1. Financial Accounting: Tools for Business Decision Making
Kimmel, Weygandt, Kieso
ELS
Prepared by:
Ellen L. Sweatt
Georgia Perimeter College

2. Chapter 13 `
Statement of
Cash Flows

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

4. The Primary Purpose of the Statement of Cash Flows Is...
PowerPoint Slides
The Primary Purpose of the Statement of Cash Flows Is...
To provide information about:
cash receipts,
cash payments, and
the net change in cash resulting from:
operating,
investing, and
financing activities of a company during a period. 2

5. Questions the Statement of Cash Flow Answers
Where did the cash come from?
What was the cash used for?
What was the change in
the cash balance?

6. Involve Income Statement Items
Operating Activities
Include:
The cash effects of transactions that create revenues and expenses and
Enter into determination of net income.
Involve Income Statement Items

7. Involve Investments and Long-Term Asset Items
Investing Activities
Include:
Purchasing and disposing of investments and productive long-lived assets using cash and
Lending money and collecting the loans.
Involve Investments and Long-Term Asset Items

8. Involve Long-Term Liability and Stockholders Equity
Financing Activities
Include:
Obtaining cash from issuing debt and repaying the amounts borrowed and
Obtaining cash from stockholders and paying them dividends.
Involve Long-Term Liability and Stockholders Equity

9. Types of Cash Flows - Operating Activities
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Cash inflows:
From sale of goods or services
From returns on loans (interest received) and on equity securities (dividends received)
Cash outflows:
To suppliers for inventory
To employees for services
To government for taxes
To lenders for interest
To others for expenses

10. Types of Cash Flows - Investing Activities
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Cash inflows:
From sale of property, plant, and equipment
From sale of debt or equity securities of other entities
From collection of principal on loans to other entities
Cash outflows:
To purchase property, plant, and equipment
To purchase debt or equity securities of other entities
To make loans to other entities

11. Types of Cash Flows - Financing Activities
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Cash inflows:
From sale of equity securities (company's own stock)
From issuance of debt (bonds and notes)
Cash outflows:
To stockholders as dividends
To redeem long-term debt or reacquire capital stock

12. Operating Activities - ALERT
Some cash flows relating to investing or financing activities are classified as operating activities. For example...
Receipts of investment revenue (interest and dividends) and
Payments of interest to lenders are classified as operating activities because these items are reported in the income statement.

13. Significant Noncash Activities...
That do not affect cash are NOT reported in the body of the statement of cash flows.
Are reported:
In a separate schedule at the bottom of the statement of cash flows or
In a separate note or supplementary schedule to the financial statements.

14. Significant Noncash Activities...
1. Issuance of common stock to purchase assets.
2. Conversion of bonds into common stock.
3. Issuance of debt to purchase assets.
4. Exchanges of plant assets.

15. Format of the Statement of Cash Flows
Four parts:
operating
investing
financing
noncash investing and financing activities

16. The Product Life Cycle A series of phases all products go through
The phases are often referred to as the:
introductory phase,
growth phase,
maturity phase,
and decline phase.
The phase a company is in affects its cash flows.

17. Introductory Phase
To support asset purchases the company may issue stock or debt. Expect cash from operations to be negative, cash from investing to be negative, and cash from financing to be positive.

18. Introductory Phase
Occurs when the company is purchasing fixed assets and beginning to produce and sell
Expect the company to be spending considerable amounts to purchase productive assets, but not to be generating much cash from operations.

19. Growth Phase
The company is striving to expand its production and sales.
Expect to see the company start to generate small amounts of cash from operations.
Cash from operations continues to be less than net income during this phase because inventory must be purchased for future projected sales.

20. Growth Phase
Because sales are projected to be increasing, the size of inventory purchases must increase.
However, less inventory will be expensed on an accrual basis than purchased on a cash basis in the growth phase.
Cash collections on accounts receivable will lag behind sales, and because sales are growing, accrual sales during a period will exceed cash collections during that period.

21. Growth Phase
Cash needed for asset acquisitions continues to exceed cash provided by operations, requiring that the company make up the deficiency by issuing new stock or debt.
The company continues to show negative cash from investing and positive cash from financing.

