Statement of Cash Flows

Statement of Cash Flows
Chapter 17 Statement of Cash Flows Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University

Learning Objectives State the principal purposes and uses of the statement of cash flows, and identify its components. Analyze the statement of cash flows. Use the indirect method to determine cash flows from operating activities. Copyright © Houghton Mifflin Company. All rights reserved.

Learning Objectives (cont’d)
Determine cash flows from investing activities. Determine cash flows from financing activities. Copyright © Houghton Mifflin Company. All rights reserved.

Overview of the Statement of Cash Flows
Objective 1 State the principal purposes and uses of the statement of cash flows, and identify its components Copyright © Houghton Mifflin Company. All rights reserved.

The Statement of Cash Flows
… shows how a company’s operating, investing, and financing activities affected cash during an accounting period Explains the net increase (or decrease) in cash during the accounting period Copyright © Houghton Mifflin Company. All rights reserved.

Cash and Cash Equivalents
Cash includes cash and cash equivalents Cash Money on hand Deposits in company checking accounts Cash equivalents Short-term, highly liquid investments including Money market accounts Commercial paper U.S. Treasury bills Combined with the Cash account on the statement of cash flows Copyright © Houghton Mifflin Company. All rights reserved.

Purpose of the Statement of Cash Flows
… is to provide information about a company’s cash receipts and cash payments during an accounting period Other financial statements may also provide some of this information Copyright © Houghton Mifflin Company. All rights reserved.

Internal Uses of the Statement of Cash Flows
Management uses the statement of cash flows to Assess liquidity Determine if short-term financing is necessary Determine dividend policy Decide whether to raise or lower dividends Evaluate the effects of investment and financing decisions Plan for investing and financing needs Copyright © Houghton Mifflin Company. All rights reserved.

External Uses of the Statement of Cash Flows
Investors and creditors use the statement of cash flows to assess a company’s ability to Manage cash flows Generate positive future cash flows Pay its liabilities Pay dividends and interest Anticipate its need for additional financing Copyright © Houghton Mifflin Company. All rights reserved.

Classification of Cash Flows
The statement of cash flows classifies cash receipts and cash payments into categories Operating activities Investing activities Financing activities Copyright © Houghton Mifflin Company. All rights reserved.

Operating Activities … include the cash effects of transactions and other events that affect the income statement In effect, items on the income statement are changed from an accrual to a cash basis Copyright © Houghton Mifflin Company. All rights reserved.

Operating Activities (cont’d)
Cash inflows Cash receipts from customers for goods and services Interest and dividends received on loans and investments Sales of trading securities Cash outflows Cash payments for Wages Goods and services Expenses Interest Taxes Purchases of trading securities Copyright © Houghton Mifflin Company. All rights reserved.

Investing Activities … include the cash effects of transactions that affect long-term assets Acquiring and selling long-term assets Acquiring and selling marketable securities other than trading securities or cash equivalents Making and collecting loans Copyright © Houghton Mifflin Company. All rights reserved.

Investing Activities (cont’d)
Cash inflows Cash receipts from selling long-term assets and marketable securities Collecting loans Cash outflows Cash expended for purchases of long-term assets and marketable securities Cash loaned to borrowers Copyright © Houghton Mifflin Company. All rights reserved.

Financing Activities … include the cash effects of transactions that affect long-term liabilities and stockholders’ equity Obtaining resources from stockholders Returning resources to stockholders and providing them with a return on their investment Obtaining resources from creditors Repaying amounts borrowed from creditors or otherwise settling obligations Repayments of accounts payable or accrued liabilities are classified under operating activities Copyright © Houghton Mifflin Company. All rights reserved.

Financing Activities (cont’d)
Cash inflows Proceeds from issues of stock Proceeds from short-term and long-term borrowing Cash outflows Repayment of loans Payments to owners (cash dividends) Treasury stock transactions Copyright © Houghton Mifflin Company. All rights reserved.

Classification of Cash Inflows and Cash Outflows

Noncash Investing and Financing Transactions
Companies may engage in significant noncash investing and financing activities involving only long-term assets, long-term liabilities, or stockholders’ equity Not reflected on the statement of cash flows because they do not involve either cash inflows or cash outflows These transactions will affect future cash flows Should be disclosed in a separate schedule as part of the statement of cash flows Copyright © Houghton Mifflin Company. All rights reserved.

