1. 1 Financial Accounting: Tools for Business Decision Making, 2nd Ed. Kimmel, Weygandt, Kieso ELS

2. Chapter 13 `

3. 3 Chapter 13 Statement of Cash Flows After studying Chapter 13, 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.

4. 4 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.

5. 5 Questions the Statement of Cash Flow Answers

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

7. 7 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 Long- Term Asset Items

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

9. 9 Types of Cash Flows - Operating Activities zCash inflows: yFrom sale of goods or services yFrom interest received and 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 13-1

10. 10 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 13-1

11. 11 Types of Cash Flows - Financing Activities zCash inflows: yFrom issuance 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 13-1

12. 12 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.

13. 13 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.

14. 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. 15 Format of the Statement of Cash Flows Four parts: yoperating y investing yfinancing ynoncash investing and financing activities

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 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. Impact of Product Life Cycle on Cash Flows Illustration 13-3 0

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. COMPUTER SERVICES COMPANY Comparative Balance Sheet December 31, 2000 Illustration 13-5

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. Income Statement and Additional Information COMPUTER SERVICES COMPANY Income Statement For the Year Ended December 31, 2000 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 2000. No depreciation was taken in 2000. Illustration 13-6

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. Steps in Preparing Statement of Cash Flows Illustration 13-4 $34,000 - 0 = $34,000

35. 35 Statement Of Cash Flows - Indirect Method zThe transactions of Computer Services Company for the year ended 2000 are used to illustrate the preparation of a statement of cash flows. zComputer services Company started in January 1, 2000, 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. Steps in Preparing Statement of Cash Flows Illustration 13-4

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. Net Income Versus Net Cash Provided by Operating Activities Illustration 13-7 Add Cash advances Add 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. COMPUTER SERVICES COMPANY Statement of Cash Flows--Indirect Method (Partial) For the Year Ended December 31, 2000 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) Illustration 13-12

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. COMPUTER SERVICES COMPANY Statement of Cash Flows--Indirect Method (Partial) For the Year Ended December 31, 2000 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 Illustration 13-12

44. Steps in Preparing Statement of Cash Flows Illustration 13-4

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. COMPUTER SERVICES COMPANY Comparative Balance Sheet December 31, 2000 Illustration 13-5

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. COMPUTER SERVICES COMPANY Statement of Cash Flows--Indirect Method (Partial) For the Year Ended December 31, 2000 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 Illustration 13-12

49. 49 YEAR TWO

50. 50 COMPUTER SERVICES COMPANY Comparative Balance Sheet December 31 Illustration 13-13 Second-Year Operations

51. 51 20012000Change Illustration 13-13 Second-Year Operations COMPUTER SERVICES COMPANY Comparative Balance Sheet December 31

52. 52 Revenues $507,000 Operating expenses $261,000 Depreciation expenses 15,000 Loss on sale of equipment 3,000 279,000 Income from operations 228,000 Income tax expense 89,000 Net income $139,000 COMPUTER SERVICES COMPANY Income Statement For the Year Ended December 31, 2001 Illustration 13-14 Second-Year Operations

53. 53 Additional Information: (a) In 2001 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 2001 the company sold equipment with a book value of $7,000 (cost $8,000 less accumulated depreciation $1,000) for $4,000 cash. Illustration 13-14 Second-Year Operations

54. 54 Determine the Net Increase or Decrease in Cash Cash increased $22,000 ($56,000-$34,000)

55. 55 Determine Net Cash Provided/Used By Operating Activities Adjust net income for items that did not affect cash.

56. 56 zDepreciation expense - During 2001 Computer Services Company reported depreciation expense of $15,000. zDepreciation and other charges that do not require the use of cash, such as amortization of intangible assets are added to net income. Determine Net Cash Provided/Used By Operating Activities

57. 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 Computer Services Company Statement of Cash Flows (Partial) For the Year Ended December 31, 2001 Illustration 13-16 INDIRECT METHOD

58. 58 zLoss 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). zThe loss reduced net income but did not reduce cash. zThe $3,000 loss is added to net income in determining net cash provided by operating activities. Determine Net Cash Provided/Used By Operating Activities

59. 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 Computer Services Company Statement of Cash Flows (Partial) For the Year Ended December 31, 2001 Illustration 13-16 INDIRECT METHOD

60. 60 zAccounts 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. Determine Net Cash Provided/Used By Operating Activities

61. COMPUTER SERVICES COMPANY Comparative Balance Sheet December 31 Illustration 13-13 Second-Year Operations

62. 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 Computer Services Company Statement of Cash Flows (Partial) For the Year Ended December 31, 2001 Illustration 13-16 INDIRECT METHOD