22. Maturity Phase Sales and production level off
Cash from operations and net income are approximately the same.
Cash generated from operations exceeds investing needs.
The company can actually start to retire debt or buy back stock.

23. Decline Phase
Sales of the product fall due to a weakening consumer demand.
Cash from operations decreases.
Cash from investing might become positive as the firm sells off excess assets, and cash from financing may be negative as the company buys back stock and retires debt.

24. Impact of Product Life Cycle on Cash Flows
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Impact of Product Life Cycle on Cash Flows

25. Why Report the Causes of Changes in Cash?
Because investors, creditors, and other interested parties want to now what is happening to a company’s most liquid asset,
CASH

26. Statement of Cash Flows Helps Users Evaluate
1. The entity's ability to generate future cash flows
2. The entity's ability to pay dividends and meet obligations
3. The reasons for the difference between net income and net cash provided (used) by operating activities
4. The cash investing and financing transactions during the period

27. Statement of Cash Flows Helps Answer the Following Questions
How did cash increase when there was a net loss for the period?
How were the proceeds of the bond issue used?
How was the expansion in the plant and equipment financed?
Why were dividends not increased?
How was the retirement of debt accomplished?
How much money was borrowed during the year?
Is cash flow greater or less than net income?

28. Sources of Information for the Statement of Cash Flows
Comparative balance sheet
Current income statement
Additional information

29. Comparative Balance Sheet
Information in this statement indicates the amount of the changes in assets, liabilities, and stockholders' equities from the beginning to the end of the period.

30. Comparative Balance Sheet
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Comparative Balance Sheet
The comparative balance sheet for the beginning and end of 1997, showing increases or decreases appears as follows:
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31

31. Current Income Statement
Information in this statement helps the reader determine the amount of cash provided or used by operations during the period.

32. Additional Information
Additional information includes transaction data that are needed to determine how cash was provided or used during the period.

33. Income Statement and Additional Information
Page 588 in book
COMPUTER SERVICES COMPANY
Income Statement
For the Year Ended December 31, 1997
Revenues $85,000
Operating expenses ,000
Income before income taxes ,000
Income tax expense ,000
Net income $35,000
Additional Information:
(a) Examination of selected data indicates that a dividend of $15,000 was declared and paid during the year.
(b) The equipment was purchased at the end of No depreciation was taken in 1997.

34. Steps in Preparing Statement of Cash Flows
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Steps in Preparing Statement of Cash Flows

35. Comparative Balance Sheet
Page 587 in book
Comparative Balance Sheet
The comparative balance sheet for the beginning and end of 1997, showing increases or decreases appears as follows:
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31

36. Steps in Preparing Statement of Cash Flows
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Steps in Preparing Statement of Cash Flows

37. Indirect and Direct Methods
In order to determine the cash provided/used by operating activities, net income must be converted from an accrual basis to a cash basis.
This conversion may be done by either of two methods:
indirect
direct

38. Indirect and Direct Methods
Both methods arrive at the same total amount for "Net cash.” provided by operating activities.
The methods differ in disclosing the items that make up the total amount.
The choice of methods affects only the operating activities section; the investing and financing activities sections are the same.

39. Indirect Method The indirect method is used extensively in practice.
Most companies favor the indirect method for the following reasons:
it is easier to prepare,
it focuses on the differences between net income and net cash flow from operating activities, and
it tends to reveal less company information to competitors.

40. Direct Method
The FASB prefers the direct method but allows the use of either method.
When the direct method is used, the net cash flow from operating activities as computed using the indirect method must also be reported in a separate schedule.

41. Statement Of Cash Flows - Indirect Method
The transactions of Computer Services Company for the years 1997 and 1998 are used to illustrate the preparation of a statement of cash flows .
Computer services Company started in January 1, 1997, when it issued 50,000 shares of $1 par value common stock for $50,000 cash.
The company rented its office space and furniture and performed consulting services throughout the first year.

42. Step 2 - Indirect Method
Determine net cash provided or used by operating activities by adjusting net income for items that did not affect cash.
Net income must be converted because earned revenues may include credit sales that have not been collected in cash and expenses incurred that may not have been paid in cash.

