LU4:

Statement of Cash Flows

Joan and Joe: A Tale of Woe
Joe added up profits and went to see Joan,
Assured of obtaining a much-needed loan.
When Joe arrived, he announced with good
cheer:
My firm has had an outstanding year,
And now I need a loan from your bank.
Eyeing the statements, Joans heart sank.
Your profits are fine, Joan said to Joe.
But where, oh where, is your companys cash
flow?
Im sorry to say: the answer is no.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-1
4-1
--L. Fraser
Statement of Cash Flows
It is possible for a company to post a
healthy net income but not have
cash needed to pay its employees,
suppliers, and bankers.
Positive net income on the income
statement is ultimately
insignificant unless a company can
translate its earnings into cash.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-2
4-2
Statement of Cash Flows
Provides information about cash
inflows and outflows during an
accounting period
Extremely important as an analytical
tool
Only source in financial statement
data for learning about the
generation of cash from operations
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-3
4-3
Preparing a Statement of
Cash Flows
Begins with a return to the balance
sheet
Requires a reordering of the
information presented on a
balance sheet
Shows changes over time rather
than the absolute dollar amount of
the accounts at a point in time
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-4
4-4
Preparing a Statement of
Cash Flows
Prepared by
calculating changes in all of the balance
sheet accounts, including cash
listing the changes in all of the accounts
except cash as inflows or outflows
categorizing the flows by operating,
financing, or investing activities
The inflows less the outflows balance
to and explain the change in cash.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-5
4-5
Four Parts of a Statement
of Cash Flows
Cash
Operating activities
Investing activities
Financing activities

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-6

4-6
Four Parts of a Statement
of Cash Flows
Cash
Cash and highly liquid short-term
marketable securities
Also called cash equivalents
If a company separates marketable
securities into two accounts (cash and
cash equivalents and short-term
investments), the short-term
investments are classified as investing
activities.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-7
4-7
Four Parts of a Statement
of Cash Flows
Operating activities
Delivering or producing goods for
sale and providing services
Cash effects of transactions and
other events

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-8

4-8
Four Parts of a Statement
of Cash Flows
Investing activities
Acquiring and selling or otherwise
disposing of securities that are
not cash equivalents
productive assets that are expected to
benefit the firm for long periods of time
Lending money and collecting on
loans

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-9

4-9
Four Parts of a Statement
of Cash Flows
Financing activities
Borrowing from creditors and
repaying the principal
Obtaining resources from owners
and providing them with a return
on the investment

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-10

4-10
Preparing a Statement of
Cash Flows
First Step:
Look at changes in balance sheet
accounts from the beginning to
the end of an accounting period.
Next Step:
Transfer the account changes to the
appropriate area of a statement
of cash flows.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-11
4-11
Preparing a Statement of
Cash Flows

Inflow Outflow
- Asset account + Asset account
+ Liability - Liability account
account
+ Equity account - Equity account

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-12

4-12
Preparing a Statement of
Cash Flows
Operating activities inflows
Revenue from sales of goods
Revenue from services
Returns on equity securities
(dividends)
Returns on interest-earning assets
(interest)
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-13
4-13
Preparing a Statement of
Cash Flows
Operating activities outflows
Payments for purchases of inventory
Payments for operating expenses
(salaries, rent, etc.)
Payments for purchases from suppliers,
other than inventory
Payments to lenders (interest)
Payments for taxes

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-14

4-14
Preparing a Statement of
Cash Flows
Investing activities inflows
Revenue from sales of long-lived
assets
Returns from loans (principal) to
others
Revenue from sales of debt or equity
securities of other entities (except
securities traded as cash equivalents)
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-15
4-15
Preparing a Statement of
Cash Flows
Investing activities outflows
Acquisitions of long-lived assets
Loans (principal) to others
Purchase of debt or equity
securities of other entities

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-16

4-16
Preparing a Statement of
Cash Flows
Financing activities inflows
Proceeds from borrowing
Proceeds from issuing the firms own
equity securities
Financing activities outflows
Repayments of debt principal
Repurchase of a firms own shares
Payments of dividends

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-17

4-17
Calculating Cash Flow
from Operating Activities
Operating activities represent cash
generated internally.
Investing and financing activities
provide cash from external sources.
Firms may use one of two methods to
calculate cash flow:
Direct Method
Indirect Method

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-18

4-18
Calculating Cash Flow
from Operating Activities
Direct and indirect methods yield
identical figures for net cash flow
from operating activities, because
the underlying accounting
concepts are the same.
594 firms out of 600 used the
indirect method in 2007 according
to Accounting Trends and
Techniques.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-19
4-19
Direct Method
Shows
cash collections from customers
interest and dividends collected
other operating cash receipts
cash paid to suppliers and employees
interest paid
taxes paid
other operating cash payments
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-20
4-20
Indirect Method
Starts with net income and adjusts for
deferrals
accruals
noncash items, such as
depreciation and amortization
nonoperating items, such as gains
and losses on asset sales

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-21

4-21
Net Cash Flow from
Operating Activities
Indirect Method
Depreciation and amortization are added
to net income.
Increase in deferred tax liability is added.
Decrease in deferred tax liability is
deducted.
Increase in deferred tax asset is deducted.
Decrease in deferred tax asset is added.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-22

4-22
Net Cash Flow from
Operating Activities
Indirect Method
Increase in investment account from
equity income is deducted.
Decrease in investment account
from equity income is added.
Gain on sale of assets is deducted.
Loss on sale of assets is added.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-23

