4/10/2012. Statement of Cash Flows. Learning Objectives (LO) LO 1 - Purpose of Cash Flow Statement. Learning Objectives (LO)

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1 Statement of Flows CHAPTER Learning Objectives (LO) After studying this chapter, you should be able to 1. Identify the purposes of the statement of cash flows 2. Classify activities affecting cash as operating, investing, or financing activities 3. Compute and interpret cash flows from financing activities 4. Compute and interpret cash flows from investing activities. Use the direct method to calculate cash flows from operations 2of 33 Learning Objectives (LO) After studying this chapter, you should be able to 6. Use the indirect method to explain the difference between net income and net cash provided by (used for) operating activities 7. Understand why we add depreciation to net income when using the indirect method for computing cash flow from operating activities 8. Show how the balance sheet equation provides a conceptual framework for the statement of cash flows 9. Identify free cash flow, and interpret information in statements of cash flow The concept underlying the statement Same as statements of income and retained earnings Explains change in an account (cash) from the beginning to the end of the reporting period What is cash Money in bank accounts and on hand equivalents (maturity less than 9 days and easily and quickly convertible into cash Money market funds Treasury bills Very low probability of change in value 3of 33 4of 33 Helps predict future cash flows Evaluates how management generates and uses cash Determines a company s ability to pay interest, dividends, and debts when they are due Identifies specific increases and decreases in a firm s productive assets of 33 6of 33 1

2 LO 2 - Flow Activities What information may users find/derive from the statement? Past Why net income differs from cash flows Identifies specific increases and decreases in a firm s productive assets Evaluates how management generated/used cash Present - determines a company s ability to pay interest, dividends, and debts when they are due Future helps predict future cash flows 7of 33 8of 33 LO 3 - Financing Flows LO 3 - Financing Flows From two successive balance sheets, observe: Short/long term debt (related to borrowing) Capital stock accounts Treasury Stock (Chapter 1) From this year s retained earning statement, observe: Dividends Declared From two successive balance sheets, observe Dividends Payable Increased Decreased <dividends declared >dividends declared Sometimes some changes are related to noncash events such as purchasing a building by issuing new stock to the seller. In those cases the noncash amount would be reported in a separate schedule if the buying company felt it was significant. 9of 33 1 of 33 LO 4 - Investing Flows LO 4 - Investing Flows From two successive balance sheets, observe: Intangible Assets Long-term Investments Loans to others From two successive balance sheets, observe: Plant, Property, Equipment Depreciation complicates this Balance Sheet Income Statement Equipment Accumulated Depreciation Loss on sale of Depreciation Expense Equipment Your firm bought $11 of equipment, paying cash. How much cash was received from the sale of equipment? (Figures are taken from last and this years financial statements. 11 of of 33 2

3 LO 4 - Investing Flows From two successive balance sheets, observe: Plant, Property, Equipment Balance Sheet Equipment Accumulated Depreciation Depreciation complicates this Income Statement Depreciation Expense 1 Loss on sale of Equipment Your firm bought $11 of equipment, paying cash. How much cash was received from the sale of equipment? (Figures are taken from last and this years financial statements.) LO - Operating Flows Operating cash flows All cash flows other than investing and financing flows with the normal operations of the business 13 of of 33 LO - Operating Flows LO - Operating Flows Operating cash flows can precede an income statement event Buy supplies before using them Receive cash before earning it An income statement event can precede a cash flow Sell goods on credit with collection next month Consume utilities before paying for them /income statement event occur simultaneously sale to customer Pay for advertising used this reporting period Operating Flows Two methods Direct method Operating cash inflows less operating cash outflows = operating cash flows Preferred method because it is easily understood If use this method, must also show indirect method Indirect Explains why net income is different from net operating cash flows Do not have to show the direct method Most commonly used method 1 of of 33 LO - Operating Flows - Direct LO - Operating Flows - Direct If have access to all cash flow information, just select and list operating cash flows Payments for inventory $(86,) (next page) Collections from customers $1,. Payments for interest $(1,) Tax refund $2, Etc. Operating Flow $64, Access only to statements other than cash flow Balance Sheet () Inventory 9.2 Accounts Payable 2.2 Income Statement () Cost of Goods Sold 1 Payments for inventory $(86,) 17 of of 33 3

