Directory UMM :wiley:Public:college:accounting:kimmel:
Financial Accounting:
Tools for Business Decision Making
Kimmel, Weygandt, Kieso
S
EL
Chapter
13
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Chapter 13
Statement of Cash Flows
After studying Chapter 13, you should be
able to:
Indicate the primary purpose 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.
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.
4
Questions the Statement of
Cash Flow Answers
5
Operating Activities
Include:
The cash effects of transactions that
create revenues and expenses and
Enter into determination of net income.
Involve Income Statement Items
6
Investing Activities
Include:
Purchasing and disposing of
investments and productive long-lived
assets using cash and
Lending money and collecting the loans.
Involve Investments and LongTerm Asset Items
7
Financing Activities
Include:
Obtaining cash from issuing debt and
repaying the amounts borrowed and
Obtaining cash from stockholders and
paying them dividends.
Involve Long-Term Liability and
Stockholders Equity
8
Types of Cash Flows Operating Activities
Page 580 in Book
Cash inflows:
From sale of goods or services
From returns 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
9
Types of Cash Flows Investing Activities
Page 580 in Book
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
10
Types of Cash Flows Financing Activities
Page 580 in Book
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
11
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.
12
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.
13
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.
14
Format of the
Statement of Cash Flows
Four parts:
operating
investing
financing
noncash investing and financing activities
15
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,
and decline phase.
The phase a company is in affects its cash
flows.
16
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, and cash from
financing to be positive.
17
Introductory Phase
Occurs when the company is purchasing
fixed assets and beginning to produce
and sell
Expect the company to be spending
considerable amounts to purchase
productive assets, but not to be
generating much cash from operations.
18
Growth Phase
The company is striving to expand its
production and sales.
Expect to see the company start to generate
small amounts of cash from operations.
Cash from operations continues to be less
than net income during this phase because
inventory must be purchased for future
projected sales.
19
Growth Phase
Because sales are projected to be increasing,
the size of inventory purchases must increase.
However, less inventory will be expensed on an
accrual basis than purchased on a cash basis
in the growth phase.
Cash collections on accounts receivable will
lag behind sales, and because sales are
growing, accrual sales during a period will
exceed cash collections during that period.
20
Growth Phase
Cash needed for asset acquisitions
continues to exceed cash provided by
operations, requiring that the company
make up the deficiency by issuing new
stock or debt.
The company continues to show
negative cash from investing and
positive cash from financing.
21
Maturity Phase
Sales and production level off
Cash from operations and net income are
approximately the same.
Cash generated from
operations exceeds investing
needs.
The company can actually
start to retire debt or buy
back stock.
22
Decline Phase
Sales of the product fall due to a
weakening consumer demand.
Cash from operations decreases.
Cash from investing might become
positive as the firm sells off excess
assets, and cash from financing
may be negative as the company
buys back stock and retires debt.
23
Page 582 in book
Impact of Product Life Cycle on Cash Flows
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
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 cash investing and financing transactions
during the period
26
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?
27
Sources of Information for the
Statement of Cash Flows
Comparative balance sheet
Current income statement
Additional information
28
Comparative Balance Sheet
Information in this statement
indicates the amount of the changes
in assets, liabilities, and
stockholders' equities from the
beginning to the end of the period.
29
Page 587 in book
Comparative Balance Sheet
The comparative balance sheet for the beginning and end of 1997,
showing increases or decreases appears as follows:
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31
Assets
Cash
Accounts receivable
Equipment
Total
Liabilities and
stockholders’ equity
Accounts payable
Common stock
Retained earnings
Total
Dec. 31, 1997 J an. 1, 1997
$34,000
$0
30,000
0
10,000
0
$74,000
$0
$4,000
50,000
20,000
$74,000
$0
0
0
$0
Change
Increase/Decrease
$34,000 increase
30,000 increase
10,000 increase
$4,000 increase
50,000 increase
20,000 increase
Current Income Statement
Information in this
statement helps the reader
determine the amount of
cash provided or used by
operations during the
period.
31
Additional Information
Additional information
includes transaction data
that are needed to
determine how cash was
provided or used during
the period.