Format of the Statement of Cash Flows
Divided into three sections Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities A reconciliation of beginning and ending cash balances appears near the bottom of the statement Copyright © Houghton Mifflin Company. All rights reserved.

Discussion Why are money market accounts, commercial paper (short-term notes), and U.S. Treasury bills considered cash equivalents? Because they are highly liquid, temporary (90 days or less) holding places for cash that is not currently needed to operate the business. They can be converted quickly into cash if needed Copyright © Houghton Mifflin Company. All rights reserved.

Discussion (cont’d) If noncash investing and financing transactions do not produce cash flows, why must they be disclosed? Because they involve activities that might be important to the reader. Also, many noncash transactions involve a simultaneous inflow and outflow of cash and will require cash flows in the future Copyright © Houghton Mifflin Company. All rights reserved.

Discussion (cont’d) What are the purposes of the statement of cash flows? Primary purpose To provide information about a company’s cash receipts and cash payments during an accounting period Secondary purpose To provide information about a company’s operating, investing, and financing activities during the period Copyright © Houghton Mifflin Company. All rights reserved.

Analyzing the Statement of Cash Flows
Objective 2 Analyze the statement of cash flows Copyright © Houghton Mifflin Company. All rights reserved.

Analyzing the Statement of Cash Flows
Statement of cash flows can be analyzed to show significant relationships Analysts examine Cash-generating efficiency Free cash flow Copyright © Houghton Mifflin Company. All rights reserved.

Cash-Generating Efficiency (CGE)
…shows the company’s ability to generate cash from its current or continuing operations Three measures of CGE Cash flow yield Cash flows to sales Cash flows to assets Copyright © Houghton Mifflin Company. All rights reserved.

Cash Flow Yield … is the ratio of net cash flows from operating activities to net income *If special items on the income statement are material, use income from continuing operations For 2002, Marriott International’s cash flows from operating activities was $516 million and its net income was $448 million This means that Marriott's operating activities generated 20 percent more cash flow than net income Copyright © Houghton Mifflin Company. All rights reserved.

… is the ratio of net cash flows from operating activities to sales
Cash Flows to Sales … is the ratio of net cash flows from operating activities to sales For 2002, Marriott International’s cash flows from operating activities was $516 million and sales totaled $8,441 million This means that Marriott generated 6.1 percent of its net cash from sales Copyright © Houghton Mifflin Company. All rights reserved.

Cash Flows to Assets … is the ratio of net cash flows from operating activities to average total assets For 2002, Marriott International’s cash flows from operating activities was $516 million. Total assets were $9,107 million and $8,296 million for 2001 and 2002, respectively This means that each dollar of assets generated 5.9 cents in operating cash flows during 2002 Copyright © Houghton Mifflin Company. All rights reserved.

Free Cash Flow (FCF) … is the amount of cash that remains after paying for continuing operations at the current level, interest, income taxes, dividends, and net capital expenditures Shows how much cash a company has available to reduce debt or expand Copyright © Houghton Mifflin Company. All rights reserved.

Free Cash Flow (cont’d)
If free cash flow is positive, the company Has met all of its planned cash commitments Has cash available to reduce debt or expand If free cash flow is negative, the company will have to Sell investments Borrow money Issue stock in the short term to continue at its planned level of operation Copyright © Houghton Mifflin Company. All rights reserved.

Free Cash Flow (cont’d)
For 2002, Marriott International had net cash flows from operations of $516 million, paid $65 million in dividends, purchased $292 million in plant assets, and sold $729 million in plant assets This means the company has met all its planned cash commitments and has $888 million in cash available to reduce debt or to expand It is best to look at trends in cash flow measures over several years Cash flows vary from year to year Marriott's cash flow yield decreased from 2001 to 2002 Watch in 2003 Copyright © Houghton Mifflin Company. All rights reserved.

Discussion Define cash-generating efficiency and identify three ratios that measure cash-generating efficiency. Cash-generating efficiency is the ability of a company to generate cash from its current or continuing operations. Three ratios that measure cash-generating efficiency are cash flow yield, cash flows to sales, and cash flows to assets Copyright © Houghton Mifflin Company. All rights reserved.