4 LO - Operating Flows - Direct Access only to statements other than cash flow 134 Balance Sheet () Inventory Accounts Payable Income Statement () Cost of Goods Sold 1 Payments for inventory $(134,) Background Many do not understand accrual accounting produces information different than cash accounting When the cash flow statement was being considered by the FASB, concern arose that operating cash flow presented by direct method might confuse some who believed that amount should match net income. The FASB would prefer the operating section be prepared using the direct method. If it is, it must be accompanied by another statement explaining why net income is different than operating cash flows. 19 of 33 2 of 33 Indirect method of preparing the operating section of the statement of cash flows Start End Critical steps in deriving operating cash flow from net income Assume all items found in net income were related to operating activities and in the form of cash flows If analysis shows some are not cash or operating flows, remove them from net income What should be left is an adjusted net income figure that represents only cash and operating cash flows Then examine changes in most current balance sheet accounts (assets and liabilities) to see if they suggest further adjustments are needed. 21 of of 33 Depreciation Expense (See Learning Objective 7) Was deducted in net income Is not a cash item and applies to investing activities To remove it from net income, add it back Accounts Receivable By assuming net income is all in cash, all revenue ($16,) is assumed to be in cash Accounts Receivables increased from $ to $1, this year, meaning $1, of this year s revenue ($16,) was not collected in cash by year-end Increase in Receivables (1,) 23 of of 33 4

5 Inventory (see slide 18) Beginning + Bought Sold = Ending? 1, 9,2 Bought $19,2 Net income includes only $1, deduction Deduct an additional $9,2 Increase in Receivables (1,) Increase in Inventory (9,2) Accounts Payable (see slide 18) Beginning + Charged Paid off = Ending 19,2? 2,2 Paid off $134, Net income includes $1, + adjustment t $9,2 Add back $2,2 Increase in Receivables (1,) Increase in Inventory (9,2) Increase in Accounts Payable 2,2 2 of of 33 Accounts Payable continued Deducted in net income for cost of goods sold) (1,) Subtracted from net income due to inventory increase (9,2) Added back to net income because accounts payable increased 2,2 paid for inventory $134, Prepaid Rent Beginning + Bought Used = Ending? 2, 4, Bought $6, (no payable so all in cash) Net income includes only $2, deduction Deduct an additional $4, Increase in Receivables (1,) Increase in Inventory (9,2) Increase in Accounts Payable 2,2 Increase in Prepaid Rent (4,) Net cash used for operations $13, 27 of of 33 Summary of the process Start with net income Remove noncash and nonoperating items such as depreciation Further adjust net income by the changes that occurred in most current asset/liability accounts by Adding decreases in operating assets Deducting increases in operating assets Adding increases in operating liabilities Deducting decreases in operating liabilities LO 7 Adjustments to Net Income (NI) Noncash and Nonoperating items Assumption is NI is all in cash and operating NI includes many noncash and nonoperating items (discussed in later chapters) Loss on inventory Bad debts expense Gain on sale of equipment Contingent losses Premiums and discounts related to interest expense on long-term debt If it was subtracted in NI, remove it by adding it back If it was added in NI, remove it by subtracting it 29 of 33 3 of 33

6 LO 8 Balance Sheet Equation and Statement of Flows Assets + Noncash Assets = Liabilities + Owners Equity Begin 1 1, = + 6 Change 3 4 = End = ,1717 = 117 Change in = Change in all other accounts Assets = Liabilities + Owners Equity Assets Noncash Begin 1 = + 6 1, Change 3 = End 13 = = 13 LO 9 Free Flow (Net) Operating flows Less capital expenditures Less dividends sometimes Free Flow Includes operating outflows Essential nonoperating cash outflows Negative - must go outside of company to finance capital expenditures If for growth ok If for essential capital expenditures - bad Positive - own operations can finance growth and essential capital expenditures - good 31 of of 33 LO 9 Interpreting Flow Information Income statement Uses accrual accounting to measure overall economic performance and change in owners equity Matches revenues and expenses flow statement Identifies sources and uses of one asset, cash, for Investing activities Financing activities Operating activities (if using the direct method) 33 of 33 6

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