43. Net Income Versus Net Cash Provided by Operating Activities
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Net Income Versus Net Cash Provided by Operating Activities

44. Step 2 - Indirect Method
Receivables, payables, prepayments, and inventories must be analyzed for their effects on cash.
Accounts receivable - When accounts receivable increase during the year, revenues on an accrual basis are higher than revenues on a cash basis.
Although operations of the period led to revenues, not all of these revenues resulted in an increase in cash.

45. Step 2 - Indirect Method
Computer Services Company had revenues of $85,000 in its first year of operations.
However, CSC collected only $55,000 in cash. Although accrual basis revenue was $85,000, cash basis revenue would be only $55,000.
The increase in accounts receivable of $30,000 must be deducted from net income.
If accounts receivable decrease, the decrease must be added to net income.

46. Step 2 - Indirect Method
Accounts payable - When accounts payable increase during a year, operating expenses on an accrual basis are higher than they are on a cash basis.
For Computer Services Company, operating expenses reported in the income statement were $40,000.
However, since Accounts Payable increased $4,000 only, $36,000 ($40,000 – $4,000) of the expenses were paid in cash.
To convert net income to net cash provided by operating activities, an increase in accounts payable must be added to net income.

47. Step 2 - Indirect Method
Conversely, a decrease in accounts payable would have to be subtracted from net income.
For Computer Services Company, the changes in accounts receivable and accounts payable were the only changes in current assets and current liability accounts.
Any other revenues or expenses reported in the income statement were received or paid in cash, and no adjustment of net income is necessary.

48. Step 2 - Indirect Method
The operating activities section of the statement of cash flows would appear as follows:
COMPUTER SERVICES COMPANY
Partial Statement of Cash Flows--Indirect Method
For the Year Ended December 31, 1997
Cash from operating activities
Net income $35,000
Adjustments to reconcile net income to
net cash provided by operating activities:
Increase in accounts receivable $(30,000)
Increase in accounts payable , (26,000)
Net cash provided by operating activities $9,000

49. Comparative Balance Sheet
Page 587 in book
Comparative Balance Sheet
The comparative balance sheet for the beginning and end of 1997, showing increases or decreases appears as follows:
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31

50. Income Statement and Additional Information
Page 588 in book
COMPUTER SERVICES COMPANY
Income Statement
For the Year Ended December 31, 1997
Revenues $85,000
Operating expenses ,000
Income before income taxes ,000
Income tax expense ,000
Net income $35,000
Additional Information:
(a) Examination of selected data indicates that a dividend of $15,000 was declared and paid during the year.
(b) The equipment was purchased at the end of No depreciation was taken in 1997.

51. Step 3 - Indirect Method
Study the balance sheet to determine changes in noncurrent assets.
Changes in each noncurrent account are then analyzed using selected transaction data to determine the effect, if any, the changes had on cash.
Computer Service Company's three noncurrent accounts are Equipment, Common Stock, and Retained Earnings, all three of which had increases during the year.

52. Step 3 - Indirect Method
No data are given for the increases in Equipment of $10,000 and Common Stock of $50,000. When other explanations are lacking, assume any differences involve cash.
The increase in equipment is assumed to be a purchase of equipment for $10,000 cash. This purchase is reported as a cash outflow in the investing activities section.
The increase of common stock is assumed to result from the issuance of common stock for $50,000 cash. It is reported as an inflow of cash in the financing activities section of the statement of cash flows.

53. Step 3 - Indirect Method
The reasons for the increase of $20,000 in the Retained Earnings account are determined by analysis.
First, net income increased retained earnings by $35,000.
Second, the additional information indicates that a cash dividend of $15,000 was declared and paid.
The $35,000 increase due to net income is reported in the operating activities section. The cash dividend paid is reported in the financing activities section.

54. Step 3 - Indirect Method
The $20,000 increase in Retained Earnings in 1997 is a net change.
Having completed the three steps, we can prepare the statement of cash flows by the indirect method.
The statement starts with the operating activities section, followed by the investing activities section, and then the financing section.