Preparing the Statement of Cash Flows: Operating Activities
Objective 3 Use the indirect method to determine cash flows from operating activities Copyright © Houghton Mifflin Company. All rights reserved.

Determining Cash Flows from Operating Activities
There are two methods of converting the income statement from an accrual basis to a cash basis The direct method Adjusts each item in the income statement to its cash equivalent More easily understood by the average reader The indirect method Lists only necessary adjustments to convert net income to net cash flows Superior from an analyst’s perspective Used by most companies Both methods result in the same net figure Copyright © Houghton Mifflin Company. All rights reserved.

Indirect Method of Determining Net Cash Flows from Operating Activities
Copyright © Houghton Mifflin Company. All rights reserved.

Depreciation Depreciation, amortization, and depletion expense are allocations of expense and do not involve cash flows An adjustment is needed to increase net income by the amount recorded Copyright © Houghton Mifflin Company. All rights reserved.

Adjustments to Depreciation
Ryan Corporation reported $37,000 depreciation expense on its income statement Affects net income Affects cash flows Depreciation Expense Accumulated Depreciation Cash 37,000 37,000 $37,000 reduction No effect Add $37,000 to net income Cash flow out is $37,000 less because depreciation expense has no cash effect Copyright © Houghton Mifflin Company. All rights reserved.

Adjustments to Depreciation
Ryan Corporation reported $37,000 depreciation expense on its income statement Affects net income Affects cash flows Depreciation Expense Accumulated Depreciation Cash 37,000 37,000 Copyright © Houghton Mifflin Company. All rights reserved.

Gains and Losses Gains and losses do not affect cash flows from operating activities and need to be removed from this section The cash receipts that resulted in the gains or losses are shown with investing activities Copyright © Houghton Mifflin Company. All rights reserved.

Adjustments to Gains and Losses
Ryan Corporation reported on its income statement a gain of $12,000 on the sale of an investment. The investment had an original cost of $90,000 and sold for $102,000 Affects net income Affects cash flows Gain on Sale - Investments Investments Cash 12,000 90,000 90,000 102,000 -0- $12,000 increase $102,000 increase (shown under investing activities) Deduct $12,000 from net income Gains do not affect cash flows from operating activities and need to be removed from this section Copyright © Houghton Mifflin Company. All rights reserved.

Ryan Corporation reported on its income statement a gain of $12,000 on the sale of an investment. The investment had an original cost of $90,000 and sold for $102,000 Affects net income Affects cash flows Gain on Sale - Investments Investments Cash 12,000 90,000 90,000 102,000 -0- Copyright © Houghton Mifflin Company. All rights reserved.

Ryan Corporation reported on its income statement a loss of $3,000 on the sale of plant assets. The assets had an original cost of $10,000 and sold for $5,000 Affects net income Affects cash flows Loss on Sale of Plant Assets Accum. Dep. Plant Assets Plant Assets Cash 3,000 10,000 10,000 2,000 2,000 5,000 -0- -0- $3,000 decrease $5,000 increase (shown under investing activities) Add $3,000 to net income Losses do not affect cash flows from operating activities and need to be removed from this section Copyright © Houghton Mifflin Company. All rights reserved.

Ryan Corporation reported on its income statement a loss of $3,000 on the sale of plant assets. The assets had an original cost of $10,000 and sold for $5,000 Affects net income Affects cash flows Loss on Sale of Plant Assets Accum. Dep. Plant Assets Plant Assets Cash 3,000 10,000 10,000 2,000 2,000 5,000 -0- -0- Copyright © Houghton Mifflin Company. All rights reserved.

Changes in Current Assets
Decreases are added to net income Increases are deducted from net income Copyright © Houghton Mifflin Company. All rights reserved.

Adjustments to Changes in Current Assets
Example Accounts Receivable balance decreased by $8,000 ($47,000 - $55,000) Add $8,000 to net income because cash received from sales was $8,000 more than sales ($706,000 - $698,000) Accounts Receivable Beg. Bal ,000 End. Bal ,000 Cash Receipts from Customers 706,000 Sales to Customers 698,000 Copyright © Houghton Mifflin Company. All rights reserved.

