Statement of Cash Flows

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Chapter 13 Statement of Cash Flows Walsh Acct 102
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Chapter 13 Statement of Cash Flows

• After studying Chapter 13, you should be able
  to
• Indicate the usefulness of the statement of cash
  flows.
• Distinguish among operating, investing, and
  financing activities.
• Explain the impact of the product life cycle on a
  company's cash flows.
• Prepare a statement of cash flows using one of
  two approaches
• (a) the indirect method, or
• (b) the direct method.
• Use the statement of cash flows to evaluate a
  company.

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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.

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Questions the Statement of Cash Flow Answers
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Operating Activities...

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

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Investing Activities...

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

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Financing Activities...

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

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Types of Cash Flows -Operating Activities

• Cash inflows
• From sale of goods or services
• From return on loans (interest received) and on
  equity securities (dividends received)
• Cash outflows
• To suppliers for inventory
• To employees for services
• To government for taxes
• To lenders for interest
• To others for expenses

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Types of Cash Flows -Investing Activities

• 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

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Types of Cash Flows -Financing Activities

• Cash inflows
• From sale 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

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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 are classified as
  operating activities because these items are
  reported in the income statement.

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Significant Noncash Activities...

• That do NOT affect cash are NOT reported in the
  body of the statement of cash flows.
• Are reported
• In a separate schedule at the bottom of the
  statement of cash flows or
• In a separate note or supplementary schedule to
  the financial statements.

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Significant Noncash Activities...

• 1. Issuance of common stock to obtain assets
  other than cash
• 2. Conversion of bonds into common stock.
• 3. Issuance of debt to purchase assets.
• 4. Exchanges of plant assets.

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Lets Review
Which is an example of a cash flow from an
operating activity?
a. Payment of cash to lenders for interest.
b. Receipt of cash from the sale of capital stock.
c. Payment of cash dividends to the companys
stockholders.
d. None of the above.
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Lets Review
Which is an example of a cash flow from an
operating activity?
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Format of the Statement of Cash Flows

• Three parts
• operating
• investing
• financing

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Format of the Statement of Cash Flows

• Three activities
• operating
• investing
• financing
• PLUS
• noncash investing and financing activities

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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.

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Introductory Phase

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

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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.

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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.

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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.

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Why Report the Causes of Changes in Cash?
Because investors, creditors, and other
interested parties want to now what is happening
to a companys most liquid asset CASH
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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.

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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?

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Sources of Information for the Statement of Cash
Flows

• Comparative balance sheet
• Current income statement
• Additional information

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Comparative Balance Sheet

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

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Intelmarket Comparative Balance Sheet
Balance Sheet
Increase 12/31/04 1/1/04
(Decrease) Assets Cash 25,000 -0- 25,000
Accounts Receivable 32,000 -0-
32,000 Inventory 29,000 -0-
29,000 Land 110,000 -0- 110,000 Total
196,000 -0- 196,000 Liabilities and
Equity Accounts Payable 24,000 -0-
24,000 Common Stock 147,000 -0-
147,000 Retained Earnings 25,000 -0-
25,000 Total 196,000 -0-
196,000
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Current Income Statement

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

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Indirect Method
Intelmarkets begins operations on 1.1.2004. The
income statement and balance sheet for year 2004
are as follows
Income Statement Revenues
200,000 Less Cost of goods sold (
110,000) Gross Margin 90,000 Less
Operating expenses ( 40,000) Net Income
before Tax 50,000 less Income Tax (
15,000) Net Income after Tax 35,000
Operating expenses do not contain any non-cash
charges
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3 Major Steps in Preparing the Statement of Cash
Flows
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Indirect and Direct Methods

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

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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.

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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.

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The Statement of Cash Flows Indirect Method
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Format of Indirect Method
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Indirect Method Example
Intelmarkets begins operations on 1.1.2004. The
income statement and balance sheet for year 2004
are as follows
Income Statement Revenues
200,000 Less Cost of goods sold (
110,000) Gross Margin 90,000 Less
Operating expenses ( 40,000) Net Income
before Tax 50,000 less Income Tax (
15,000) Net Income after Tax 35,000
Operating expenses do not contain any non-cash
charges
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IntelMarketsStatement of Cash FlowsFor the year
ended 12/31/04

• Cash Flows from Operating Activities
• Net Income
  35,000
• Adjustments to reconcile net income to
• cash provided by (or used ) by operations

Always start with Net Income Under Indirect Method
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Intelmarket Comparative Balance Sheet
Balance Sheet
Increase 12/31/04 1/1/04
(Decrease) Assets Cash 25,000 -0- 25,000
Accounts Receivable 32,000 -0-
32,000 Inventory 29,000 -0-
29,000 Land 110,000 -0- 110,000 Total
196,000 -0- 196,000 Liabilities and
Equity Accounts Payable 24,000 -0-
24,000 Common Stock 147,000 -0-
147,000 Retained Earnings 25,000 -0-
25,000 Total 196,000 -0-
196,000
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IntelMarketsStatement of Cash FlowsFor the year
ended 12/31/04