55. Adjustments to reconcile net income to
Page 591 in book
COMPUTER SERVICES COMPANY
Partial Statement of Cash Flows--Indirect Method
For the Year Ended December 31, 1997
Cash from operating activities
Net income $35,000
Adjustments to reconcile net income to
net cash provided by operating activities:
Increase in accounts receivable $(30,000)
Increase in accounts payable , (26,000)
Net cash provided by operating activities $ 9,000
Cash flows from investing activities
Purchase of equipment (10,000)
Cash flows from financing activities
Issuance of Common Stock $50,000
Payment of cash dividends (15,000)
Net cash provided by financing activities ,000
Net increase in cash $34,000

56. Second-Year Operations
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Second-Year Operations
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31

57. Second-Year Operations
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Second-Year Operations
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31
1998
1997
Change

58. Second-Year Operations
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Second-Year Operations
COMPUTER SERVICES COMPANY
Income Statement
For the Year Ended December 31, 1998
Revenues $507,000
Operating expenses $261,000
Depreciation expenses ,000
Loss on sale of equipment , ,000
Income from operations ,000
Income tax expense ,000
Net income $139,000

59. Second-Year Operations
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Second-Year Operations
Additional Information:
(a) In 1998 the company declared and paid a $15,000 cash dividend.
(b) The company obtained land through the issuance of $130,000 of long-term bonds.
(c) An office building costing $160,000 was purchased for cash; equipment costing $25,000 was also purchased for cash.
(d) During 1998 the company sold equipment with a book value of $7,000 (cost $8,000 less accumulated depreciation $1,000) for $4,000 cash.

60. Step 1 - Indirect Method
Determine the net increase or decrease in cash.
Cash increased $22,000 ($56,000-$34,000).

61. Second-Year Operations
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Second-Year Operations
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31

62. Step 2 - Indirect Method
Determine net cash provided or used by operating activities under the indirect method by adjusting net income for items that did not affect cash.

63. Step 2 - Indirect Method
Accounts Receivable - Accounts receivable decreases during the period because cash receipts are higher than revenues reported on an accrual basis. The decrease of $10,000 must be added to net income.

64. Step 2 - Indirect Method
Prepaid Expenses - Prepaid expenses increase during a period because cash paid for expenses is greater than expenses reported on an accrual basis.
To convert net income to net cash provided by operating activities, the increase of $4,000 in prepaid expenses must be deducted from net income

65. Step 2 - Indirect Method
Accounts Payable - Like the increase in 1997, the 1998 increase of $55,000 in accounts payable must be added to net income to convert to net cash provided by operating activities.

66. Step 2 - Indirect Method
Depreciation expense - During 1998 Computer Services Company reported depreciation expense of $15,000.
An analysis of the accumulated depreciation accounts reveals that $11,000 related to the building and $4,000 related to the equipment.
Depreciation and other charges that do not require the use of cash, such as amortization of intangible assets are added to net income.

67. Step 2 - Indirect Method
Loss on Sale of Equipment - Computer Services Company reported a $3,000 loss on the sale of equipment (book value $7,000 less cash proceeds $4,000).
The loss reduced net income but did not reduce cash.
The $3,000 loss is added to net income in determining net cash provided by operating activities.
As a result of the previous adjustments, net cash provided by operating activities is $218,000.

68. Computer Services Company Partial Statement of Cash Flows For the Year Ended December 31, 1998
Cash flows from operating activities
Net Income $139,000
Adjustments to reconcile net income to net cash provided by operating activities :
Depreciation expense $15,000
Loss on sale of equipment 3,000
Decrease in accounts receivable 10,000
Increase in prepaid expenses (4,000)
Increase in accounts payable 55, ,000
Net cash provided by operating 218, activities

69. Steps in Preparing Statement of Cash Flows
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Steps in Preparing Statement of Cash Flows

70. Step 3 - Indirect Method
After determining the net cash provided by operating activities, the remaining changes in balance sheet accounts must be analyzed in order to determine net cash provided/used by investing and financing activities.

71. Step 3 - Indirect Method
Land - Land of $130,000 was purchased through the issuance of long-term bonds.
Although the exchange of bonds payable for land has no effect on cash, it is a significant noncash investing and financing activity that must be disclosed.

72. Step 3 - Indirect Method
Building - An office building was acquired using cash of $160,000.
This transaction is a cash outflow reported in the investing activities section.