32
Page 588 in book
Income Statement and
Additional Information
COMPUTER SERVICES COMPANY
Income Statement
For the Year Ended December 31, 1997
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 1997. No
depreciation was taken in 1997.
Page 585 in book
Steps in Preparing
Statement of Cash Flows
Page 587 in book
Comparative Balance Sheet
The comparative balance sheet for the beginning and end of 1997,
showing increases or decreases appears as follows:
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31
Assets
Cash
Accounts receivable
Equipment
Total
Liabilities and
stockholders’ equity
Accounts payable
Common stock
Retained earnings
Total
Dec. 31, 1997 J an. 1, 1997
$34,000
$0
30,000
0
10,000
0
$74,000
$0
$4,000
50,000
20,000
$74,000
$0
0
0
$0
Change
Increase/Decrease
$34,000 increase
30,000 increase
10,000 increase
$4,000 increase
50,000 increase
20,000 increase
Page 585 in book
Steps in Preparing
Statement of Cash Flows
Indirect and Direct Methods
In order to determine the cash
provided/used by operating activities,
net income must be converted from
an accrual basis to a cash basis.
This conversion may be done by
either of two methods:
indirect
direct
37
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.
38
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, and
it tends to reveal less company information
39
to competitors.
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.
40
Statement Of Cash Flows Indirect Method
The transactions of Computer Services
Company for the years 1997 and 1998 are used
to illustrate the preparation of a statement of
cash flows .
Computer services Company started in
January 1, 1997, when it issued 50,000 shares of
$1 par value common stock for $50,000 cash.
The company rented its office space and
furniture and performed consulting services
throughout the first year.
41
Step 2 - Indirect Method
Determine net cash provided or used by
operating activities by adjusting 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.
42
Page 589 in book
Net Income Versus Net Cash
Provided by Operating
Activities
Step 2 - Indirect Method
Receivables, payables, prepayments, and
inventories must be analyzed for their effects
on cash.
Accounts receivable - When accounts
receivable increase during the year, revenues
on an accrual basis are higher than revenues
on a cash basis.
Although operations of the period led to
revenues, not all of these revenues resulted in
an increase in cash.
44
Step 2 - Indirect Method
Computer Services Company had revenues
of $85,000 in its first year of operations.
However, CSC collected only $55,000 in cash.
Although accrual basis revenue was $85,000,
cash basis revenue would be only $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.
45
Step 2 - Indirect Method
Accounts payable - When accounts payable increase
during a year, operating expenses on an accrual basis
are higher than they are on a cash basis.
For Computer Services Company, operating expenses
reported in the income statement were $40,000.
However, since Accounts Payable increased $4,000
only, $36,000 ($40,000 – $4,000) of the expenses were
paid in cash.
To convert net income to net cash provided by
operating activities, an increase in accounts payable
must be added to net income.
46
Step 2 - Indirect Method
Conversely, a decrease in accounts payable
would have to be subtracted from net income.
For Computer Services Company, the changes
in accounts receivable and accounts payable
were the only changes in current assets and
current liability accounts.
Any other revenues or expenses reported in the
income statement were received or paid in cash,
and no adjustment of net income is necessary.
47
Step 2 - Indirect Method
The operating activities section of the statement of
cash flows would appear as follows:
COMPUTER SERVICES COMPANY
Partial Statement of Cash Flows--Indirect Method
For the Year Ended December 31, 1997
Cash 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
Page 587 in book
Comparative Balance Sheet
The comparative balance sheet for the beginning and end
of 1997, showing increases or decreases appears as follows:
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31
Assets
Cash
Accounts receivable
Equipment
Total
Liabilities and
stockholders’ equity
Accounts payable
Common stock
Retained earnings
Total
Dec. 31, 1997 J an. 1, 1997
$34,000
$0
30,000
0
10,000
0
$74,000
$0
$4,000
50,000
20,000
$74,000
$0
0
0
$0
Change
Increase/Decrease
$34,000 increase
30,000 increase
10,000 increase
$4,000 increase
50,000 increase
20,000 increase
Page 588 in book
Income Statement and
Additional Information
COMPUTER SERVICES COMPANY
Income Statement
For the Year Ended December 31, 1997
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 1997.
