1. The Relationship Between Business Activities and Cash Flows
Cash Equivalents
Currency
Neither the balance sheet nor the income statement provides all of the needed information about the company’s cash situation. What financial statement users really need is a report that identifies the activities that produced the amount of cash shown on the balance sheet. Furthermore, the timing of cash receipts and payments may differ from the items shown on the income statement, which reports revenues when they are earned and expenses when they are incurred.
The statement of cash flows shows each major type of business activity that caused a company’s cash to increase or decrease during the accounting period. For the purposes of this statement, cash is defined to include cash and cash equivalents. Cash equivalents are short-term, highly liquid investments that are both readily convertible to known amounts of cash and so near maturity there is little risk that their value will change if interest rates change.
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).

2. The Relationship Between Business Activities and Cash Flows
Cash inflows and outflows directly related to earnings from normal operations.
Operating Activities
Cash inflows and outflows related to the acquisition or sale of productive facilities and investments in the securities of other companies.
Investing Activities
Part I
The statement of cash flows reports cash inflows and outflows in three broad categories: operating activities, investing activities, and financing activities.
Part II
The operating activities section reports the cash effects of the elements of net income.
Part III
The investing activities section reports the cash effects of the acquisition and disposition of assets (other than inventory and cash equivalents).
Part IV
The financing activities section reports the cash effects of the sale or repurchase of shares, the issuance or repayment of debt securities, and the payment of cash dividends.
We will discuss each of these sections in more detail in the next few slides.
Cash inflows and outflows related to external sources of financing (owners and creditors) for the enterprise.
Financing Activities

3. Business CASH INFLOWS CASH OUTFLOWS Investing Activities
Operating Activities
Financing Activities
Sale of operational assets
Sale of investments
Collections of loans
Cash received from revenues
Issuance of stock
Issuance of bonds and notes
CASH INFLOWS
Business
CASH OUTFLOWS
Purchase of operational assets
Purchase of investments
Loans to others
Cash paid for expenses
Payment of dividends
Repurchase of stock
Repayment of debt
Many decisions benefit from information about the company’s underlying cash flow process. Cash continually flows into and out of an active business. This graphic illustrates several examples of cash inflows and outflows classified as operating, investing and financing activities. Take a few minutes to review these examples before we take a closer look at each section.

4. Cash Flows from Operating Activities
Inflows
Cash received from:
Customers
Dividends and interest on investments +
Cash Flows from Operating Activities
Outflows
Cash paid for:
Purchase of goods for resale and services (electricity, etc.)
Salaries and wages
Income taxes
Interest on liabilities _
Cash flows from operating activities are cash inflows and outflows directly related to earnings from normal operations. Cash inflows include cash received from customers and dividends and interest on investments in other companies. Cash outflows include cash paid for purchases of goods for resale and services, salaries and wages, income taxes and interest on liabilities. The cash flows in this section are illustrated in the examples in this slide.

5. Cash Flows from Operating Activities
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
There are two acceptable formats for presenting the cash flows from operating activities. The direct method reports components of cash flows from operating activities as gross receipts and gross payments. The indirect method adjusts net income to compute cash flows from operating activities. Note that no matter which format is used, the same amount of net cash flows from operating activities is generated.
Note that no matter which format is used, the same amount of net cash flows from operating activities is generated.

6. Cash Flows from Investing Activities
Inflows
Cash received from:
Sale or disposal of property, plant and equipment
Sale or maturity of investments in securities +
Cash Flows from Investing Activities _
Outflows
Cash paid for:
Purchase of property, plant and equipment
Purchase of investments in securities
Cash flows from investing activities are cash inflows and outflows related to the acquisition or sale of productive facilities and investments in the securities of other companies. Included in this classification are cash payments to acquire property, plant and equipment, and investment in securities of other companies. When these assets later are sold, any cash receipts from their disposition also are classified as investing activities. The cash flows in this section are illustrated in the examples in this slide.

7. Cash Flows from Financing Activities
Inflows
Cash received from:
Borrowings on notes, mortgages, bonds, etc. from creditors
Issuing stock to owners +
Cash Flows from Financing Activities
Outflows
Cash paid for:
Repayment of principal to creditors (excluding interest, which is an operating activity)
Repurchasing stock from owners
Dividends to owners _
Cash flows from financing activities are cash inflows and outflows related to external sources of financing (owners and creditors) for the enterprise. Included in this classification are cash inflows from borrowings on notes, mortgages, bonds and other debts from creditors and from proceeds from the issuance of stock. Subsequent transactions related to these financing transactions, such as a buyback of stock, the repayment of debt, and the payment of cash dividends to shareholders, also are classified as financing activities. The cash flows in this section are illustrated in the examples in this slide.

