1. 1 Chapter 12 `

2. 2 Chapter 12 Statement of Cash Flows After studying Chapter 12, you should be able to: zIndicate the primary purpose of the statement of cash flows. zDistinguish among operating, investing, and financing activities. zExplain the impact of the product life cycle on a company's cash flows. zPrepare a statement of cash flows using one of two approaches: y(a) the indirect method, or y(b) the direct method. zUse the statement of cash flows to evaluate a company.

3. 3 The Primary Purpose of the Statement of Cash Flows Is... zTo provide information about: ycash receipts, ycash payments, and ythe net change in cash resulting from: xoperating, xinvesting, and xfinancing activities of a company during a period.

4. 4 Questions the Statement of Cash Flow Answers

5. 5 Operating Activities... Include: yThe cash effects of transactions that create revenues and expenses and yEnter into determination of net income. Involve Income Statement Items

6. 6 Investing Activities... Include: yPurchasing and disposing of investments and productive long-lived assets using cash and yLending money and collecting the loans. Involve Investments and Noncurrrent Asset Items

7. 7 Financing Activities... Include: yObtaining cash from issuing debt and repaying the amounts borrowed and yObtaining cash from stockholders and paying dividends. Involve Noncurrent Liability and Stockholders’ Equity Items

8. 8 Types of Cash Flows - Operating Activities zCash inflows: yFrom sale of goods or services yFrom return on loans (interest received) and on equity securities (dividends received) zCash outflows: yTo suppliers for inventory yTo employees for services yTo government for taxes yTo lenders for interest yTo others for expenses Illustration 12-1

9. 9 Types of Cash Flows - Investing Activities zCash inflows: yFrom sale of property, plant, and equipment yFrom sale of debt or equity securities of other entities yFrom collection of principal on loans to other entities zCash outflows: yTo purchase property, plant, and equipment yTo purchase debt or equity securities of other entities yTo make loans to other entities Illustration 12-1

10. 10 Types of Cash Flows - Financing Activities zCash inflows: yFrom sale of equity securities (company's own stock) yFrom issuance of debt (bonds and notes) zCash outflows: yTo stockholders as dividends yTo redeem long-term debt or reacquire capital stock Illustration 12-1

11. 11 Operating Activities - ALERT zSome cash flows relating to investing or financing activities are classified as operating activities. For example... yReceipts of investment revenue (interest and dividends) and yPayments of interest to lenders are classified as operating activities because these items are reported in the income statement.

12. 12 Significant Noncash Activities... zThat do NOT affect cash are NOT reported in the body of the statement of cash flows. zAre reported: yIn a separate schedule at the bottom of the statement of cash flows or yIn a separate note or supplementary schedule to the financial statements.

13. 13 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.

14. 14 Format of the Statement of Cash Flows Three parts: yoperating y investing yfinancing Plus significant noncash investing and financing activities in separate schedule or at bottom of the statement of cash flows.

15. 15 Format of the Statement of Cash Flows Three activities: yoperating y investing yfinancing PLUS ynoncash investing and financing activities Body of Statement

16. 16 The Product Life Cycle zA series of phases all products go through zThe phases are often referred to as the: yintroductory phase ygrowth phase ymaturity phase ydecline phase. zThe phase a company is in affects its cash flows.

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

18. 18 The company is striving to expand its production and sales. Expect: ísmall amounts of cash to be generated from operations. ícash from investing to be negative. ícash from financing to be positive. Growth Phase

19. 19 Sales and production level-off Expect: ícash from operations to exceed investing needs. ícash from investing to be neutral. ícash from financing to be negative. Maturity Phase

20. 20 Sales and production decline Expect: ícash from operations to decline ícash from investing to possibly become positive. ícash from financing to possibly become negative Decline Phase

21. 21 Impact of Product Life Cycle on Cash Flows 0

22. 22 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

23. 23 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 investing and financing transactions during the period

24. 24 Statement of Cash Flows Helps Answer the Following Questions zHow did cash increase when there was a net loss for the period? zHow were the proceeds of the bond issue used? zHow was the expansion in the plant and equipment financed? zWhy were dividends not increased? zHow was the retirement of debt accomplished? zHow much money was borrowed during the year? zIs cash flow greater or less than net income?