No depreciation was taken in 1997.
Step 3 - Indirect Method
Study the balance sheet to determine changes
in noncurrent assets.
Changes in each noncurrent account are then
analyzed using selected transaction data to
determine the effect, if any, the changes had on
cash.
Computer Service Company's three
noncurrent accounts are Equipment, Common
Stock, and Retained Earnings, all three of
which had increases during the year.51
Step 3 - Indirect Method
No data are given for the increases in Equipment of
$10,000 and Common Stock of $50,000. When other
explanations are lacking, assume any differences involve
cash.
The increase in equipment is assumed to be 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 is assumed to result from
the issuance of common stock for $50,000 cash. It is
reported as an inflow of cash in the financing activities
52
section of the statement of cash flows.
Step 3 - Indirect Method
The reasons for the increase of $20,000 in the
Retained Earnings account are determined by
analysis.
First, net income increased retained earnings by
$35,000.
Second, the additional information indicates that a
cash dividend of $15,000 was declared and paid.
The $35,000 increase due to net income is reported
in the operating activities section. The cash dividend
paid is reported in the financing activities section.
53
Step 3 - Indirect Method
The $20,000 increase in Retained Earnings
in 1997 is a net change.
Having completed the three steps, we can
prepare the statement of cash flows by the
indirect method.
The statement starts with the operating
activities section, followed by the investing
activities section, and then the financing
section.
54
Page 591 in book
COMPUTER SERVICES COMPANY
Partial Statement of Cash Flows--Indirect Method
For the Year Ended December 31, 1997
Cash 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
Page 592 in book
Second-Year Operations
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31
Assets
Cash
Accounts receivable
Prepaid Expenses
Land
Building
Accumulated
depreciation-building
Equipment
Accumulated
depreciation-equipment
Total
1998
$56,000
20,000
4,000
130,000
160,000
1997
$34,000
30,000
0
0
0
Change
Increase/Decrease
$22,000 increase
10,000 decrease
4,000 increase
130000 increase
160,000 increase
(11,000)
27,000
0
10,000
11,000 increase
17,000 increase
(3,000)
$383,000
0
$74,000
3,000 increase
56
Page 592 in book
Second-Year Operations
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31
1998
Liabilities and
Stockholders’ equity
Accounts payable
$59,000
Bonds payable
130,000
Common stock
50,000
Retained earnings
144,000
Total
$383,000
1997
$4,000
0
50,000
20,000
$74,000
Chang
e
$55,000 increase
130,000 increase
0
124,000 increase
57
Page 592 in book
Second-Year Operations
COMPUTER SERVICES COMPANY
Income Statement
For the Year Ended December 31, 1998
Revenues
$507,000
Operating expenses
$261,000
Depreciation expenses
Loss on sale of equipment
279,000
15,000
3,000
Income from operations
Income tax expense
Net income
228,000
89,000
$139,000
58
Page 592 in book
Second-Year Operations
Additional Information:
(a) In 1998 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 1998 the company sold equipment with a
book value of $7,000 (cost $8,000 less accumulated
depreciation $1,000) for $4,000 cash.
59
Step 1
-
Indirect Method
Determine the net
increase or decrease in
cash.
Cash increased
$22,000 ($56,000$34,000).
60
Page 592 in book
Second-Year Operations
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31
Assets
Cash
Accounts receivable
Prepaid Expenses
Land
Building
Accumulated
depreciation-building
Equipment
Accumulated
depreciation-equipment
Total
1998
$56,000
20,000
4,000
130,000
160,000
1997
$34,000
30,000
0
0
0
Change
Increase/Decrease
$22,000 increase
10,000 decrease
4,000 increase
130000 increase
160,000 increase
(11,000)
27,000
0
10,000
11,000 increase
17,000 increase
(3,000)
$383,000
0
$74,000
3,000 increase
61
Step 2
-
Indirect Method
Determine net cash provided or
used by operating activities under
the indirect method by adjusting
net income for items that did not
affect cash.
62
Step 2
-
Indirect Method
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.
