1. Reporting and Analyzing Cash Flows
Chapter 12
Reporting and Analyzing Cash Flows
In this chapter, we will learn about the three main sections of the Statement of Cash Flows. They are the Operating Section, the Investing Section and the Financing Section. We also learn how to prepare a Statement of Cash Flows using both the direct and indirect methods.

2. Conceptual Learning Objectives
C1: Explain the purpose and importance of cash flow information
C2: Distinguish between operating, investing, and financing activities
C3: Identify and disclose noncash investing and financing activities
C4: Describe the format of the statement of cash flows

3. Analytical Learning Objectives
A1: Analyze the statement of cash flows
A2: Compute and apply the cash flow on total assets ratio

4. Procedural Learning Objectives
P1: Prepare a statement of cash flows
P2: Compute cash flows from operating activities using the indirect method
P3: Determine cash flows from both investing and financing activities
P4: Appendix 16A: Illustrate use of a spreadsheet to prepare a statement of cash flows
P5: Appendix 16B: Compute cash flows from operating activities using the direct method

5. Purpose of the Statement of Cash Flows
Where does a company spend its cash?
How does a company obtain its cash?
What explains the change in the cash balance?
The Statement of Cash flows helps users determine how a company obtains its cash and where it spends its cash. By providing this information, this statement helps explain the change in the cash balance from the beginning of the period to the end of the period.

6. Importance of Cash Flows
How did the business fund its operations?
Does the business have sufficient cash to pay its debts as they mature?
While it is important for users to know how much cash a company has, it is also important to know how a company funded its operations. Did it have to borrow money or sell stock to help pay the operating expenses of the company? If so, users need to be aware of this so they can fully assess the cash flow position of the company. Cash flow information is also useful to determine if the business has sufficient cash to pay its debts or if the business paid dividends during the period.
Did the business borrow any funds or repay any loans?
Did the business make any dividend payments?

7. Measurement of Cash Flows
Cash Equivalents
Currency
Cash includes currency and cash equivalents. Cash equivalents are short-term, highly liquid investments that are easily converted into cash and that have very little risk of loss. An example of a cash equivalent would be a short-term Treasury Bill that is government issued, is very close to maturity, and has very little risk associated with it.
Short-term, highly liquid investments.
Readily convertible into cash.
Sufficiently close to maturity so that market value is unaffected by interest rate changes.

8. Classifying Cash Flows
The Statement of Cash Flows includes the following three sections:
Operating Activities
Investing Activities
Financing Activities
There are three basic sections on the Statement of Cash Flows:
 Operating Activities
 Investing Activities
 Financing Activities
On the next few slides we will discuss each of these sections.

9. Operating Activities Inflows Outflows Receipts from customers
Cash dividends received
Interest from borrowers
Other.
Outflows
Salaries and wages
Payments to suppliers
Taxes and fines
Interest paid to lenders
Other
The Operating Activities Section includes cash inflows and cash outflows that result from the operations of the business and some incidental business transactions. Operating cash inflows include cash received from customers in payment of goods sold. It also includes cash received as dividends and interest. Operating cash outflows include cash payments for salaries, supplies, inventory, taxes, and interest.

10. Investing Activities Inflows Outflows
Selling long-term productive assets
Selling equity investments
Collecting principal on loans
Other
Outflows
Purchasing long-term productive assets
Purchasing equity investments
Purchasing debt investments
Other
The Investing Activities Section includes cash inflows and cash outflows that result from the sale and purchase of fixed assets and investments. If a company purchases a piece of equipment, it would be classified as a cash outflow in the investing section. If a company has excess cash and invests it in the stock of another company, it would also be classified as a cash outflow in the investing section. If, in the future, this equity investment is sold, it would be classified as a cash inflow in the investing section.

11. Financing Activities Inflows Outflows
Issuing its own equity securities
Issuing bonds and notes
Issuing short- and long-term liabilities
The Financing Activities Section includes cash inflows and cash outflows that result from transactions with the company’s creditors and stockholders. If a company borrows money from a bank, it would be classified as a cash inflow in the financing section. If, in the future, this debt is repaid, the amount of the principal payment would be classified as a cash outflow in the financing section. Remember that the interest payment is classified as a cash outflow in the operating section. If a company issues stock of the company, it would be classified as a cash inflow in the financing section.
Outflows
Pay dividends
Purchasing treasury stock
Repaying cash loans
Paying owners’ withdrawals

12. Noncash Investing and Financing
Items requiring separate disclosure include:
Retirement of debt by issuing equity securities.
Conversion of preferred stock to common stock.
Leasing of assets in a capital lease transaction.
Some transactions involve investing activities and or financing activities but no cash. An example would be purchasing equipment and paying for it by issuing company stock. In this transaction, the purchase of equipment is an investing activity and the issuance of stock is a financing activity. But, not a single dollar of cash was exchanged in the transaction. As a result, this transaction would NOT appear on the Statement of Cash Flows. As a result, these noncash investing and financing transactions must be disclosed in the financial statements or the notes.