Affects net income Affects cash flows Sales Accounts Receivable Cash 698,000 55,000 706,000 706,000 698,000 47,000 $698,000 increase $706,000 increase Add $8,000 to net income Cash flow in is $8,000 more than sales because the Accounts Receivable account decreased $8,000 Copyright © Houghton Mifflin Company. All rights reserved.

Inventory Cash 110,000 34,000 34,000 144,000 Affects cash flows None $34,000 decrease Deduct $34,000 from net income Cash flow out is $34,000 more because the Inventory account increased $34,000 Copyright © Houghton Mifflin Company. All rights reserved.

Affects net income Affects cash flows Insurance Expense Prepaid Expenses Cash 6,000 5,000 6,000 2,000 2,000 1,000 $6,000 decrease $2,000 decrease Add $4,000 to net income Cash flow out is $4,000 less than expenses because the Prepaid Expenses account decreased $4,000 Copyright © Houghton Mifflin Company. All rights reserved.

Changes in Current Liabilities
Increases are added to net income Decreases are deducted from net income Copyright © Houghton Mifflin Company. All rights reserved.

Adjustments to Changes in Current Liabilities
Example Accounts Payable balance increased by $7,000 ($50,000 - $43,000) Add $7,000 to net income because cash paid for purchases was $7,000 less than what appears on the income statement ($554,000 - $547,000) Accounts Payable Beg. Bal ,000 End. Bal ,000 Cash Paid to Suppliers 547,000 554,000 Purchases Copyright © Houghton Mifflin Company. All rights reserved.

Affects net income Affects cash flows Cost of Goods Sold Accounts Payable Cash 520,000 513,000 43,000 513,000 520,000 50,000 $520,000 decrease $513,000 decrease Add $7,000 to net income Cash flow out is $7,000 less because the Accounts Payable account increased $7,000 Copyright © Houghton Mifflin Company. All rights reserved.

Relationship of Inventory and Accounts Payable Accounts
Affects net income Affects cash flows Cost of Goods Sold Inventory Accounts Payable Cash 520,000 110,000 520,000 547,000 43,000 547,000 554,000 554,000 144,000 50,000 $520,000 decrease $547,000 decrease Already deducted $27,000 from net income $34,000 deducted from net income for increase in Inventory($144,000 - $110,000) $7,000 added to net income for increase in Accounts Payable ($50,000 - $43,000) Copyright © Houghton Mifflin Company. All rights reserved.

Relationship of Inventory and Accounts Payable Accounts
Affects net income Affects cash flows Cost of Goods Sold Inventory Accounts Payable Cash 520,000 110,000 520,000 547,000 43,000 547,000 554,000 554,000 144,000 50,000 Copyright © Houghton Mifflin Company. All rights reserved.

Accrued Expenses Accrued Liabilities 3,000 9,000 3,000 12,000 Affects net income $3,000 decrease None Add $3,000 to net income Cash flow out is $3,000 less than expenses Copyright © Houghton Mifflin Company. All rights reserved.

Current Liabilities Income Taxes Payable Cash 2,000 5,000 2,000 3,000
Affects cash flows None $2,000 decrease Deduct $2,000 from net income Cash flow out is $2,000 more because the Income Taxes Payable account decreased $2,000 Copyright © Houghton Mifflin Company. All rights reserved.

Current Liabilities Income Taxes Payable Cash 2,000 5,000 2,000 3,000

Schedule of Cash Flows from Operating Activities: Indirect Method

Effects of Items on the Income Statement That Do Not Affect Cash Flows

Adjustments for Increases and Decreases in Current Assets

Discussion How is depreciation expense treated on the statement of cash flows? Depreciation expense is a deduction on the income statement that does not affect the Cash account. Therefore, it is added back to net income on the statement of cash flows under cash flows from operating activities Copyright © Houghton Mifflin Company. All rights reserved.

Cash Flows from Investing Activities
Analyze increases and decreases in the Investments account to determine effects on Cash account Objective Explain the change in each account balance from one year to the next Focus Long-term assets (balance sheet) Short-term investments (current asset section of the balance sheet) Investment gains and losses (income statement) Copyright © Houghton Mifflin Company. All rights reserved.