8. Net Increase (Decrease) in Cash
Together, the net cash flows from operating activities, investing activities, and financing activities must equal the net increase (decrease) in cash for the period. For 2006, Nautilus reported a net decrease in cash of $1,000. That explains the change in cash on the company’s balance sheet from the beginning balance of $8,000 to the ending balance of $7,000.
This ending cash balance on the Statement of Cash Flows should agree with the cash balance on the Balance Sheet.

9. Relationships to the Balance Sheet and the Income Statement
Information needed to prepare a
Statement of Cash Flows is found in:
Comparative Balance Sheets.
A complete Income Statement.
Additional details concerning selected accounts.
Preparing and interpreting the cash flow statement requires an analysis of balance sheet and income statement accounts that relate to the three sections of the cash flow statement. Preparers must analyze the numbers recorded in the accounts under the accrual method and adjust them to a cash basis. To prepare a statement of cash flows, preparers need comparative balance sheets, a complete income statement, and additional details concerning selected accounts where the total change amount in an account balance during the year does not reveal the underlying nature of the cash flows.

10. Relationships to the Balance Sheet and the Income Statement
This exhibit illustrates the relationship for selected cash transactions and other accounts that are affected. For example, when a company collects cash on an accounts receivable, cash increases and the noncash asset accounts receivable decreases. Take a minute and review the relationships highlighted on this slide.

11. Reporting Cash Flows from Operating Activities—Indirect Method
The indirect method adjusts net income by eliminating noncash items.
+/- Changes in current assets and current liabilities
Cash Flows from Operating Activities - Indirect Method
Net Income
+ Losses and - Gains
+ Noncash expenses such as depreciation
Remember that the indirect method starts with net income and converts it to cash flows from operating activities. This involves adjusting net income for the differences in the timing of accrual basis net income and cash flows, as shown by the items in the yellow boxes on this slide. Let’s look more closely at the changes in current assets and current liabilities on the next slide.

12. Depreciation and Gains and Losses on Sale of Long-Term Assets
Depreciation does not affect cash, so we must eliminate its effect by adding it back to net income.
Depreciation
Gains must be subtracted from net income to avoid double counting the gain.
Gains
On the income statement, depreciation is subtracted to determine net income. But depreciation does not affect cash, so we must eliminate its effect by adding it back to net income.
Transactions that cause gains and losses should be classified on the cash flow statement as operating, investing, or financing activities, depending on their dominant characteristics. For example, if the sale of equipment produced a gain, it would be classified as an investing activity.
Gains must be subtracted from net income to avoid double counting the gain.
Losses must be added to net income to avoid double counting the loss.
Losses
Losses must be added to net income to avoid double counting the loss.

13. Changes in Current Assets and Current Liabilities
This table summarizes how to adjust net income for changes in current assets and current liabilities. If a current asset account has increased, the increase would be subtracted from accrual basis net income. Similarly, if a current asset account has decreased, the decrease would be added to accrual basis net income. For liabilities, increases are added to and decreases are subtracted from accrual basis net income.
Use this table when adjusting Net Income to Operating Cash Flows using the indirect method.

14. Reporting Cash Flows from Operating Activities—Indirect Method
Use the following financial statements for Nautilus and prepare the Statement of Cash Flows for the year ended December 31, 2006.
We will use Nautilus’ financial statements on the following slides to help prepare the Statement of Cash Flows for the year ended December 31, 2006.

15. Here are the comparative balance sheets for Nautilus, Inc
Here are the comparative balance sheets for Nautilus, Inc. for 2005 and The account changes have already been calculated in the last column for us.

16. Here is the 2006 income statement for Nautilus, Inc
Here is the 2006 income statement for Nautilus, Inc. We will use the indirect method so we will start our statement of cash flows with the net income reported on this income statement.
The Statement of Cash Flows will begin with net income from the Income Statement.