13. Format of the Statement of Cash Flows
This is a summary of the components of a Statement of Cash Flows. You can see the operating, investing and financing sections that we just discussed are on the statement. There is also a cash reconciliation at the bottom of the statement that reconciles the change in cash with the beginning and ending cash balances. The ending cash balance on the Statement of Cash Flows should always equal the cash balance on the Balance Sheet.

14. Format of the Statement of Cash Flows
There are two acceptable methods to determine Cash Flows from Operating Activities:
Direct Method
Indirect Method
There are two acceptable formats for preparing the Cash Flows from Operating Activities:
 The Direct Method.
 The Indirect Method.
While each method uses a different format to arrive at Net Cash Provided (Used) by Operating Activities, the end result is the same under each method. In other words, they may use a different path to get to the end, but in the end, they both arrive at the same answer.

15. Preparing the Statement of Cash Flows
Let’s look at the Indirect Method for preparing the Cash Flows from Operating Activities section.
Now, let’s learn how to use the indirect method for preparing the Cash Flows from Operating Activities.

16. Changes in current assets and current liabilities.P2
Indirect Method
Changes in current assets and current liabilities.
Net Income
Cash Flows from Operating Activities
The indirect method is used by almost all companies. The indirect method starts with the accrual based net income and makes certain adjustments to arrive at Cash Flows from Operating Activities. Adjustments to the accrual based net income include adding back any noncash items that are included to arrive at net income, such as depreciation and amortization. Adding these back on the Statement of Cash Flows basically cancels out the fact that they were originally subtracted to arrive at net income. Since these items do not represent cash outlays, we would not want them included in the Statement of Cash Flows.
Other items on the income statement to consider are gains and losses. Gains and losses result from the sale of an asset. Gains are added on the income statement and losses are subtracted on the income statement to arrive at net income. Since the gain and loss do not represent an operating cash flow, we cancel out gains by subtracting them and cancel out losses by adding them to net income in the operating section. The actual cash flow from the sale of the asset will be properly reported, in most cases, in the investing section. We also have to make appropriate adjustments to reflect the change from accrual based revenues and expenses reported on the income statement to cash based revenues and expenses. This is accomplished by analyzing the changes in noncash current assets and current liabilities.
+ Losses and - Gains
+ Noncash expenses such as depreciation and amortization.
97.5% of all companies use the indirect method.

17. P2
Indirect Method
This chart explains how to treat a change in a noncash current asset or current liability in the operating section of the statement of cash flows. Maybe a couple of examples will help you see how this table works. Let’s start with current assets. If Accounts Receivable, a current asset, decreased during the year, this decrease would be added to net income. A decrease in Accounts Receivable means that customer cash payments on account exceeded customer charges on account during the period. This excess of cash payments over charges is used to adjust the accrual based revenues reported on the income statement to report the total cash received from customers during the period. Similarly, if Accounts Receivable increased during the year, this increase would be subtracted from net income. An increase in Accounts Receivable means that customer charges on account exceeded customer cash payments on account during the period. This excess of charges over cash payments is used to adjust the accrual based revenues reported on the income statement to report the total cash received from customers during the period. Now, let’s look at how to treat changes in current liabilities. If Salaries Payable, a current liability, decreased during the year, this decrease would be subtracted from net income. A decrease in Salaries Payable means that the company paid off more in salaries than it charged during the period. This excess of cash payments over charges is used to adjust the accrual based expense reported on the income statement to report the total cash paid for salaries during the period. Similarly, if Salaries Payable increased during the year, this increase would be added to net income. An increase in Salaries Payable means the company charged more than it paid off during the period. This excess of charges over cash payments is used to adjust the accrual based expense reported on the income statement to report the total cash paid for salaries during the period.
Use this table when adjusting Net Income to Operating Cash Flows.

18. Indirect Method Example
East, Inc. reports $125,000 net income for the year ended December 31, 2008.
Accounts Receivable increased by $7,500 during the year and Accounts Payable increased by $10,000.
During 2008, East reported $12,500 of Depreciation Expense.
Now, let’s try a small example using East Incorporated. East Incorporated reported one hundred twenty five thousand dollars in net income for the period. During the period, Accounts Receivable increased seven thousand five hundred dollars and Accounts Payable increased ten thousand dollars. During the period, East Incorporated reported twelve thousand five hundred dollars in depreciation expense. What is East Incorporated’s cash flows from operating activities for the period?
What is East, Inc.’s Operating Cash Flow for 2008?

19. Indirect Method Example
Net income
125,000 $
Deduct: Increase in accounts
receivable
Cash provided by operating
activities
For the indirect method, start with net income.
First, start with net income.

20. Indirect Method Example
Net income
125,000 $
Add: Depreciation expense
12,500
Deduct: Increase in accounts
receivable
Cash provided by operating
activities
Add noncash expenses such as depreciation, depletion, amortization, or bad debt expense.
Then, add back the noncash items such as depreciation expense.

21. Indirect Method Example
Net income
125,000 $
Add: Depreciation expense
12,500
Deduct: Increase in accounts
receivable
(7,500)
Cash provided by operating
activities
Next, use the table and determine whether to add or subtract the change in noncash current assets and current liabilities. Since accounts receivable, a current asset, increased, the change needs to be subtracted from net income.