25. 25 Sources of Information for the Statement of Cash Flows zComparative balance sheet zCurrent income statement zAdditional information

26. 26 Comparative Balance Sheet Indicates the amount of changes in assets, liabilities, and stockholders' equities from the beginning to the end of the period.

27. 27 COMPUTER SERVICES COMPANY Comparative Balance Sheet December 31, 2003

28. 28 Current Income Statement Information in this statement helps the reader determine the amount of cash provided or used by operations during the period.

29. 29 Income Statement and Additional Information COMPUTER SERVICES COMPANY Income Statement For the Year Ended December 31, 2003 Revenues$85,000 Operating expenses 40,000 Income before income taxes 45,000 Income tax expense 10,000 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 2003. No depreciation was taken in 2003.

30. 30 Indirect and Direct Methods zConvert net income from an accrual basis to a cash basis. zThis conversion may be done by two methods: yindirect ydirect

31. 31 Indirect and Direct Methods zBoth methods arrive at the same total amount for “Net cash” provided by operating activities. zThe methods differ in disclosing the items that make up the total amount. zThe choice of methods affects only the operating activities section; the investing and financing activities sections are the same.

32. 32 Indirect Method zThe indirect method is used extensively in practice. zMost companies favor the indirect method for the following reasons: yit is easier to prepare yit focuses on the differences between net income and net cash flow from operating activities yit tends to reveal less company information to competitors.

33. 33 Direct Method zThe FASB prefers the direct method but allows the use of either method. zWhen 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.

34. 34 Steps in Preparing Statement of Cash Flows $34,000 - 0 = $34,000

35. 35 Statement Of Cash Flows - Indirect Method zThe transactions of Computer Services Company for the year ended 2003 are used to illustrate the preparation of a statement of cash flows. zComputer services Company started in January 1, 2003, when it issued 50,000 shares of $1 par value common stock for $50,000 cash. zThe company rented its office space and furniture and performed consulting services throughout the first year.

36. 36 Steps in Preparing Statement of Cash Flows

37. 37 Determine Net Cash Provided/Used By Operating Activities zAdjust net income for items that did not affect cash. zNet 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.

38. 38 Net Income Versus Net Cash Provided by Operating Activities Add Cash advancesDeduct prepaid expenses

39. 39 Receivables, payables, prepayments, and inventories must be analyzed for their effects on cash. Determine Net Cash Provided/Used By Operating Activities

40. 40 zComputer Services Company had revenues of $85,000 in its first year of operations. zHowever, CSC collected only $55,000 in cash. Accrual basis revenue was $85,000, cash basis revenue would be $55,000. zThe increase in accounts receivable of $30,000 must be deducted from net income. zIf accounts receivable decrease, the decrease must be added to net income. Determine Net Cash Provided/Used By Operating Activities

41. 41 COMPUTER SERVICES COMPANY Statement of Cash Flows--Indirect Method (Partial) For the Year Ended December 31, 2003 Cash flows 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)

42. 42 zAccounts payable - When accounts payable increase during a year, operating expenses on an accrual basis are higher than they are on a cash basis. zFor CSC, operating expenses reported in the income statement were $40,000. zSince Accounts Payable increased $4,000, $36,000 ($40,000 – $4,000) of the expenses were paid in cash. zTo convert net income to net cash provided by operating activities, an increase in accounts payable must be added to net income, a decrease subtracted. Determine Net Cash Provided/Used By Operating Activities

43. 43 COMPUTER SERVICES COMPANY Statement of Cash Flows--Indirect Method (Partial) For the Year Ended December 31, 2003 Cash flows 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 4,000 (26,000) Net cash provided by operating activities $ 9,000

44. 44 Steps in Preparing Statement of Cash Flows

45. 45 Determine Net Cash Provided/Used By Investing and Financing Activities zNo data are given for the increases in Equipment of $10,000 and Common Stock of $50,000. Assume any differences involve cash. zThe increase in equipment is from a purchase of equipment for $10,000 cash. This purchase is reported as a cash outflow in the investing activities section. zThe increase of common stock results 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.