Accounting for Investments
Gain on Sale - Investments Investments Cash 12,000 127,000 90,000 102,000 78,000 78,000 115,000 Purchase of investment, $78,000 decrease Sale of investment, $102,000 increase Copyright © Houghton Mifflin Company. All rights reserved.

Plant Assets Explain changes in both the asset and related accumulated depreciation accounts Purchases increase plant assets Sales decrease plant assets Accumulated depreciation is Increased by the amount of depreciation expense Decreased by the removal of accumulated depreciation associated with plant assets that are sold Copyright © Houghton Mifflin Company. All rights reserved.

Accounting for Plant Assets
Accum. Dep. Plant Assets Plant Assets 505,000 68,000 37,000 715,000 103,000 Recall that Ryan Corporation recorded $37,000 of depreciation expense for the year Copyright © Houghton Mifflin Company. All rights reserved.

Loss on Sale Plant Assets Accum. Dep. Plant Assets Plant Assets Cash 8,000 505,000 10,000 2,000 68,000 5,000 120,000 120,000 37,000 715,000 103,000 Purchase of plant assets, $120,000 decrease Sale of plant assets, $5,000 increase Copyright © Houghton Mifflin Company. All rights reserved.

Loss on Sale Plant Assets Accum. Dep. Plant Assets Plant Assets Cash 8,000 505,000 10,000 2,000 68,000 5,000 120,000 120,000 37,000 ??? 715,000 103,000 All items affecting the Plant Assets account have not been accounted for Copyright © Houghton Mifflin Company. All rights reserved.

Accounting for Noncash Investing and Financing Transactions
Plant Assets Bonds Payable 505,000 10,000 100,000 120,000 100,000 ??? 715,000 None All items affecting Plant Assets have now been accounted for Copyright © Houghton Mifflin Company. All rights reserved.

Accounting for Cash Flows from Investing Activities

Accounting for Noncash Investing and Financing Transactions

Discussion What types of transactions are considered investing activities? Investing activities center on the long-term assets shown on the balance sheet Also include transactions affecting short-term investments from the current assets section of the balance sheet and investment gains and losses from the income statement Examples include purchases and sales of investments and plant assets Copyright © Houghton Mifflin Company. All rights reserved.

Cash Flows from Financing Activities
Analysis similar to investing activities, including treatment of related gains or losses Focus Short-term borrowings Long-term liabilities Stockholders’ equity accounts Cash dividends from the statement of stockholders’ equity must also be considered Copyright © Houghton Mifflin Company. All rights reserved.

Accounting for Cash Flows from Financing Activities
Income Taxes Payable Cash 50,000 245,000 50,000 100,000 295,000 Repayment of bonds, $50,000 decrease Copyright © Houghton Mifflin Company. All rights reserved.

Statement of Cash Flows: Indirect Method

Discussion What is the proper treatment on the statement of cash flows for a transaction in which a building that cost $50,000 with accumulated depreciation of $32,000 is sold for a loss of $5,000? The sale of the building would result in a cash flow of $13,000 [Carrying value of $18,000 ($50,000 - $32,000) less a loss of $5,000] Cash Flows from Operating Activities Loss on Sale of Building $5,000 Cash Flows from Investing Activities Sale of Building $13,000 Copyright © Houghton Mifflin Company. All rights reserved.

Discussion (cont’d) Using the indirect method to prepare the statement of cash flows, tell whether each of the following items would appear As cash flows from operating activities As cash flows from investing activities As cash flows from financing activities In the schedule of noncash investing and financing transactions Not at all Copyright © Houghton Mifflin Company. All rights reserved.

Discussion (cont’d) Dividends paid c Cash receipts from sales e
As cash flows from operating activities As cash flows from investing activities As cash flows from financing activities In the schedule of noncash investing and financing transactions Not at all Dividends paid c Cash receipts from sales e Decrease in accounts receivable a Sale of plant assets b Gain on sale of investment a Issue of stock for plant assets d Issue of common stock c Net income a Copyright © Houghton Mifflin Company. All rights reserved.

Time for Review State the principal purposes and uses of the statement of cash flows and identify its components Analyze the statement of cash flows Use the indirect method to determine cash flows from operating activities Copyright © Houghton Mifflin Company. All rights reserved.

Statement of Cash Flows

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