• Cash Flows from Operating Activities
• Net Income
  35,000
• Adjustments to reconcile net income to
• cash provided by (or used ) by operations
• Increase In A/R
  (32,000)

A/R increased by 32,000
Reduce net income by 32,000 to derive cash flows
from operations
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IntelMarketsStatement of Cash FlowsFor the year
ended 12/31/04

• Cash Flows from Operating Activities
• Net Income
  35,000
• Adjustments to reconcile net income to
• cash provided by (or used ) by operations
• Increase In A/R
  (32,000)
• Increase in Inventory (29,000)

When Inv purchased gtInv sold, CGS on accrual
basislt on cash basis Therefore reduce NI to
derive cash flows from operations
Greater cash outflow than reflected on I/S
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IntelMarketsStatement of Cash FlowsFor the year
ended 12/31/04

• Cash Flows from Operating Activities
• Net Income
  35,000
• Adjustments to reconcile net income to
• cash provided by (or used ) by operations
• Increase In A/R
  (32,000)
• Increase in Inventory (29,000)
• Increase in A/P
  24,000 (37,000)
• Net Cash Flows Used by operating activities
  (2,000)

If positive cash flow Net Cash Flow Provided by
Operating Activities
Increase in A/P Expense xxx
Accounts Payable xxx
Cash outflowlt Expense on I/S, Add back to NI
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IntelMarketsStatement of Cash FlowsFor the year
ended 12/31/04

• Cash Flows from Operating Activities
• Net Income
  35,000
• Adjustments to reconcile net income to
• cash provided by (or used ) by operations
• Increase In A/R
  (32,000)
• Increase in Inventory (29,000)
• Increase in A/P
  24,000 (37,000)
• Net Cash Flows Used by operating activities
  (2,000)

What happened?
Cash tied up in A/R Inventorycan cause Cash
Crunch !!
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Operating Section Indirect Method To convert to
Cash Basis from NI
Adjustments to NET INCOME to reconcile Income to
Cash provided (or used) by operations
DEDUCT Increase in Current Assets
ADD Decrease in Current Assets
ADD Increase in Current
Liabilities DEDUCT Decrease in
Current Liabilities ADD back non cash
charges, such as
depreciation amortization DEDUCT gains
ADD losses that resulted from investing
and financing activities

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Investing Activities Analyze Non-current assets
Balance Sheet
Increase 12/31/04 1/1/04
(Decrease) Assets Cash 25,000 -0- 25,000
Accounts Receivable 32,000 -0-
32,000 Inventory 29,000 -0-
29,000 Land 110,000 -0- 110,000 Total
196,000 -0- 196,000 Liabilities and
Equity Accounts Payable 24,000 -0-
24,000 Common Stock 147,000 -0-
147,000 Retained Earnings 25,000 -0-
25,000 Total 196,000 -0-
196,000
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IntelMarketsStatement of Cash FlowsFor the year
ended 12/31/04

• Cash Flows from Operating Activities
• Net Income
  35,000
• Adjustments to reconcile net income to
• cash provided by (or used ) by operations
• Increase In A/R
  (32,000)
• Increase in Inventory (29,000)
• Increase in A/P
  24,000 (37,000)
• Net Cash Flows Used by operating activities
  (2,000)
• Cash Flows From Investing Activities
• Purchase of Land (110,000)
• Net Cash Flows Used by Investing Activities
  (110,000)

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Financing Activities Analyze L/T Liabilities
Stockholders Equity

Balance Sheet
Increase 12/31/04 1/1/04
(Decrease) Assets Cash 25,000 -0- 25,000
Accounts Receivable 32,000 -0-
32,000 Inventory 29,000 -0-
29,000 Land 110,000 -0- 110,000 Total
196,000 -0- 196,000 Liabilities and
Equity Accounts Payable 24,000 -0-
24,000 Common Stock 147,000 -0-
147,000 Retained Earnings 25,000 -0-
25,000 Total 196,000 -0-
196,000
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Analyze Using T-accounts
Common Stock
Retained Earnings
35,000 Net income
10,000
147,000
25,000 Increase
Issuance of Common Stock
Cash Dividends
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IntelMarketsStatement of Cash FlowsFor the year
ended 12/31/04