63
Step 2
-
Indirect Method
Prepaid Expenses - Prepaid expenses
increase during a period because cash
paid for expenses is greater than
expenses reported on an accrual basis.
To convert net income to net cash
provided by operating activities, the
increase of $4,000 in prepaid expenses
must be deducted from net income
64
Step 2
-
Indirect Method
Accounts Payable - Like the increase
in 1997, the 1998 increase of $55,000 in
accounts payable must be added to net
income to convert to net cash provided
by operating activities.
65
Step 2
-
Indirect Method
Depreciation expense - During 1998 Computer
Services Company reported depreciation
expense of $15,000.
An analysis of the accumulated depreciation
accounts reveals that $11,000 related to the
building and $4,000 related to the equipment.
Depreciation and other charges that do not
require the use of cash, such as amortization of
intangible assets are added to net income.
66
Step 2
-
Indirect Method
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.
As a result of the previous adjustments, net cash
67
provided by operating activities is $218,000.
Computer Services Company
Partial Statement of Cash Flows
For the Year Ended December 31, 1998
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
Page 585 in book
Steps in Preparing
Statement of Cash Flows
Step 3
-
Indirect Method
After determining the net cash
provided by operating activities, the
remaining changes in balance sheet
accounts must be analyzed in order to
determine net cash provided/used by
investing and financing activities.
70
Step 3
-
Indirect Method
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.
71
Step 3
-
Indirect Method
Building - An office
building was acquired
using cash of
$160,000.
This transaction is a
cash outflow reported
in the investing
activities section.
72
Step 3
-
Indirect Method
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.
73
Step 3
-
Indirect Method
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.
74
Step 3
-
Indirect Method
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.
75
Man, Oh
Man!
Does This
Seem
Confusing!
Major Classes of Cash Receipts
and Payments - Direct Method
Page 600 in book
Page 612 in book
Using Cash Flows
to Evaluate a Company
The 1995 statement of cash flows of Microsoft
Corporation provides information for the computations of
these measures.
MICROSOFT CORPORATION
PARTIAL STATEMENT OF CASH FLOWS
1995
Cash flows from operations
$1,990
Additions to property, plant,
and equipment
$495
Other assets
230
Short-term investments
651
Total cash flows from investing (1,376)
Cash flows from financing
(138)
Free Cash Flow
In the statement of cash flows, cash from
operations is intended to indicate the cashgenerating capability of the company.
Cash from operations fails to take into
account that a company must invest in new
fixed assets just to maintain its current level
of operations and it must at least maintain
dividends at current levels to satisfy
investors.
79
Free Cash Flow
Cash Provided By Operations
–
–
Capital Expenditures
Dividends Paid
Free Cash Flow
80
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.
81
Capital Expenditure Ratio =
Cash Provided by Operations
Capital Expenditures
82
Assessing Liquidity, Solvency, and
Profitability Using Cash Flows
Previous chapters have presented ratios used to
analyze a company's liquidity, solvency, and
profitability using accrual-based numbers from
the income statement and balance sheet.
This chapter introduce ratios that are cash-based
rather than accrual-based.
Rather than using numbers from the income
statement, these ratios use numbers from the
statement of cash flows.
83
Cash-Based Measures
Many analysts are critical of
accrual-based numbers because they
feel that the adjustment process
allows too much management
discretion.
One disadvantage to the cash-based
measures is that, unlike the more
commonly employed accrual-based
measures, there are no readily
available published industry
averages for comparison.
84
Liquidity
Liquidity is the ability of a business to meet its
immediate obligations.
Earlier, we learned that 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, which may not be
representative of a company's position during
most of the year.
85
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.
86
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.
87
Profitability
Profitability refers to a company's ability
to generate a reasonable return.
Earlier chapters introduced accrualbased ratios that measure profitability,
such as gross profit rate, profit rate
margin, and return on assets.
A cash-based measure of performance is
the cash return on sales ratio.
88
Cash Return on Sales Ratio
The cash return on sales ratio indicates the
company's ability to turn sales into dollars
for the firm.
A 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.
89
Cash Return on Sales Ratio
Cash From Operations
Net Sales
=
90
COP Y R I GHT
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for errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.