46. 46 COMPUTER SERVICES COMPANY Comparative Balance Sheet December 31, 2003

47. 47 Determine Net Cash Provided/Used By Investing and Financing Activities zReasons for the increase of $20,000 in the Retained Earnings. yNet income increased retained earnings by $35,000. REPORTED IN THE OPERATING ACTIVITIES SECTION. yThe additional information indicates that a cash dividend of $15,000 was declared and paid. REPORTED IN THE FINANCING ACTIVITIES SECTION.

48. 48 COMPUTER SERVICES COMPANY Statement of Cash Flows--Indirect Method (Partial) For the Year Ended December 31, 2003 Cash flows 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 4,000 (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 35,000 Net increase in cash $34,000

49. 49 Major Classes of Cash Receipts and Payments -- Direct Method

50. 50 Formula to Compute Cash Receipts from Customers-Direct Method

51. 51 Formula to Compute Cash Payment to Suppliers-Direct Method

52. 52 Formula to Compute Cash Payments for Operating Expenses-Direct Method

53. 53 COMPUTER SERVICES COMPANY Statement of Cash Flows--Direct Method (Partial) For the Year Ended December 31, 2003 Cash flows from operating activities Cash receipts from customers $ 765,000 Cash payments To supplier$550,000 For operating expenses 158,000 For income taxes 48,000 756,000 Net cash provided by operating activities $ 9,000

54. 54 Free Cash Flow zIn the statement of cash flows, cash from operations is intended to indicate the cash- generating capability of the company. zStatement of Cash flows fails to take into account that a company must invest in new fixed assets to maintain its current level of operations and it must maintain dividends at current levels to satisfy investors.

55. 55 Cash Provided By Operations – Capital Expenditures – Dividends Paid Free Cash Flow

56. 56 The 2001 statement of cash flows of Microsoft Corporation provides information for the computations of these measures. MICROSOFT CORPORATION STATEMENT OF CASH FLOWS (PARTIAL) 2001 Cash flows from operations $13,422 Additions to property, plant, and equipment$ (1,103) Other assets and investments ( 66,346) Short-term investments 58,315 Cash used by investing activities (9,134) Cash paid for dividends on preferred stock (0) Using Cash Flows to Evaluate a Company

57. 57 MICROSOFT CORPORATION STATEMENT OF CASH FLOWS (Partial) 2001 Cash flows from operations 13,422 Less: Expenditures on property, plant, and equipment 1,103 Dividends z 0 Free Cash Flow12,319

58. 58 Rather than using numbers from the income statement for assessment purposes, we use numbers from the statement of cash flows. Assessing Liquidity, Solvency, and Profitability Using Cash Flows The ratios are cash-based instead of accural-based.

59. 59  Accrual-based measures allows too much management discretion. íOne disadvantage to the cash-based measures is no readily available published industry averages for comparison. Cash-Based Measures

60. 60 Liquidity ïLiquidity is the ability of a business to meet its immediate obligations. ïOne measure of liquidity is the current ratio. ïA disadvantage of the current ratio is that it uses year-end balances of current assets and current liabilities (may not be representative of a company's position during most of the year.)

61. 61 Current Cash Debt Coverage Ratio zA ratio that partially corrects this is the current cash debt coverage ratio. Cash provided by operations Average current liabilities zSince 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.

62. 62 Solvency zSolvency is the ability of a firm to survive over the long term. yOne measure of solvency is the debt to total assets ratio. zA measure of solvency that uses cash figures is the cash debt coverage ratio. Cash Provided By Operations Average Total Liabilities zThis ratio measures a company's ability to repay its liabilities from cash generated from operations.

63. 63 Profitability zProfitability refers to a company's ability to generate a reasonable return. zAccrual-based ratios that measure profitability are gross profit rate, profit rate margin, and return on assets. zA cash-based measure of performance is the cash return on sales ratio.