1. Needles Powers Principles of Financial Accounting 12e The Statement of Cash Flows 15 C H A P T E R ©human/iStockphoto

2. Concepts Underlying the Statement of Cash Flows  The statement of cash flows shows how a company’s operating, investing, and financing activities have affected cash during a period. It explains the net increase (or decrease) in cash during the period.  Cash is defined as including both cash and cash equivalents. –Cash equivalents are investments that can be quickly converted to cash. They have a maturity of 90 days or less when they are purchased and include the following:  Money market accounts  Commercial paper (short-term corporate notes)  U.S. Treasury bills ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3. Concepts Underlying the Statement of Cash Flows  Cash equivalents should not be confused with short-term investments, also called marketable securities, which have a maturity of more than 90 days but are intended to be held only until cash is needed for current operations. –Purchases of marketable securities are treated as cash outflows, and sales of marketable securities are treated as cash inflows. –Transfers between the Cash account and cash equivalents are not treated as cash inflows or outflows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4. Relevance of the Statement of Cash Flows  The statement of cash flows provides information about a company’s cash receipts and cash payments during a period.  Management uses the statement of cash flows to: assess liquidity; determine dividend policy; evaluate the effects of major policy decisions involving investments and financing needs.  Investors and creditors use the statement of cash flows to assess a company’s ability to: manage cash flows; generate positive future cash flows; pays its liabilities; pay dividends and interest; anticipate the need for additional financing. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5. Classification of Cash Flows  Operating activities—involve the cash inflows and outflows from activities that enter into the determination of net income. –Cash inflows include:  Cash receipts from the sale of goods and services  Cash receipts from the sale of trading securities—marketable securities that a company buys and sells for making a profit in the near term as opposed to holding them indefinitely for investment purposes.  Interest received on loans and dividends received on investments –Cash outflows include:  Cash payments for wages, inventory, expenses, interest, and taxes  Purchases of trading securities ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6. Classification of Cash Flows  Investing activities—involve the acquisition and sale of property, plant, and equipment and other long-term assets, including long-term investments. –Cash inflows include cash received from:  Selling marketable securities, other than trading securities  Selling long-term assets  Collecting on loans –Cash outflows include:  Cash expended on purchasing securities and assets  Cash lent to borrowers ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. Classification of Cash Flows  Financing activities—involve obtaining resources from stockholders and creditors. –Cash inflows include:  Proceeds from stock issues  Short-term and long-term borrowing –Cash outflows include:  Repayments of loans (excluding interest)  Payments to owners, including cash dividends –Treasury stock transactions are also considered financing activities. –Repayments of accounts payable or accrued liabilities are not considered repayments of loans and are classified as cash outflows under operating activities. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

8. Required Disclosure of Noncash Investing and Financing Transactions  Companies occasionally engage in significant noncash investing and financing transactions. –These transactions involve only long-term assets, long- term liabilities, or stockholders’ equity. –Although noncash transactions represent significant investing and financing activities, they are not reflected in the body of the statement of cash flows because they do not affect current cash inflows and outflows. –They will, however, affect future cash flows, so they must be disclosed in a separate schedule, usually following the statement of cash flows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9. Alternate Presentations of Operating Activities  The direct method converts each item on the income statement from the accrual basis to the cash basis. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10. Alternate Presentations of Operating Activities  The indirect method does not require the conversion of each item on the income statement. –It lists only the items necessary to convert net income to cash flows from operations. –Both analysts and companies overwhelmingly prefer the indirect method, which is easier to prepare. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11. Preparation of the Statement of Cash Flows  Preparing a statement of cash flows involves four steps:  Determine Cash Flows from Operating Activities  Determine Cash Flows from Investing Activities  Determine Cash Flows from Financing Activities  Prepare the Statement of Cash Flows ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. Step One: Determining Cash Flows from Operating Activities  Because the income statement is prepared on an accrual basis, it does not reflect the inflow and outflow of cash related to operating activities. –To ascertain cash flows from operations, the figures on the income statement must be converted from an accrual basis to a cash basis. –The indirect method focuses on adjusting items on the income statement to reconcile net income to net cash flows from operating activities. These items include:  Depreciation, amortization, and depletion  Gains and losses  Changes in the balances of current assets and current liabilities ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13. Step Two: Determining Cash Flows from Investing Activities  In this step, accounts involving cash receipts and cash payments from investing activities are examined individually. The object is to explain the change in each account balance from one period to the next. –The following transactions pertain to Eureka’s investing activities in 2014: 1. Purchased investments in the amount of $78,000. 2. Sold for $102,000 investments that cost $90,000. 3. Purchased plant assets in the amount of $120,000. 4. Sold for $5,000 plant assets that cost $10,000 and that had accumulated depreciation of $2,000. 5. Issued $100,000 of bonds at face value in a noncash exchange for plant assets. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

14. Step Three: Determining Cash Flows from Financing Activities  Determining cash flows from financing activities is very similar to determining cash flows from investing activities, but the accounts analyzed relate to short-term borrowings, long-term liabilities, and stockholders’ equity. –The following transactions pertain to Eureka’s financing activities in 2014: 1. Issued $100,000 of bonds at face value in a noncash exchange for plant assets. 2. Repaid $50,000 of bonds at face value at maturity. 3. Issued 15,200 shares of $5 par value common stock for $175,000. 4. Paid cash dividends in the amount of $7,000. 5. Purchased treasury stock for $25,000. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15. Cash Flow Ratios  Cash flows from operating activities represent the cash generated from current or continuing operations. –They are a measure of the ability to pay bills on time and to meet unexpected needs for cash, as well as how management spends the company’s cash.  The focal point of cash flow analysis is on cash inflows and outflows from operating activities. –These cash flows are used in ratios that measure cash-generating efficiency, which is a company’s ability to generate cash from its current or continuing operations. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

16. Cash Flow Yield  Cash flow yield is the ratio of net cash flows from operating activities to net income. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

17. Cash Flows to Sales  Cash flows to sales is the ratio of net cash flows from operating activities to net sales. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

18. Cash Flows to Assets  Cash flows to assets is the ratio of net cash flows from operating activities to average total assets. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. Free Cash Flow  Free cash flow is the amount of cash that remains after deducting the funds a company must commit to continue operating at its planned level. –Free cash flow can be positive or negative:  Positive free cash flow means that the company has met all of its planned cash commitments and has cash available to reduce debt or to expand.  Negative free cash flow means that the company will have to sell its investments, borrow money, or issue stock in the short term to continue at its planned level. If a company’s free cash flow remains negative for several years, it may not be able to raise cash by issuing stocks or bonds. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

20. Asking the Right Questions About the Statement of Cash Flows  In interpreting a statement of cash flows, it pays to know the right questions to ask. –Cash Flows and Net Income: What are the primary reasons that the company’s cash flows from operating activities differed from net income? –Investing Activities: What were the company’s most important investing activities other than capital expenditures? –Financing Activities: How did the company manage its financing activities during the year? –Cash Flow Trends: What has been the trend of cash flows for the company? ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

21. Ethical Considerations in Analyzing the Statement of Cash Flows  Because of the emphasis on cash flows as an important measure of performance, an incentive exists to overstate these cash flows.  A company may show an apparent (but false) improvement in its performance: –by classifying payments of operating expenses as investments on the statement of cash flows. –through lack of transparency, or lack of full disclosure, in its financial statements—such as by netting the proceeds of securitization against the accounts receivable in the operating activities section of the statement of cash flows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.