Chapter 6: Statement of Cash Flows

Transcription

1 Chapter 6: Statement of Cash Flows Outline: Why a cash flow statement? Classifications of cash flows Preparation of cash flow statements Determining the change in cash Determining net cash from operating activities methods Sidestep: net income vs. net cash from operating activities Determining net cash from investing and financing activities 1

2 Purpose of cash flow statement Objective of a business enterprise: profit Corporations maximize profitability, RoE Essential constraint: solvency all liabilities can be paid out of liquid assets at due date otherwise Management loses control over assets Profitability Liquidity In the long-run you cannot maintain solvency without profitability and vice versa! 2

3 Profitability vs. liquidity the W. T. Grant Bankruptcy in 1975 Millions of Dollars Year at that time, largest bankruptcy filing in the U.S. (credit) sales increased steadily; profits were generated first cash shortages emerged in 1969 Income Cash Flow from Operations filing of bankruptcy on October 2,

4 Substantial content information on sources and uses of cash during the accounting period independent of accounting discretion, more objective than income statement important to forecast the entity s ability to generate future cash flows, the entity s ability to pay dividends and meet obligations, important to understand the reasons for the difference between net income and net cash flow from operating activities, and the cash and noncash investing and financing transactions during the period 4

5 Cash flow statements according to IAS 7 If a firm sets up financial statements according to IFRS it is required to prepare a Cash flow statement This holds for all types of firms, industries and sizes Detailed rules are specified in IAS 7 Cash flow includes changes in cash and cash equivalents Operating cash flow, cash flow from investment activities, and financing activities need to be presented separately To determine the cash flow from operating activities one of two methods is to be applied: Direct method Indirect method For cash flows from financing and investment always direct method 5

6 Classification of Cash Flows Cash flows are the results of either Operating activities principal revenue-producing activities of the entity, and all other non-investing or non-financing activities Investing activities acquisition and disposal of long-term assets and other investments not included in cash equivalents Financing activities transactions that lead to changes in size and composition of the entity s equity capital and liabilities interest and dividend payments or receipts can be either considered a result from operating, investing or financing activities 6

7 Graphical model of cash flows Investing Activities Operating Activities Cash Financing Activities 7 Investments Disinvestments Cash expediture for factor input Cash receipts from revenues Capital repaid Capital raised Range of Cash Flow Statement for a period

8 Preparation of cash flow statements Sources of information: comparative balance sheet changes in assets, liabilities, and equities over a period current income statement operating profit selected transaction data additional information of cash provisions and uses during the period (e.g. dividends, share repurchases,...) Three steps from the data to statement of cash flow: 1. Determine change in cash 2. Determine net cash flow from operating activities 3. Determine net cash flows from investing and financing activities 8

9 Two methods to analyze and report cash from operating activities Direct method discloses major classes of gross cash receipts and gross cash payments directly derived directly from the cash account a respective account is not usually present in the accounting system easily implementable with EDP-based accounting Indirect method adjusting net income eliminate noncash revenues and expenses adjust for any deferrals or accruals of past or future operating cash receipts or payments adjust for items of income or expense associated with investing or financing cash flows 9

10 Example We use the following data to go through the preparation process: Dream Grades, Inc. Comparative Balance Sheet Change Assets Dec. 31, 2001 Jan. 1, 2001 Increase / (Decrease) Cash Accounts receivable Prepaid insurance Total Liabilities and stockholder's equity Accounts payable Long-term liability Unearned revenue Common stock ( 10 par) Retained earnings Total

11 Example cont d Dream Grades, Inc. Income Statement For the year ended December 31, 2001 Revenues Operating expenses Income before taxes Income tax expense (35%) Net income Additional information The company obtained in cash through a bank loan; repayment of the loan is due in ten installment payments of and the first of them was due during the year. Cash dividends in a total amount of were paid during the year. 11

12 Example cont d Step 1 Determine the Change in Cash The balance in the cash account increased from zero to ; thus, we record a change in cash for 2001 that was an increase of Step 2 Determine Net Cash Flow from Operating Activities accrual accounting net income cash basis accounting net cash flow from operating activities 12

13 Example cont. direct method Cash collected from revenues Cash payment for expenses Income before income taxes Cash payments for income taxes Net cash used by operating activities Cash collected from revenues: Cash payment for expenses: Note: The issue of deferred taxes is neglected here. For example, prepaid expenses and unearned revenues would cause a difference between taxable income and financial income. See chapter