91
Tools for Business Decision Making
Kimmel, Weygandt, Kieso
S
EL
Chapter
13
`
Chapter 13
Statement of Cash Flows
After studying Chapter 13, you should be
able to:
Indicate the primary purpose 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.
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.
4
Questions the Statement of
Cash Flow Answers
5
Operating Activities
Include:
The cash effects of transactions that
create revenues and expenses and
Enter into determination of net income.
Involve Income Statement Items
6
Investing Activities
Include:
Purchasing and disposing of
investments and productive long-lived
assets using cash and
Lending money and collecting the loans.
Involve Investments and LongTerm Asset Items
7
Financing Activities
Include:
Obtaining cash from issuing debt and
repaying the amounts borrowed and
Obtaining cash from stockholders and
paying them dividends.
Involve Long-Term Liability and
Stockholders Equity
8
Types of Cash Flows Operating Activities
Page 580 in Book
Cash inflows:
From sale of goods or services
From returns 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
9
Types of Cash Flows Investing Activities
Page 580 in Book
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
10
Types of Cash Flows Financing Activities
Page 580 in Book
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
11
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.
12
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.
13
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.
14
Format of the
Statement of Cash Flows
Four parts:
operating
investing
financing
noncash investing and financing activities
15
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,
and decline phase.
The phase a company is in affects its cash
flows.
16
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, and cash from
financing to be positive.
17
Introductory Phase
Occurs when the company is purchasing
fixed assets and beginning to produce
and sell
Expect the company to be spending
considerable amounts to purchase
productive assets, but not to be
generating much cash from operations.
18
Growth Phase
The company is striving to expand its
production and sales.
Expect to see the company start to generate
small amounts of cash from operations.
Cash from operations continues to be less
than net income during this phase because
inventory must be purchased for future
projected sales.
19
Growth Phase
Because sales are projected to be increasing,
the size of inventory purchases must increase.
However, less inventory will be expensed on an
accrual basis than purchased on a cash basis
in the growth phase.
Cash collections on accounts receivable will
lag behind sales, and because sales are
growing, accrual sales during a period will
exceed cash collections during that period.
20
Growth Phase
Cash needed for asset acquisitions
continues to exceed cash provided by
operations, requiring that the company
make up the deficiency by issuing new
stock or debt.
The company continues to show
negative cash from investing and
positive cash from financing.
21
Maturity Phase
Sales and production level off
Cash from operations and net income are
approximately the same.
Cash generated from
operations exceeds investing
needs.
The company can actually
start to retire debt or buy
back stock.
22
Decline Phase
Sales of the product fall due to a
weakening consumer demand.
Cash from operations decreases.
Cash from investing might become
positive as the firm sells off excess
assets, and cash from financing
may be negative as the company
buys back stock and retires debt.
23
Page 582 in book
Impact of Product Life Cycle on Cash Flows
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
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 cash investing and financing transactions
during the period
26
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?
27
Sources of Information for the
Statement of Cash Flows
Comparative balance sheet
Current income statement
Additional information
28
Comparative Balance Sheet
Information in this statement
indicates the amount of the changes
in assets, liabilities, and
stockholders' equities from the
beginning to the end of the period.
29
Page 587 in book
Comparative Balance Sheet
The comparative balance sheet for the beginning and end of 1997,
showing increases or decreases appears as follows:
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31
Assets
Cash
Accounts receivable
Equipment
Total
Liabilities and
stockholders’ equity
Accounts payable
Common stock
Retained earnings
Total
Dec. 31, 1997 J an. 1, 1997
$34,000
$0
30,000
0
10,000
0
$74,000
$0
$4,000
50,000
20,000
$74,000
$0
0
0
$0
Change
Increase/Decrease
$34,000 increase
30,000 increase
10,000 increase
$4,000 increase
50,000 increase
20,000 increase
Current Income Statement
Information in this
statement helps the reader
determine the amount of
cash provided or used by
operations during the
period.
31
Additional Information
Additional information
includes transaction data
that are needed to
determine how cash was
provided or used during
the period.