4-23
Net Cash Flow from
Operating Activities
Indirect Method
Increase in accounts receivable is
deducted.
Decrease in accounts receivable is
added.
Increase in inventory is deducted.
Decrease in inventory is added.
Increase in prepaid expenses is
deducted.
Decrease in prepaid expenses is added.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-24
4-24
Net Cash Flow from
Operating Activities
Indirect Method
Increase in interest receivable is
deducted.
Decrease in interest receivable is
added.
Increase in accounts payable is added.
Decrease in accounts payable is
deducted.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-25

4-25
Net Cash Flow from
Operating Activities
Indirect Method
Increase in accrued liabilities is
added.
Decrease in accrued liabilities is
deducted.
Increase in deferred revenue is added.
Decrease in deferred revenue is
deducted.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-26

4-26
Analyzing the Statement of
Cash Flows
The statement of cash flows is an
important analytical tool for
creditors, investors, and other
users of financial statement data.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-27

4-27
Analyzing the Statement of
Cash Flows
Statement of cash flows helps to
determine a firms
ability to generate cash flows in the future
capacity to meet cash obligations
future external financing needs
success in productively managing
investing activities
effectiveness in implementing financing
and investing strategies

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-28

4-28
Cash Flow from
Operations
It is possible for a firm to be highly
profitable and
not be able to pay dividends
not be able to invest in new
equipment
not be able to service debt
go bankrupt

How? The problem is cash.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-29
4-29
Cash Flow from Operations
Ongoing operation depends upon its
success in generating cash from
operations.
Firms need cash to satisfy creditors and
investors.
Temporary shortfalls of cash can be
satisfied by borrowing or other means,
but ultimately a firm must generate
cash.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-30
4-30
Nocash Corporation
The Nocash Corporation had sales of
$100,000 in its second year of
operations, up from $50,000 in
the first year.
Expenses, including taxes,
amounted to $70,000 in year 2,
compared with $40,000 in year 1.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-31

4-31
Nocash Corporation
Nocash Corporation Income Statement
for Year 1 and Year 2
Year 1 Year 2
Sales $50,000 $100,000
Expenses 40,000 70,000
Net income $10,000 $30,000

The comparative income statements for the

two years indicate substantial growth.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-32
4-32
Nocash Corporation
Other relevant facts that do not appear on
income statement. Nocash
eased credit policies in year 2, attracting
customers of lower quality.
purchased a new line of inventory near the end
of year 1 and had to sell it below cost.
had problems with accounts receivable causing
suppliers to refuse the sale of goods on credit.
The effect of these factors can be found on
Nocashs balance sheet.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-33
4-33
Nocash Corporation
Balance Sheet at
December 31 Year 1 Year 2 $Chang
e
Cash $2,000 $2,000 0
Accounts Receivable 10,000 30,000 +20,00
0
Inventories 10,000 25,000 +15,00
0
Total Assets $22,00 $57,00 +35,00
0 0 0
Accounts payable 7,000 2,000 -5,000
NotesCopyright
payable to 0 10,000 +10,00
2010 Pearson Education, Inc. Publishing as Prentice Hall 4-34
4-34
 Nocash Corporation
If Nocashs net income is recalculated on a cash
basis, the following adjustments would be made:

Net income $30,000

Accounts (20,000)
receivable
Inventories (15,000)
Accounts payable (5,000)
Cash Income ($10,00
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-35
4-35

0)
Nocash Corporation
Increase in accounts receivable is
subtracted, because more sales
revenue was recognized in computing
net income than was collected in cash.
Increase in inventory is deducted,
reflecting the cash outflow for
inventory purchases in excess of the
expense recognized through cost of
goods sold.
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-36
4-36
Nocash Corporation
Decrease in accounts payable is
deducted, because the cash payments
to suppliers in year 2 were greater
than the amount of expense recorded.
Appearance of a $10,000 note payable
indicates that borrowing has enable
Nocash to operate, but unless it can
generate cash, its problems will
compound.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-37

4-37
Analysis of the Statement
of Cash Flows
Should, at a minimum, cover the
following areas:
Cash flow from operating
activities
Cash inflows
Cash outflows

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-38

4-38
Analysis of the Statement of
Cash Flows Analyst
Concerns
Success or failure of the firm in
generating cash from operations
Underlying causes of the positive or
negative operating cash flow
Magnitude of positive or negative
operating cash flow
Fluctuations in cash flow from
operations over time
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-39
4-39
Summary Analysis of the
Statement of Cash Flows
Summary Table
Provides an approach to analyzing a
statement of cash flows that can be
used for any firm that provides
comparative cash flow data
Underlines the importance of internal
cash generation and the implications
for investing and financing activities
when this does and does not occur
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-40
4-40
Summary Analysis of the
Statement of Cash Flows
Summary Table
A way to common size the cash
flow statement
Shows the cash inflows as a
percentage of total inflows
Shows the cash outflows as a
percentage of total outflows

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-41

4-41
Analysis of Cash Inflows
Generating cash from operations is
the preferred method for obtaining
excess cash to finance
capital expenditures and
expansion
repayment of debt
payment of dividends

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-42

4-42
Analysis of Cash Outflows
When analyzing the cash outflows, the
analyst should consider
the necessity of the outflow
how the outflow was financed

Generally, it is best to finance

short-term assets with short-term debt
long-term assets with long-term debt
or issuance of stock
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-43
4-43
Analysis of Cash Outflows
Repayment of debt is a necessary
outflow.
Notes reveal future debt repayments
and are useful in assessing how
much cash will be needed in
upcoming years to repay
outstanding debt.

Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall 4-44

4-44