Chapter 14 Statement of Cash Flows

1
Chapter 14 Statement of Cash Flows

• State its primary purpose
• Discuss op, invest, and fin activities, and
  noncash.
• Analyze a company
• Prepare one using
• (a) the indirect method, or
• (b) the direct method.
• Explain the impact of the product life cycle on a
  company's cash flows. (WARNING NOT IN BOOK!)

2
The Primary Purpose of the Statement of Cash
Flows Is...

• To provide information about
• cash receipts,
• cash payments, and
• the net change in cash resulting from
• operating,
• investing, and
• financing activities of a company during a period.

3
Questions the Statement of Cash Flow Answers
Where did the cash come from?
What was the cash used for?
4
Operating Activities...

• Include
• The cash effects of transactions that create
  revenues and expenses and
• Enter into determination of net income.

5
Investing Activities...

• Include
• Purchasing and disposing of investments and
  productive long-lived assets using cash and
• Lending money and collecting the loans.

6
Financing Activities...

• Include
• Obtaining cash from issuing debt and repaying the
  amounts borrowed and
• Obtaining cash from stockholders and paying them
  dividends.

7
Types of Cash Flows -Operating Activities
Illustration 13-1

• Cash inflows
• From sale of goods or services
• From interest received and dividends received
• To receive cash on account
• Cash outflows
• To suppliers for inventory
• To pay down accounts payable
• To employees for services
• To government for taxes
• To lenders for interest
• To others for expenses

8
Types of Cash Flows -Investing Activities
Illustration 13-1

• Cash inflows
• From sale of property, plant, and equipment
• From sale of debt or equity securities of other
  entities
• From collection of principal on loans to other
  entities
• Cash outflows
• To purchase property, plant, and equipment
• To purchase debt or equity securities of other
  entities
• To make loans to other entities

9
Types of Cash Flows -Financing Activities
Illustration 13-1

• Cash inflows
• From issuance of equity securities (company's own
  stock)
• From issuance of debt (bonds and notes)
• Cash outflows
• To stockholders as dividends
• To redeem long-term debt or reacquire capital
  stock

10
Operating Activities - ALERT

• Some cash flows relating to investing or
  financing activities are classified as operating
  activities. For example...
• Receipts of investment revenue (interest and
  dividends) and
• Payments of interest to lenders
• Sale or Purchase of Trading Securities

11
Significant Noncash Activities...

• That do not affect cash are NOT reported in the
  body of the statement of cash flows.
• Are reported
• Separately--bottom of CF statement or
• Separately--note to the financial statements.

12
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.

13
Format of the Statement of Cash Flows

• Four parts (see page 629, Ryan Corp, or 649)
• operating
• investing
• financing
• noncash investing and financing activities

14
Why Report the Causes of Changes in Cash?
Because investors, creditors, and other
interested parties want to know what is happening
to a companys most liquid asset, CASH
15
Statement of Cash Flows Helps Users Evaluate

• 1. Future cash flows?
• 2. Pay Dividends and meet obligations?
• 3. Reasons for differences between net income and
  net cash provided (used) by operating activities
• 4. What happened in investing and financing?

16
Sources of Information for the Statement of Cash
Flows

• Comparative balance sheet
• Current income statement
• Additional information

17
Income Statement and Additional Information
Illustration 13-6

• 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.

18
Indirect and Direct Methods

• Convert net income from an accrual basis to a
  cash basis.
• This conversion may be done by two methods
• Indirect PREFERRED METHOD
• direct

19
LETS DO IT!

• Get your handout out NOW
• Computer Services
• Year ONE of business
• NOTE HANDOUT IS YEAR 2, THIS IS YEAR 1

20
Statement Of Cash Flows - Indirect Method

• Computer Services Company--year ended 2000
  Business Consulting Services
• FIRST YEAR OF BUSINESS!
• Computer Services Co. started 1/1/ 2000
• It issued 50,000 shares of 1 par value common
  stock for 50,000 cash.
• It rented its office space and furniture .

21
Illustration 13-4
Steps in Preparing Statement of
Cash Flows
34,000 - 0 34,000
22
COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31, 2000
Illustration 13-5
23
Income Statement and Additional Information
Illustration 13-6

• 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.

24
Illustration 13-4
Steps in Preparing Statement of
Cash Flows
25
Determine Net Cash Provided/Used By Operating
Activities

• Adjust net income for items that did not affect
  cash.
• Net 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.

26
Determine Net Cash Provided/Used By Operating
Activities

• Receivables, payables, prepayments, and
  inventories must be analyzed for their effects on
  cash.

27
Determine Net Cash Provided/Used By Operating
Activities

• Computer Services Company had revenues of 85,000
  in its first year of operations.
• However, CSC collected only 55,000 in cash.
  Accrual basis revenue was 85,000, cash basis
  revenue would be 55,000.
• The increase in accounts receivable of 30,000
  must be deducted from net income.
• (If accounts receivable decrease, the decrease
  must be added to net income).