32
Page 588 in book
Income Statement and
Additional Information
COMPUTER SERVICES COMPANY
Income Statement
For the Year Ended December 31, 1997
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 1997. No
depreciation was taken in 1997.
Page 585 in book
Steps in Preparing
Statement of Cash Flows
Page 587 in book
Comparative Balance Sheet
The comparative balance sheet for the beginning and end of 1997,
showing increases or decreases appears as follows:
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31
Assets
Cash
Accounts receivable
Equipment
Total
Liabilities and
stockholders’ equity
Accounts payable
Common stock
Retained earnings
Total
Dec. 31, 1997 J an. 1, 1997
$34,000
$0
30,000
0
10,000
0
$74,000
$0
$4,000
50,000
20,000
$74,000
$0
0
0
$0
Change
Increase/Decrease
$34,000 increase
30,000 increase
10,000 increase
$4,000 increase
50,000 increase
20,000 increase
Page 585 in book
Steps in Preparing
Statement of Cash Flows
Indirect and Direct Methods
In order to determine the cash
provided/used by operating activities,
net income must be converted from
an accrual basis to a cash basis.
This conversion may be done by
either of two methods:
indirect
direct
37
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.
38
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, and
it tends to reveal less company information
39
to competitors.
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.
40
Statement Of Cash Flows Indirect Method
The transactions of Computer Services
Company for the years 1997 and 1998 are used
to illustrate the preparation of a statement of
cash flows .
Computer services Company started in
January 1, 1997, when it issued 50,000 shares of
$1 par value common stock for $50,000 cash.
The company rented its office space and
furniture and performed consulting services
throughout the first year.
41
Step 2 - Indirect Method
Determine net cash provided or used by
operating activities by adjusting 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.
42
Page 589 in book
Net Income Versus Net Cash
Provided by Operating
Activities
Step 2 - Indirect Method
Receivables, payables, prepayments, and
inventories must be analyzed for their effects
on cash.
Accounts receivable - When accounts
receivable increase during the year, revenues
on an accrual basis are higher than revenues
on a cash basis.
Although operations of the period led to
revenues, not all of these revenues resulted in
an increase in cash.
44
Step 2 - Indirect Method
Computer Services Company had revenues
of $85,000 in its first year of operations.
However, CSC collected only $55,000 in cash.
Although accrual basis revenue was $85,000,
cash basis revenue would be only $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.
45
Step 2 - Indirect Method
Accounts payable - When accounts payable increase
during a year, operating expenses on an accrual basis
are higher than they are on a cash basis.
For Computer Services Company, operating expenses
reported in the income statement were $40,000.
However, since Accounts Payable increased $4,000
only, $36,000 ($40,000 – $4,000) of the expenses were
paid in cash.
To convert net income to net cash provided by
operating activities, an increase in accounts payable
must be added to net income.
46
Step 2 - Indirect Method
Conversely, a decrease in accounts payable
would have to be subtracted from net income.
For Computer Services Company, the changes
in accounts receivable and accounts payable
were the only changes in current assets and
current liability accounts.
Any other revenues or expenses reported in the
income statement were received or paid in cash,
and no adjustment of net income is necessary.
47
Step 2 - Indirect Method
The operating activities section of the statement of
cash flows would appear as follows:
COMPUTER SERVICES COMPANY
Partial Statement of Cash Flows--Indirect Method
For the Year Ended December 31, 1997
Cash 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
Page 587 in book
Comparative Balance Sheet
The comparative balance sheet for the beginning and end
of 1997, showing increases or decreases appears as follows:
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31
Assets
Cash
Accounts receivable
Equipment
Total
Liabilities and
stockholders’ equity
Accounts payable
Common stock
Retained earnings
Total
Dec. 31, 1997 J an. 1, 1997
$34,000
$0
30,000
0
10,000
0
$74,000
$0
$4,000
50,000
20,000
$74,000
$0
0
0
$0
Change
Increase/Decrease
$34,000 increase
30,000 increase
10,000 increase
$4,000 increase
50,000 increase
20,000 increase
Page 588 in book
Income Statement and
Additional Information
COMPUTER SERVICES COMPANY
Income Statement
For the Year Ended December 31, 1997
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 1997.