• Cash Flows from Operating Activities
• Net Income
  35,000
• Adjustments to reconcile net income to
• cash provided by (or used ) by operations
• Increase In A/R
  (32,000)
• Increase in Inventory (29,000)
• Increase in A/P
  24,000 (37,000)
• Net Cash Flows Used by operating activities
  (2,000)
• Cash Flows From Investing Activities
• Purchase of Land (110,000)
• Net Cash Flows Used by Investing Activities
  (110,000)
• Cash Flows Provided by Financing Activities
• Proceeds from Issuance of C/S 147,000
• Payment of Cash Dividend
  (10,000)
• Net Cash Flows Provided by Financing Activities
  137,000

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IntelMarketsStatement of Cash FlowsFor the year
ended 12/31/04

• Cash Flows from Operating Activities
• Net Income
  35,000
• Adjustments to reconcile net income to
• cash provided by (or used ) by operations
• Increase In A/R
  (32,000)
• Increase in Inventory (29,000)
• Increase in A/P
  24,000 (37,000)
• Net Cash Flows Used by operating activities
  (2,000)
• Cash Flows From Investing Activities
• Purchase of Land (110,000)
• Net Cash Flows Used by Investing Activities
  (110,000)
• Cash Flows Provided by Financing Activities
• Issuance of common stock 147,000
• Payment of Cash Dividend (25,000)
• Net Cash Flows Provided by Financing Activities
  137,000
• Net Increase (Decrease) in Cash
  25,000
• Cash Balance _at_ Beginning of Period
  -0-
• Cash Balance _at_ End of Period
  25,000
• 
  

Agrees with Cash Balance on B/S
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Indirect Method Non-Cash Items included in Net
Income

• Non-Cash items must be eliminated from net
  income to compute CASH provided from operating
  activities
• Depreciation Expense is added to NI
• Loss on sale of assets is added to NI
• Gain on sale of assets is deducted from NI

Cash amt Included in Investing section
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Example of Noncash Item Depreciation

• Given 2004 2003
• Property, plant, and equipment 277,000
  247,000
• Accumulated depreciation (178,000)
  (167,000)
• Other information
• Depreciation expense 33,000
• Gain on sale of equipment 14,500
• During 2004, equipment costing 45,000 was sold
  for cash
• Present relevant T- accounts and cash flow
  information

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Analyze using T-Accounts
P, P E
Accumulated Depreciation
247,000
167,000
45,000 equip sold
22,000
75,000
33,000 Depreciation Expense
277,000
Acc Deprec. On equip. sold
178,0000
Purchases during period
Compute CASH inflow from sale of equipment
BV of equipment sold (45,000-22,000) 23,000
Gain on sale
14,500 CASH Inflow from sale
37,500
Operating
Investing
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XYZ CompanyStatement of Cash FlowsFor the year
ended 12/31/04

• Cash Flows from Operating Activities
• Net Income
  xxxx
• Adjustments to reconcile net income
• to cash provided from operations
• Depreciation Expense 33,000
• Gain on sale of plant asset (14,500)
• Cash Flows from Investing Activities
• Purchase of PP E (75,000)
• Proceeds from sale of asset 37,500

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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.

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Format of the Statement of Cash Flows Direct
Method
Cash flows from operating activities Cash
receipts (individually) Inflows XXX Cash
payments to suppliers (separately) outflows
( XXX) Net cash flow from operating
activities XXX
Cash flows from investing activities (List of
individual inflows and outflows) XX Net
cash flow from investing activities XXX
Cash flows from financing activities (List of
individual inflows and outflows) XX Net
cash flow from financing activities XXX
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Operating Section Direct Method
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Reporting Significant Non-Cash Transactions

• Transactions not involving cash inflows or cash
  outflows are non-cash transactions.
• They are not reported in the body of the cash
  flow statement.
• If material, they are reported as notes to the
  statement or in a supplementary schedule to the
  financial statements (_at_ bottom of cash flow
  statement).
• Example Issue of bonds (payable) for purchase of
  land.

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Free Cash Flow

• In the statement of cash flows, cash from
  operations is intended to indicate the
  cash-generating capability of the company.
• Statement 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.

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Free Cash Flow

• Cash Provided By Operations
• Capital Expenditures
• Dividends Paid
• Free Cash Flow

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Using Cash Flows to Evaluate a Company

• 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)

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• MICROSOFT CORPORATION
• STATEMENT OF CASH FLOWS (Partial)
• 2001
• Cash flows from operations 13,422
• Less Expenditures on property, plant,
• and equipment 1,103
• Dividends 0
• Free Cash Flow 12,319

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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.

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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 are available.

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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.)

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Current Cash Debt Coverage Ratio
Cash Debt Coverage Ratio
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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.

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Solvency

• Solvency is the ability of a firm to survive over
  the long term.
• One measure of solvency is the debt to total
  assets ratio.
• A measure of solvency that uses cash figures is
  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.

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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.