THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a

THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a

firm’s cash flows from operating, investment, and financing activities. The statement of cash flows for Fictitious is shown in Exhibit 6.5.

The firm’s statement of cash flows lists separately its operating cash flows, investing cash flows, and financing cash flows. By analyzing these individual flows, current and potential owners and creditors can exam- ine such aspects of the business as:

■ The source of financing for business operations, whether through internally generated funds or external sources of funds. ■ The ability of the company to meet debt obligations (interest and prin- cipal payments). ■ The ability of the company to finance expansion through operating cash flow. ■ The ability of the company to pay dividends to shareholders. ■ The flexibility the business has in financing its operations.

A firm that generates cash flows only by selling off its assets (obtaining cash flows from investments) or by issuing more securities (obtaining cash

Financial Statements

flows from financing) cannot keep that up for very long. For future pros- perity the firm must be able to generate cash flows from its operations.

Cash Flows from Operating Activities The cash flow from operating activities is the most complex of the three.

Ideally, we could obtain it directly, by summing all cash receipts (inflows) and disbursements (outflows) for the periods covered by the statement. However, in spite of its usefulness, this sum is, in practice, burdensome to prepare. Instead, the cash flow from operations is generally obtained indi- rectly. Using the indirect method, we begin with net income as reported on the income statement and adjust it for each change in current assets and current liabilities and each noncash operating item; what remains is the cash flow from (used for) operations, as shown in Exhibit 6.5.

EXHIBIT 6.5 Fictitious Company Statement of Cash Flows, Years Ended December

31, in Thousands 2003

Cash flow from (used for) operating activities Net income

$1,200 $1,000 Add or deduct adjustments to cash basis: Change in accounts receivables

$200 $(200) Change in accounts payable

100 400 Change in marketable securities

(200) 200 Change in inventories

(800) (600) Change in other current liabilities

300 Depreciation

800 Cash flow from operations

$1,800 $1,800 Cash flow from (used for) investing activities

Purchase of plant and equipment $(1,000) $0 Cash flow from (used for) investing activities

$(1,000) $0 Cash flow from (used for) financing activities

Sale of common stock $1,000 $0 Repayment of long-term debt

(1,000) (1,500) Payment of preferred dividends

(100) (100) Payment of common dividends

(500) (400) Cash flow from (used for) financing activities

(600) (1,900) Increase (decrease) in cash flow

$200 $(100) Cash at the beginning of the year

200 300 Cash at the end of the year

FOUNDATIONS

EXHIBIT 6.6 Adjustment of Net Income for Changes in Working Capital Accounts

to Arrive at Cash Flow from Operations Change in Working Capital Account

Adjustment to Net Income

An increase in a current asset account Deduct the change A decrease in a current asset account

Add the change An increase in a current liability account Add the change A decrease in a current liability account

Deduct the change The basic adjustments to net income for changes in current assets

and current liabilities are summarized in Exhibit 6.6. Income is adjusted for noncash revenues and expenses, such as depreciation, by adding them because they have been deducted in the computation for net income but do not require cash to be paid out.

We adjust net income for changes in current assets and liabilities because those changes represent the difference between accrual account- ing and cash accounting. For example, an increase in the inventories account is the result of an investment of cash to generate sales in the near future. Exhibit 6.1 shows that Fictitious Corporation invested $800,000 in inventories during 2003 ($1 million in 2002 versus $1.8 million in 2003). Since that investment was an operating cash flow, we must sub- tract it from net income. As another example, Exhibit 6.1 shows that accounts receivable decreased by $200,000. That decrease in a current asset represents a flow of cash to the firm—the return of cash invested in accounts receivable. So the $200,000 must be added to net income to obtain cash flow. These adjustments are shown in the “Cash flow from operating activities” section of Exhibit 6.5, along with the other adjust- ments required to obtain Fictitious Corporation’s operating activities.