28
Determine Net Cash Provided/Used By Operating
Activities (cont)

• Accounts payable - When accounts payable increase
  during a year, operating expenses are higher
  (accrual) than they are on a cash basis.
• For CSC, operating expenses reported in the
  income statement were 40,000.
• Since Accounts Payable increased 4,000, 36,000
  (40,000 4,000) of the expenses were paid in
  cash.
• So. . . . an increase in accounts payable must be
  added to net income, (a decrease subtracted).

29
Illustration 13-12

• 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

30
Illustration 13-4
Steps in Preparing Statement of
Cash Flows
31
Determine Net Cash Provided/Used By Investing
and Financing Activities

• No data are given for the increases in Equipment
  of 10,000 and Common Stock of 50,000. Assume
  any differences involve cash.
• The 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.
• The 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.

32
Determine Net Cash Provided/Used By Investing
and Financing Activities

• Reasons for the increase of 20,000 in the
  Retained Earnings.
• Net income increased retained earnings by
  35,000. REPORTED IN THE OPERATING ACTIVITIES
  SECTION.
• The additional information indicates that a cash
  dividend of 15,000 was declared and paid.
  REPORTED IN THE FINANCING ACTIVITIES SECTION.

33
Illustration 13-12

• 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

34
YEAR TWO
35
Illustration 13-13
Second-Year Operations
COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31
36
Illustration 13-13
Second-Year Operations
COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31
2001
2000
Change
37
Illustration 13-14
Second-Year Operations
COMPUTER SERVICES COMPANY Income Statement For
the Year Ended December 31, 2001

• 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

38
Illustration 13-14
Second-Year Operations

• 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.

39
Determine the Net Increase or Decrease in Cash

• Cash increased 22,000 (56,000-34,000)

40
Determine Net Cash Provided/Used By Operating
Activities

• Adjust net income for items that did not affect
  cash.

41
Determine Net Cash Provided/Used By Operating
Activities

• Depreciation expense - During 2001 Computer
  Services Company reported depreciation expense of
  15,000.
• Depreciation and other charges that do not
  require the use of cash, such as amortization of
  intangible assets are added to net income.

42
Illustration 13-16
Computer Services Company Statement of Cash
Flows (Partial)For the Year Ended December 31,
2001
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
INDIRECT METHOD
43
Determine Net Cash Provided/Used By Operating
Activities

• Loss 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).
• The loss reduced net income but did not reduce
  cash.
• The 3,000 loss is added to net income in
  determining net cash provided by operating
  activities.

44
Illustration 13-16
Computer Services Company Statement of Cash
Flows (Partial)For the Year Ended December 31,
2001
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
INDIRECT METHOD
45
Determine Net Cash Provided/Used By Operating
Activities

• Accounts 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.

46
Illustration 13-13
Second-Year Operations
COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31
47
Illustration 13-16
Computer Services Company Statement of Cash
Flows (Partial)For the Year Ended December 31,
2001
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
INDIRECT METHOD
48
Determine Net Cash Provided/Used By Operating
Activities

• Prepaid Expenses - Prepaid expenses increase
  during a period because cash paid for expenses is
  greater than expenses reported on an accrual
  basis.
• The increase of 4,000 in prepaid expenses must
  be deducted from net income.

49
Illustration 13-13
Second-Year Operations
COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31
50
Illustration 13-16
Computer Services Company Statement of Cash
Flows (Partial)For the Year Ended December 31,
2001
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)
INDIRECT METHOD
51
Determine Net Cash Provided/Used By Operating
Activities

• Accounts Payable - The increase of 55,000 in
  accounts payable must be added to net income.

52
Illustration 13-13
Second-Year Operations
COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31
2001
2000
Change
53
Illustration 13-16
Computer Services Company Statement of Cash
Flows (Partial)For the Year Ended December 31,
2001
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
INDIRECT METHOD
54
Illustration 13-4
Steps in Preparing Statement of
Cash Flows
55
Determine Net Cash Provided/Used By Operating
Activities

• Study the balance sheet to determine changes in
  noncurrent assets.
• Changes in each noncurrent account are analyzed
  using selected transaction data to determine the
  effect, if any, the changes had on cash.

56
Determine Net Cash Provided/Used By Investing
and Financing Activities

• Land - Land of 130,000 was purchased through the
  issuance of long-term bonds.
• Although 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.

57
Determine Net Cash Provided/Used By Investing
and Financing Activities

• Building - An office building was acquired using
  cash of 160,000.
• This transaction is a cash outflow reported in
  the investing activities section.

58
Determine Net Cash Provided/Used By Investing
and Financing Activities

• Equipment - The equipment account increased
  17,000.
• The additional information provided, reveals that
  this was a net increase resulting from two
  transactions
• (1) a purchase of equipment for 25,000
• (2) sale of equipment costing 8,000 for 4,000.
  
• The 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.

59
Determine Net Cash Provided/Used By Investing
and Financing Activities

• Bonds 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.

60
Determine Net Cash Provided/Used By Investing
and Financing Activities

• Retained Earnings - Retained Earnings increased
  by 124,000.
• The increase is a net of
• (1) Net income of 139,000 that increased
  Retained Earnings and
• (2) dividends of 15,000 that decreased Retained
  earnings.
• Net income is converted to net cash provided by
  operations.
• Payment of the dividend is a cash outflow that is
  reported as a financing activity.