No depreciation was taken in 1997.
Step 3 - Indirect Method
Study the balance sheet to determine changes
in noncurrent assets.
Changes in each noncurrent account are then
analyzed using selected transaction data to
determine the effect, if any, the changes had on
cash.
Computer Service Company's three
noncurrent accounts are Equipment, Common
Stock, and Retained Earnings, all three of
which had increases during the year.51
Step 3 - Indirect Method
No data are given for the increases in Equipment of
$10,000 and Common Stock of $50,000. When other
explanations are lacking, assume any differences involve
cash.
The increase in equipment is assumed to be 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 is assumed to result from
the issuance of common stock for $50,000 cash. It is
reported as an inflow of cash in the financing activities
52
section of the statement of cash flows.
Step 3 - Indirect Method
The reasons for the increase of $20,000 in the
Retained Earnings account are determined by
analysis.
First, net income increased retained earnings by
$35,000.
Second, the additional information indicates that a
cash dividend of $15,000 was declared and paid.
The $35,000 increase due to net income is reported
in the operating activities section. The cash dividend
paid is reported in the financing activities section.
53
Step 3 - Indirect Method
The $20,000 increase in Retained Earnings
in 1997 is a net change.
Having completed the three steps, we can
prepare the statement of cash flows by the
indirect method.
The statement starts with the operating
activities section, followed by the investing
activities section, and then the financing
section.
54
Page 591 in book
COMPUTER SERVICES COMPANY
Partial Statement of Cash Flows--Indirect Method
For the Year Ended December 31, 1997
Cash 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
Page 592 in book
Second-Year Operations
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31
Assets
Cash
Accounts receivable
Prepaid Expenses
Land
Building
Accumulated
depreciation-building
Equipment
Accumulated
depreciation-equipment
Total
1998
$56,000
20,000
4,000
130,000
160,000
1997
$34,000
30,000
0
0
0
Change
Increase/Decrease
$22,000 increase
10,000 decrease
4,000 increase
130000 increase
160,000 increase
(11,000)
27,000
0
10,000
11,000 increase
17,000 increase
(3,000)
$383,000
0
$74,000
3,000 increase
56
Page 592 in book
Second-Year Operations
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31
1998
Liabilities and
Stockholders’ equity
Accounts payable
$59,000
Bonds payable
130,000
Common stock
50,000
Retained earnings
144,000
Total
$383,000
1997
$4,000
0
50,000
20,000
$74,000
Chang
e
$55,000 increase
130,000 increase
0
124,000 increase
57
Page 592 in book
Second-Year Operations
COMPUTER SERVICES COMPANY
Income Statement
For the Year Ended December 31, 1998
Revenues
$507,000
Operating expenses
$261,000
Depreciation expenses
Loss on sale of equipment
279,000
15,000
3,000
Income from operations
Income tax expense
Net income
228,000
89,000
$139,000
58
Page 592 in book
Second-Year Operations
Additional Information:
(a) In 1998 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 1998 the company sold equipment with a
book value of $7,000 (cost $8,000 less accumulated
depreciation $1,000) for $4,000 cash.
59
Step 1
-
Indirect Method
Determine the net
increase or decrease in
cash.
Cash increased
$22,000 ($56,000$34,000).
60
Page 592 in book
Second-Year Operations
COMPUTER SERVICES COMPANY
Comparative Balance Sheet
December 31
Assets
Cash
Accounts receivable
Prepaid Expenses
Land
Building
Accumulated
depreciation-building
Equipment
Accumulated
depreciation-equipment
Total
1998
$56,000
20,000
4,000
130,000
160,000
1997
$34,000
30,000
0
0
0
Change
Increase/Decrease
$22,000 increase
10,000 decrease
4,000 increase
130000 increase
160,000 increase
(11,000)
27,000
0
10,000
11,000 increase
17,000 increase
(3,000)
$383,000
0
$74,000
3,000 increase
61
Step 2
-
Indirect Method
Determine net cash provided or
used by operating activities under
the indirect method by adjusting
net income for items that did not
affect cash.
62
Step 2
-
Indirect Method
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.