63. 63 zPrepaid Expenses - Prepaid expenses increase during a period because cash paid for expenses is greater than expenses reported on an accrual basis. zThe increase of $4,000 in prepaid expenses must be deducted from net income. Determine Net Cash Provided/Used By Operating Activities

64. COMPUTER SERVICES COMPANY Comparative Balance Sheet December 31 Illustration 13-13 Second-Year Operations

65. 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) Computer Services Company Statement of Cash Flows (Partial) For the Year Ended December 31, 2001 Illustration 13-16 INDIRECT METHOD

66. 66 zAccounts Payable - The increase of $55,000 in accounts payable must be added to net income. Determine Net Cash Provided/Used By Operating Activities

67. 67 20012000Change Illustration 13-13 Second-Year Operations COMPUTER SERVICES COMPANY Comparative Balance Sheet December 31

68. 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 79,000 Net cash provided by operating 218,000 activities Computer Services Company Statement of Cash Flows (Partial) For the Year Ended December 31, 2001 Illustration 13-16 INDIRECT METHOD

69. Steps in Preparing Statement of Cash Flows Illustration 13-4

70. 70 zStudy the balance sheet to determine changes in noncurrent assets. zChanges in each noncurrent account are analyzed using selected transaction data to determine the effect, if any, the changes had on cash. Determine Net Cash Provided/Used By Operating Activities

71. 71 zLand - Land of $130,000 was purchased through the issuance of long-term bonds. zAlthough 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. Determine Net Cash Provided/Used By Investing and Financing Activities

72. 72 zBuilding - An office building was acquired using cash of $160,000. zThis transaction is a cash outflow reported in the investing activities section. Determine Net Cash Provided/Used By Investing and Financing Activities

73. 73 zEquipment - The equipment account increased $17,000. zThe additional information provided, reveals that this was a net increase resulting from two transactions y(1) a purchase of equipment for $25,000 y(2) sale of equipment costing $8,000 for $4,000. zThe 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. Determine Net Cash Provided/Used By Investing and Financing Activities

74. 74 zBonds 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. Determine Net Cash Provided/Used By Investing and Financing Activities

75. 75 zRetained Earnings - Retained Earnings increased by $124,000. zThe increase is a net of y(1) Net income of $139,000 that increased Retained Earnings and y(2) dividends of $15,000 that decreased Retained earnings. zNet income is converted to net cash provided by operations. zPayment of the dividend is a cash outflow that is reported as a financing activity. Determine Net Cash Provided/Used By Investing and Financing Activities

76. Net cash provided by operating 218,000 activities - continued Cash flows from investing activities Purchase of building (160,000) Purchase of equipment ( 25,000) Sale of equipment 4,000 Net cash used by investing act. (181,000) Cash flows from financing activities Payment of cash dividends 15,000 Net Cash used by financing act. ( 15,000) Net Increase in cash 22,000 Cash at beginning of period 34,000 Cash at end of period $56,000 Noncash investing and financing act. Issuance of bonds payable to buy land$130,000 Computer Services Company Statement of Cash Flows (Partial) For the Year Ended December 31, 2001 Illustration 13-16

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

78. Major Classes of Cash Receipts and Payments -- Direct Method Illustration 13-23

79. 79 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.

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

81. 81 The 1998 statement of cash flows of Microsoft Corporation provides information for the computations of these measures. MICROSOFT CORPORATION STATEMENT OF CASH FLOWS (PARTIAL) 1998 Cash flows from operations $6,880 Additions to property, plant, and equipment $ 656 Other assets and investments 1,788 Short-term investments 4,828 Cash used by investing activities (7,272) Cash paid for dividends on preferred stock (28) Using Cash Flows to Evaluate a Company Illustration 13-46

82. MICROSOFT CORPORATION STATEMENT OF CASH FLOWS (Partial) 1998 Cash flows from operations $6,880 Additions to property, plant, and equipment $ 656 Other assets and investments 1,788 Short-term investments 4,828 Cash used by investing activities (7,272) Cash paid for dividends on preferred stock (28) Cash provided by operations $6,880 Less: Expenditures on property,plant and equipment 656 Dividends Paid 28 Free cash flow $6,196 Illustration 13-46 Illustration 13-47

83. 83 Capital Expenditure Ratio êAn indicator of a company's ability to generate sufficient cash to finance new fixed assets. êCapital expenditures are purchases of fixed assets.

84. 84 Capital Expenditure Ratio = Cash Provided by Operations Capital Expenditures

85. 85 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.

86. 86  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

87. 87 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.)

88. 88 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.

89. 89 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.

90. 90 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.

91. 91 Cash Return on Sales Ratio zIndicates the company's ability to turn sales into dollars for the firm. zA 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.

92. 92 Cash From Operations Net Sales Cash Return on Sales Ratio =

93. 93