73. Step 3 - Indirect Method
Equipment - The equipment account increased $17,000.
The additional information provided, reveals that this was a net increase resulting from two transactions
(1) a purchase of equipment for $25,000
(2) sale of equipment costing $8,000 for $4,000.
The purchase of equipment should be shown as a $25,000 outflow of cash and the sale of equipment should be shown as a cash inflow of $4,000.

74. Step 3 - Indirect Method
Bonds Payable - The bonds payable account increased by $130,000. The issuance of bonds for land is a noncash transaction reported in a separate schedule at the bottom of the statement of cash flows.

75. Step 3 - Indirect Method
Retained Earnings - Retained Earnings increased by $124,000.
The increase is a net of
(1) Net income of $139,000 that increased Retained Earnings and
(2) dividends of $15,000 that decreased Retained earnings.
Net income is converted to net cash provided by operations.
Payment of the dividend is a cash outflow that is reported as a financing activity.

76. Man, Oh Man! Does This Seem Confusing!

77. Major Classes of Cash Receipts and Payments - Direct Method
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Major Classes of Cash Receipts and Payments - Direct Method

78. Using Cash Flows to Evaluate a Company
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Using Cash Flows to Evaluate a Company
The 1995 statement of cash flows of Microsoft Corporation provides information for the computations of these measures.
MICROSOFT CORPORATION
PARTIAL STATEMENT OF CASH FLOWS
1995
Cash flows from operations $1,990
Additions to property, plant,
and equipment $495
Other assets
Short-term investments
Total cash flows from investing (1,376)
Cash flows from financing (138)

79. Free Cash Flow
In the statement of cash flows, cash from operations is intended to indicate the cash-generating capability of the company.
Cash from operations fails to take into account that a company must invest in new fixed assets just to maintain its current level of operations and it must at least maintain dividends at current levels to satisfy investors.

80. Free Cash Flow Cash Provided By Operations – Capital Expenditures
– Dividends Paid
Free Cash Flow

81. Capital Expenditure Ratio
An indicator of a company's ability to generate sufficient cash to finance new fixed assets.
Capital expenditures are purchases of fixed assets.

82. Capital Expenditure Ratio = Cash Provided by Operations
Capital Expenditures

83. Assessing Liquidity, Solvency, and Profitability Using Cash Flows
Previous chapters have presented ratios used to analyze a company's liquidity, solvency, and profitability using accrual-based numbers from the income statement and balance sheet.
This chapter introduce ratios that are cash-based rather than accrual-based.
Rather than using numbers from the income statement, these ratios use numbers from the statement of cash flows.

84. Cash-Based Measures
Many analysts are critical of accrual-based numbers because they feel that the adjustment process allows too much management discretion.
One disadvantage to the cash-based measures is that, unlike the more commonly employed accrual-based measures, there are no readily available published industry averages for comparison.

85. Liquidity
Liquidity is the ability of a business to meet its immediate obligations.
Earlier, we learned that one measure of liquidity is the current ratio.
A disadvantage of the current ratio is that it uses year-end balances of current assets and current liabilities, which may not be representative of a company's position during most of the year.

86. Current Cash Debt Coverage Ratio
A ratio that partially corrects this is the current cash debt coverage ratio.
Cash provided by operations
Average current liabilities
Since cash from operations involves the entire year rather than a balance at one point in time, it is often considered a better representation of liquidity on the average day.

87. Cash Provided By Operations Average Total Liabilities
Solvency
Solvency is the ability of a firm to survive over the long term.
One measure of solvency is the debt to total assets ratio.
A measure of solvency that uses cash figures is the cash debt coverage ratio.
Cash Provided By Operations
Average Total Liabilities
This ratio measures a company's ability to repay its liabilities from cash generated from operations.

88. Profitability
Profitability refers to a company's ability to generate a reasonable return.
Earlier chapters introduced accrual-based ratios that measure profitability, such as gross profit rate, profit rate margin, and return on assets.
A cash-based measure of performance is the cash return on sales ratio.

89. Cash Return on Sales Ratio
The cash return on sales ratio indicates the company's ability to turn sales into dollars for the firm.
A low cash return on sales ratio should be investigated because it might indicate the firm is recognizing sales that are not really sales - that is, sales it will never collect.

90. Cash Return on Sales Ratio
Cash From Operations
Net Sales =