63
Step 2
-
Indirect Method
Prepaid Expenses - Prepaid expenses
increase during a period because cash
paid for expenses is greater than
expenses reported on an accrual basis.
To convert net income to net cash
provided by operating activities, the
increase of $4,000 in prepaid expenses
must be deducted from net income
64
Step 2
-
Indirect Method
Accounts Payable - Like the increase
in 1997, the 1998 increase of $55,000 in
accounts payable must be added to net
income to convert to net cash provided
by operating activities.
65
Step 2
-
Indirect Method
Depreciation expense - During 1998 Computer
Services Company reported depreciation
expense of $15,000.
An analysis of the accumulated depreciation
accounts reveals that $11,000 related to the
building and $4,000 related to the equipment.
Depreciation and other charges that do not
require the use of cash, such as amortization of
intangible assets are added to net income.
66
Step 2
-
Indirect Method
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.
As a result of the previous adjustments, net cash
67
provided by operating activities is $218,000.
Computer Services Company
Partial Statement of Cash Flows
For the Year Ended December 31, 1998
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
Page 585 in book
Steps in Preparing
Statement of Cash Flows
Step 3
-
Indirect Method
After determining the net cash
provided by operating activities, the
remaining changes in balance sheet
accounts must be analyzed in order to
determine net cash provided/used by
investing and financing activities.
70
Step 3
-
Indirect Method
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.
71
Step 3
-
Indirect Method
Building - An office
building was acquired
using cash of
$160,000.
This transaction is a
cash outflow reported
in the investing
activities section.
72
Step 3
-
Indirect Method
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.
73
Step 3
-
Indirect Method
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.
74
Step 3
-
Indirect Method
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.
75
Man, Oh
Man!
Does This
Seem
Confusing!
Major Classes of Cash Receipts
and Payments - Direct Method
Page 600 in book
Page 612 in book
Using Cash Flows
to Evaluate a Company
The 1995 statement of cash flows of Microsoft
Corporation provides information for the computations of
these measures.
MICROSOFT CORPORATION
PARTIAL STATEMENT OF CASH FLOWS
1995
Cash flows from operations
$1,990
Additions to property, plant,
and equipment
$495
Other assets
230
Short-term investments
651
Total cash flows from investing (1,376)
Cash flows from financing
(138)
Free Cash Flow
In the statement of cash flows, cash from
operations is intended to indicate the cashgenerating capability of the company.
Cash from operations fails to take into
account that a company must invest in new
fixed assets just to maintain its current level
of operations and it must at least maintain
dividends at current levels to satisfy
investors.
79
Free Cash Flow
Cash Provided By Operations
–
–
Capital Expenditures
Dividends Paid
Free Cash Flow
80
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.
81
Capital Expenditure Ratio =
Cash Provided by Operations
Capital Expenditures
82
Assessing Liquidity, Solvency, and
Profitability Using Cash Flows
Previous chapters have presented ratios used to
analyze a company's liquidity, solvency, and
profitability using accrual-based numbers from
the income statement and balance sheet.
This chapter introduce ratios that are cash-based
rather than accrual-based.
Rather than using numbers from the income
statement, these ratios use numbers from the
statement of cash flows.
83
Cash-Based Measures
Many analysts are critical of
accrual-based numbers because they
feel that the adjustment process
allows too much management
discretion.
One disadvantage to the cash-based
measures is that, unlike the more
commonly employed accrual-based
measures, there are no readily
available published industry
averages for comparison.
84
Liquidity
Liquidity is the ability of a business to meet its
immediate obligations.
Earlier, we learned that 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, which may not be
representative of a company's position during
most of the year.
85
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.
86
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.
87
Profitability
Profitability refers to a company's ability
to generate a reasonable return.
Earlier chapters introduced accrualbased ratios that measure profitability,
such as gross profit rate, profit rate
margin, and return on assets.
A cash-based measure of performance is
the cash return on sales ratio.
88
Cash Return on Sales Ratio
The cash return on sales ratio indicates the
company's ability to turn sales into dollars
for the firm.
A 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.
89
Cash Return on Sales Ratio
Cash From Operations
Net Sales
=
90
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