61
Illustration 13-16
Computer Services Company Statement of Cash
Flows (Partial)For the Year Ended December 31,
2001
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
62
The Product Life Cycle

• A series of phases all products go through
• The phases are often referred to as the
• introductory phase
• growth phase
• maturity phase
• decline phase.
• The phase a company is in affects its cash flows.

63
Introductory Phase

• To support asset purchases the company may issue
  stock or debt. Expect
• cash from operations to be negative
• cash from investing to be
  negative.
• cash from financing to be
  positive.

64
Growth Phase

• The company is striving to expand its production
  and sales.
• Expect
• small amounts of cash to be generated from
  operations.
• cash from investing to be negative.
• cash from financing to be positive

65
Maturity Phase

• Sales and production level-off
• Expect
• cash from operations to exceed investing needs
• cash from investing to be
  neutral
• cash from financing to be
  negative

66
Decline Phase

• Sales and production decline
• Expect
• cash from operations to decline
• cash from investing to possibly become positive
• cash from financing to possibly become negative

67
Illustration 13-23
Major Classes of Cash Receipts and Payments --
Direct Method
68
How do you analyze it, though?
69
Free Cash Flow

• Cash from operations indicates the
  cash-generating capability of the company.
• But, fails to take into account that a company
  must invest in new fixed assets to and it must
  maintain dividends at current levels.

70
Free Cash Flow

• Cash Provided By Operations
• Capital Expenditures
• Dividends Paid
  
• Free Cash Flow
• (Note Cap. Expenditures
  -purchases
• sales)

71
Solvency (not in book!)

• Solvency is the ability of a firm to survive over
  the long term.
• The cash debt coverage ratio
• Cash Provided By Operations
• Average Total Liabilities
• This ratio measures a company's ability to repay
  its liabilities from cash generated from
  operations.

72
Cash Flow to Sales Ratio

• Turning sales into dollars for the firm.
• What does it mean if it is low?

73
Cash Flow to Sales Ratio

• Cash From Operations
• Net Sales

74
Cash Flow to Assets Ratio

• Indicates the company's ability to turn assets
  into dollars for the firm.

75
Cash Flow to Assets Ratio

• Cash From Operations
• Average total assets

76
Cash Flow Yield

• Indicates the relationship between cash flows
  from operations and net income.
• A low cash flow yield (less than 1.0) means a
  company may be growing inventory and receivables
  too fast.

77
Cash Flow Yield

• Cash From Operations
• Net Income

78
Illustration 13-46
Using Cash Flows to Evaluate a Company

• 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)

79

• Review and STOP HERE!

80

• 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

81
Capital Expenditure Ratio

• An indicator of a company's ability to generate
  sufficient cash to finance new fixed assets.
• Capital expenditures are purchases of fixed
  assets.

82

Capital Expenditure Ratio

Cash Provided by Operations Capital Expenditures
83

Assessing Liquidity, Solvency, and Profitability
Using Cash Flows

• Rather than using numbers from the income
  statement for assessment purposes, we use numbers
  from the statement of cash flows.

84


Cash-Based Measures

• Accrual-based measures allows too much management
  discretion.
• One disadvantage to the cash-based measures is no
  readily available published industry averages for
  comparison.

85
Liquidity

• Liquidity is the ability of a business to meet
  its immediate obligations.
• One measure of liquidity is the current ratio.
• A 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.)

86
Current Cash Debt Coverage Ratio

• A ratio that partially corrects this is the
  current cash debt coverage ratio.
• Cash provided by operations
• Average current liabilities
• Since 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.

87
Profitability

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

88
COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31, 2000
Illustration 13-5
89
Illustration 13-12

• 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)
  

90
Statement of Cash Flows Helps Answer the
Following Questions

• How did cash increase when there was a net loss
  for the period?
• How were the proceeds of the bond issue used?
• How was the expansion in the plant and equipment
  financed?
• Why were dividends not increased?
• How was the retirement of debt accomplished?
• How much money was borrowed during the year?
• Is cash flow greater or less than net income?

91
Comparative Balance Sheet

• Indicates the amount of changes in assets,
  liabilities, and stockholders' equities from the
  beginning to the end of the period.

92
Current Income Statement

• Information in this statement helps the reader
  determine the amount of cash provided or used by
  operations during the period.

93
Indirect and Direct Methods

• Both methods arrive at the same total amount for
  Net cash. provided by operating activities.
• The methods differ in disclosing the items that
  make up the total amount.
• The choice of methods affects only the operating
  activities section the investing and financing
  activities sections are the same.

94
Indirect Method

• The indirect method is used extensively in
  practice.
• Most companies favor the indirect method for the
  following reasons
• it is easier to prepare
• it focuses on the differences between net income
  and net cash flow from operating activities
• it tends to reveal less company information to
  competitors.

95
Direct Method

• The FASB prefers the direct method but allows the
  use of either method.
• When 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.

96
Illustration 13-7
Net Income Versus Net Cash Provided by Operating
Activities
Add Cash advances
Add prepaid expenses