bonds, notes, mortgages) Cash payments for: –Cash dividends –Repayment of loans –Repurchase of stock (treasury stock)

15 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Relationship of the SCF to the Balance Sheet and Income Statement Balance SheetStmt of Cash Flows Income Statement Current Assets Current Liabilities Revenues Expenses Operating Investing Financing Net Change in Cash Long-term Assets Long-term Liabilities Stockholders’ Equity Net Income Accts Pay & Accrued Liabil Short-term Loans Pay Current Portion Long-term Accrual Adjustments

16 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Cash Flow Pattern Cash from... Cash flow is typically Inflow (positive) Outflow (negative) Operations  Investing  Financing  or

17 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Cash Flow Pattern A company’s cash flow pattern is a general reflection of where the company is in its life cycle...

18 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Investing Financing Operating Cash Flow Pattern Start-Up, High Growth Company

19 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Dividends Investing Financing Operating Cash Flow Pattern Steady-State Company

20 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Dividends Share Repurchases Loan Repayment Investing Financing Operating Cash Flow Pattern Cash Cow

21 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Noncash Investing and Financing Activities Activities that affect a company’s financial position but do not result in cash flows Example : Land acquired by issuing stock These activities should be disclosed separately in a schedule or in the notes to the financial statements

Preparing a SCF A Simple Example

23 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Analysis of Transactions

Statement of Cash Flows Same as 12/31/05 balance sheet

Analysis of Other Primary Financial Statement for SCF

26 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Alternative Approach Statement of Cash Flows Determine cash inflows and outflows through analysis of changes in –Individual income statement accounts –Individual balance sheet accounts

A Six-step Process For Preparing The SCF 1.Compute cash balance change for the year 2.Convert income statement from accrual to cash basis a.Eliminate non-cash expenses b.Eliminate gains and losses from investing and financing activities c.Adjust revenues and expenses for changes in current assets and current liabilities 3.Analyze long-term assets to determine investing activities 4.Analyze long-term debt and stockholders’ equity to determine financing activities 5.Reconcile total of steps 2, 3, & 4 with step 1; prepare statement 6.Disclosure other significant non-cash financing and investing activities

28 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Step #1 Silmaril Inc. Compute the change in the cash balance during the period.

29 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Step #2 Silmaril Inc. Convert the income statement from accrual basis to cash basis.

30 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Step #2 Silmaril Inc. 2a) Eliminate noncash expenses

31 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Step #2 Silmaril Inc. 2b) Eliminate the effects of non-operating activities

32 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Step #2 Silmaril Inc. 2c) Adjust remaining current assets and liabilities from accrual to cash

33 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Step #2 Silmaril Inc. Completed worksheet

34 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Reporting Cash Flows From Operations Two methods – Indirect Method Used by most companies because it is easy to construct from the balance sheet and income statement – Direct Method Preferred by the FASB and many users because it is easy to understand

35 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Indirect Method

36 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Some Rules of Thumb for the Indirect Method ACCOUNT Current asset Current liability DIRECTION OF CHANGE Increase Decrease Increase Decrease NECESSARY ADJUSTMENT Subtract the increase Add the decrease Add the increase Subtract the decrease

37 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Silmaril Inc. Cash Flows from Operations: Indirect Method

38 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Statement of Cash Flows Direct Method

39 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Silmaril Inc. Cash Flows from Operations: Direct Method

40 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Silmaril Inc. Cash from Operations Direct MethodIndirect Method

41 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Step #3 Silmaril Inc. Analyze long-term assets to identify financing transactions

42 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Step #4 Silmaril Inc. Analyze long-term liabilities and stockholders’ equity to identify financing transactions

Silmaril Inc. Step 5 SCF Indirect Method

Using Cash Flow Information to Forecast

45 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Using Cash Flow Information To Forecast Financial Position The same six-step process can be used to construct a forecasted statement of cash flows –Use a projected balance sheet and income statement The cash flow projection allows a company to plan the timing of new loans, stock issuances, asset acquisitions, etc.

46 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Projected cash flow statements allow –Potential lenders to evaluate the debt repaying ability of debtors –Potential investors to evaluate the likelihood of receiving cash dividends in the future Using Cash Flow Information To Forecast Financial Position

47 Financial Accounting, 7e Stice/Stice, 2006 © Thomson In Summary... SCF provides information on cash sources and uses SCF describes three types of cash activities Cash flow patterns reflect the life cycle stage of the business SCF can follow either the indirect or direct format