14 Indirect method, adjustments Additions: Depreciation expense Amortization of intangibles and deferred charges Loss on sale plant assets Loss on writedown of assets Decrease in receivables Decrease in prepaid expense Increase in accounts payable Increase in accrued liabilities Net income Deductions: Gain on sale of plant assets Increase in receivables Increase in inventories Increase in prepaid expense Decrease in accounts payable Decrease in accrued liabilities Source: adapted from Kieso/Weygandt/Warfield, p.1325 Net cash flow from operating activities 14

15 Example cont. indirect method Net income Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable Increase in accounts payable Increase in prepayments Increase in unearned revenue Net cash used by operating activities Step 3 Determine net cash flows from investing and financing activities long-term loan of (net effect at year-end) dividend payment of issuance of common stock for cash,

16 Cash flow statement for the year 2001 Dream Grades, Inc. Statement of Cash Flows For the Year Ended December 31, 2001 Cash Flows from Operating Activities Net Income Adjustments to reconcile net income to net cash used by operating activities Increase in Account Receivable Increase in Prepaid Insurance Increase in Unearned Revenue Increase in Accounts Payable Net cash flows used by operating activities Cash Flows from Financing Activities Issuance of common stock Long-term borrowing Payment of cash dividend Net Cash Flows provided by Financing Activities Net Increase (Decrease) in Cash Cash, January 1, Cash, December 31,

17 Example cont d, next year Dream Grades, Inc. We continue with the example: Comparative Balance Sheet Change Assets Dec. 31, 2002 Jan. 1, 2002 Increase / (Decrease) Cash Accounts receivable Prepaid insurance Land Building Accumulated depreciation - building Equipment Accumulated depreciation - equipment Total Liabilities and stockholder's equity Accounts payable Long-term liability Unearned revenue Common stock ( 10 par) Retained earnings Total

18 Dream Grades, Inc. Income Statement For the year ended December 31, 2002 Revenues Operating expenses Income before taxes Income tax expense (35%) Net income Additional information 1 a cash dividend of was paid during the year. 2 the second installment payment on the long-term loan was made. Step 1 Determine change in cash 3 land, building, and equipment were acquired for cash. As indicated in the comparative balance sheet, cash increased during the year. 18

19 Indirect Method Step 2 Determine net cash from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Decrease in accounts receivable Increase in accounts payable Decrease in prepayments Decrease in unearned revenue Depreciation expense Net cash provided by operating activities

20 Step 3 Determine net cash flows from investing and financing activities repayment on loan, dividend payment of purchase of land, building, and equipment,

21 Dream Grades, Inc. Statement of Cash Flows For the Year Ended December 31, 2002 Cash Flows from Operating Activities Net Income Adjustments to reconcile net income to net cash provided by operating activities Depreciation Expense Decrease in Prepaid Insurance Decrease in Account Receivable Decrease in Unearned Revenue Increase in Accounts Payable Net cash flows provided by operating activities Cash Flows from Investing Activities Purchase of land Purchase of building Purchase of equipment Net cash flows used by investing activities Cash Flows from Financing Activities Installment Payment on Long-Term Loan Payment of cash dividend Net cash flows used by financing activities Net Increase (Decrease) in Cash Cash, January 1, Cash, December 31,

22 Dream Grades, Inc. Income Statement For the year ended December 31, 2002 Revenues Operating expenses Income before taxes Income tax expense (35%) Net income Additional information 1 a cash dividend of was paid during the year. 2 the second installment payment on the long-term loan was made. Step 1 Determine change in cash 3 land, building, and equipment were acquired for cash. As indicated in the comparative balance sheet, cash increased during the year. 22

23 Indirect Method Step 2 Determine net cash from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Decrease in accounts receivable Increase in accounts payable Decrease in prepayments Decrease in unearned revenue Depreciation expense Net cash provided by operating activities

24 Step 3 Determine net cash flows from investing and financing activities repayment on loan, dividend payment of purchase of land, building, and equipment,

25 Dream Grades, Inc. Statement of Cash Flows For the Year Ended December 31, 2002 Cash Flows from Operating Activities Net Income Adjustments to reconcile net income to net cash provided by operating activities Depreciation Expense Decrease in Prepaid Insurance Decrease in Account Receivable Decrease in Unearned Revenue Increase in Accounts Payable Net cash flows provided by operating activities Cash Flows from Investing Activities Purchase of land Purchase of building Purchase of equipment Net cash flows used by investing activities Cash Flows from Financing Activities Installment Payment on Long-Term Loan Payment of cash dividend Net cash flows used by financing activities Net Increase (Decrease) in Cash Cash, January 1, Cash, December 31,