22. Indirect Method Example
Net income
125,000 $
Add: Depreciation expense
12,500
Deduct: Increase in accounts
receivable
(7,500)
Add: Increase in accounts payable
10,000
Cash provided by operating
activities
Since accounts payable, a current liability, increased, the change needs to be added to net income.

23. Indirect Method Example
Net income
125,000 $
Add: Depreciation expense
12,500
Deduct: Increase in accounts
receivable
(7,500)
Add: Increase in accounts payable
10,000
Cash provided by operating
activities
140,000
Now we can see that East Incorporated’s cash provided from operating activities is one hundred forty thousand dollars. Notice that if we used the direct method, we would use a different format but would get the same answer.
If we used the Direct Method, we would get the same $140,000 for Cash Provided by Operating Activities.

24. Indirect Method P2
Let’s prepare a Statement of Cash Flows for B&G Company using the Indirect Method.
Let’s test this idea by preparing another Statement of Cash Flows for B and G company, but this time, let’s use the indirect method.

25. P2
Here is a comparative balance sheet for B and G so we can see the changes in each account.

26. Additional Information for 2008: Net income was $105,000. P2
Additional Information for 2008:
Net income was $105,000.
Cash dividends declared and paid were $40,000.
Bonds payable of $50,000 were redeemed for $50,000 cash.
Common stock was issued for $35,000 cash.
Some additional information that we will need is that net income for the period is one hundred five thousand dollars; forty thousand dollars in cash dividends were paid during the period; fifty thousand dollars of bonds payable were paid with cash; and common stock was issued for thirty-five thousand dollars. Now, we are ready to start the Statement of Cash Flows.

27. Start with accrual-basis net income.P1
Start with accrual-basis net income.
Add noncash expenses and losses.
Subtract noncash revenues and gains.
Then, analyze the changes in current assets and current liabilities.
First, we start with the accrual-basis net income. Then, we adjust net income for noncash expenses, gains and losses. Last, we need to adjust net income for the changes in the noncash current assets and current liabilities.

28. P2
As you can see, depreciation expense is added back to net income. The changes in the noncash current assets and current liability accounts are then added or subtracted as appropriate. If you look back at the direct method for B and G, you will see that it also reported one hundred forty-one thousand dollars as net cash provided by operating activities.

29. Now, let’s complete the investing section.
Now, can you complete the investing section? HINT: it is exactly like the one we did earlier!

30. Now, let’s complete the financing section.
See, nothing new here! The financing section should be the same as well.
Now, let’s complete the financing section.

31. P1
Here is the completed Statement of Cash Flows. The only thing that is different from the first one we completed for this company is the way we arrived at cash provided by operating activities. The rest of the statement is exactly like the first one we did.

32. Analyzing Cash Sources and Uses
Looking at the Statement of Cash Flows provides useful information and can help raise good questions about a company. While each of these companies had the same net change in cash, the change is composed of different sources and uses. BMX used its cash provided by operations to purchase operating assets and pay off some debt. ATV also used cash provided by operations to purchase operating assets. A question arises as to whether any debt exists that should have or could have been paid off this period. Notice that Trex did not generate positive cash flows from its operating activities. Trex’s source of cash during the period actually resulted from going into debt and selling assets. Are these observations something about which investors should be concerned? Perhaps. Investors would need to look at the entire set of financial statements as well as published information about each company to get the whole picture of what is happening. But, reviewing the Statement of Cash Flows is a good place to generate questions that need further investigation.

33. Cash Flow on Total Assets
Used, along with income-based ratios, to assess company performance.
Cash flow on
total assets =
Operating cash flows
Average total assets
The Cash Flow on Total Assets ratio is used with income-based ratios to help assess a company’s performance. It is calculated as Operating Cash Flows divided by Average Total Assets.

34. Preparing the Statement of Cash Flows
Let’s look at the Direct Method for preparing the Cash Flows from Operating Activities section.
Now, let’s look at a Statement of Cash Flows that uses the direct method for preparing the Cash Flows from Operating Activities.

35. Analyzing the Cash AccountP5
Let’s review this Cash Account and determine where each of the transactions will appear on B and G’s Statement of Cash Flows.
Receipts from customers will appear in the Operating Section.
Receipts from sale of land will appear in the Investing Section.
Receipts from stock issuance will appear in the Financing Section.
Payments for merchandise, wages, interest and taxes will appear in the Operating Section.
Payments for equipment will appear in the Investing Section.
And finally, payments for bond retirement and dividends will appear in the Financing Section.
Now, let’s look at a completed Statement of Cash Flows for B and G.
Let’s use this Cash account to prepare B&G Company’s Statement of Cash Flows under the Direct Method.

36. P5
Notice how the transactions are properly classified based on our analysis on the previous slide. The statement also includes the cash reconciliation at the end.

37. End of Chapter 12
In this chapter, we learned about the three main sections of the Statement of Cash Flows. They are the Operating Section, the Investing Section and the Financing Section. We also learned how to prepare a Statement of Cash Flows using both the direct and indirect methods.