17. Here is the Statement of Cash Flows for Nautilus for the year ended December 31, First, let’s focus on just the operating section of the statement.
Step 1: Adjust net income for the $7,000 of depreciation expense and the $3,000 on gain on sale of land. Nautilus did not have any losses on sale of long-term assets.
Step 2: Adjust net income for changes in current assets and current liabilities as noted in previous slides. For example, accounts receivable increased $21,000 so this change is subtracted from net income and inventories decreased by $20,000 so this change is added to net income. We continue to adjust net income for the changes in the other current asset and current liability accounts as noted on the statement.
Ultimately, we arrive at net cash provided by operating activities of $29,000.

18. To prepare the second section of the statement of cash flows, we must analyze the accounts related to investments and to property, plant, and equipment. In the investing section, we must identify the causes of both increases and decreases in selected accounts. In the case of Nautilus, the balance sheet shows two investment-related accounts that changed during the year. Plant and Equipment was purchased for $16,000 cash. This purchase caused a cash outflow, which we must subtract in the investing section on the statement of cash flows. Nautilus also sold land for $5,000 cash. The book value of the land on the balance sheet at the time of the sale was $2,000. Consequently, there was a gain of $3,000 on the sale. Regardless of the amount of any gain or loss on the sale, the total amount of cash received from the sale is an investing cash inflow.

19. The third section of the statement of cash flows includes changes in the liabilities owed to owners (such as dividends payable) and financial institutions (such as bank loans payable, notes payable, and long-term debt), as well as changes in stockholders’ equity. To compute the cash flows from financing activities, we must review the changes in all debt and stockholders’ equity accounts. Looking at Nautilus’ balance sheet, we find that long-term debt, contributed capital, and retained earnings all changed during the period. In the financing section, we must separately identify the causes of both increases and decreases in selected accounts. This means that, in addition to the change in the balance sheet account, the accounting records related to the account must be examined.
The $4,000 increase in long-term debt on the balance sheet resulted from a combination of new borrowing of $6,000 and repayment of $2,000 in principal on existing debt. So, we must include both the inflow and the outflow in the financing section on the statement of cash flows.
The change in contributed capital resulted from the issuance of $1,000 in common stock, which produced a cash inflow.
Net income increases retained earnings and dividends decrease retained earnings. We have already included the cash effects related to net income in the operating section of the statement of cash flows. The only change in retained earnings that remains to be accounted for is the cash outflow for any dividends paid. From the income statement, we see that net income for Nautilus was $31,000 but the change in the retained earnings account on the balance sheet was only an increase of $7,000. The difference of $24,000 represents the dividends for the period and must be reported as a cash outflow in the financing section of the statement of cash flows. The net cash used in financing activities is $19,000.

20. The final section of the statement of cash flows provides a reconciliation of cash. This section indicates that since last year, Nautilus’ cash decreased $1,000 and had an ending cash balance of $7,000.

21. Quality of Income Ratio
Net Cash Flow from Operating Activities
Net Income
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.
The operating activities section of the statement of cash flows indicates how well a company can generate cash internally, through its operations and its management of current assets and current liabilities. Most analysts believe this section is the most important one, because in the long run, operations are the only continuing source of cash.
The quality of income ratio is computed as net cash flow from operating activities divided by net income. For Nautilus, the quality of income ratio is 0.94 times.
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.

22. Supplement 16B: Spreadsheet Approach—Indirect Method
The spreadsheet approach offers a systematic way to keep track of data. A spreadsheet is organized as follows:
Four columns to record dollar amounts are established (beginning balance, debit changes, credit changes, and ending balance).
On the far left of the top half of the spreadsheet, each account name from the balance sheet is entered.
On the far left of the bottom half of the spreadsheet, the name of each item that will be reported on the statement of cash flows is entered.
Supplement 16B: Spreadsheet Approach—Indirect Method
The spreadsheet approach offers a systematic way to keep track of data. A spreadsheet is organized as follows:
Four columns to record dollar amounts are established (beginning balance, debit changes, credit changes, and ending balance).
On the far left of the top half of the spreadsheet, each account name from the balance sheet is entered.
On the far left of the bottom half of the spreadsheet, the name of each item that will be reported on the statement of cash flows is entered.
Let’s look at a spreadsheet that helps with the preparation of the statement of cash flows.

23. After entering all the transactions illustrated in the textbook, this is what the spreadsheet looks like.
After entering all the transactions, this is what the completed spreadsheet for preparing the statement of cash flows using the indirect method looks like.