Chapter 6: Statement of Cash Flows

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

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

Profitability vs. liquidity the W. T. Grant Bankruptcy in 1975 Millions of Dollars 60 40 20 0-20 -40-60 1 2 3 4 5 6 7 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, 1975 3

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

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

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

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

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

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

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 75.000 0 75.000 Accounts receivable 65.000 0 65.000 Prepaid insurance 10.000 0 10.000 Total 150.000 0 150.000 Liabilities and stockholder's equity Accounts payable 14.000 0 14.000 Long-term liability 81.000 0 81.000 Unearned revenue 10.000 0 10.000 Common stock ( 10 par) 20.000 0 20.000 Retained earnings 25.000 0 25.000 Total 150.000 0 150.000 10

Example cont d Dream Grades, Inc. Income Statement For the year ended December 31, 2001 Revenues 145.000 Operating expenses 85.000 Income before taxes 60.000 Income tax expense (35%) 21.000 Net income 39.000 Additional information The company obtained 90.000 in cash through a bank loan; repayment of the loan is due in ten installment payments of 9.000 and the first of them was due during the year. Cash dividends in a total amount of 14.000 were paid during the year. 11

Example cont d Step 1 Determine the Change in Cash The balance in the cash account increased from zero to 75.000; thus, we record a change in cash for 2001 that was an increase of 75.000. Step 2 Determine Net Cash Flow from Operating Activities accrual accounting net income cash basis accounting net cash flow from operating activities 12

Example cont. direct method Cash collected from revenues 90.000 Cash payment for expenses 81.000 Income before income taxes 9.000 Cash payments for income taxes 21.000 Net cash used by operating activities - 12.000 Cash collected from revenues: 145.000 65.000 + 10.000 Cash payment for expenses: 85.000 14.000 + 10.000 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 17. 13

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

Example cont. indirect method Net income 39.000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable - 65.000 Increase in accounts payable 14.000 Increase in prepayments -10.000 Increase in unearned revenue 10.000-51.000 Net cash used by operating activities - 12.000 Step 3 Determine net cash flows from investing and financing activities long-term loan of 81.000 (net effect at year-end) dividend payment of 14.000 issuance of common stock for cash, 20.000 15

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 39.000 Adjustments to reconcile net income to net cash used by operating activities Increase in Account Receivable -65.000 Increase in Prepaid Insurance -10.000 Increase in Unearned Revenue 10.000 Increase in Accounts Payable 14.000-51.000 Net cash flows used by operating activities -12.000 Cash Flows from Financing Activities Issuance of common stock 20.000 Long-term borrowing 81.000 Payment of cash dividend -14.000 Net Cash Flows provided by Financing Activities 87.000 Net Increase (Decrease) in Cash 75.000 Cash, January 1, 2001 0 Cash, December 31, 2001 75.000 16

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 100.000 75.000 25.000 Accounts receivable 35.000 65.000-30.000 Prepaid insurance 6.000 10.000-4.000 Land 15.000 0 15.000 Building 40.000 0 40.000 Accumulated depreciation - building -1.000 0-1.000 Equipment 30.000 0 30.000 Accumulated depreciation - equipment -10.000 0-10.000 Total 215.000 150.000 65.000 Liabilities and stockholder's equity Accounts payable 38.000 14.000 24.000 Long-term liability 72.000 81.000-9.000 Unearned revenue 0 10.000-10.000 Common stock ( 10 par) 20.000 20.000 0 Retained earnings 85.000 25.000 60.000 Total 215.000 150.000 65.000 17

Dream Grades, Inc. Income Statement For the year ended December 31, 2002 Revenues 320.000 Operating expenses 180.000 Income before taxes 140.000 Income tax expense (35%) 49.000 Net income 91.000 Additional information 1 a cash dividend of 31.000 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 25.000 during the year. 18

Indirect Method Step 2 Determine net cash from operating activities Net income 91.000 Adjustments to reconcile net income to net cash provided by operating activities: Decrease in accounts receivable 30.000 Increase in accounts payable 24.000 Decrease in prepayments 4.000 Decrease in unearned revenue -10.000 Depreciation expense 11.000 59.000 Net cash provided by operating activities 150.000 19

Step 3 Determine net cash flows from investing and financing activities repayment on loan, 9.000 dividend payment of 31.000 purchase of land, building, and equipment, 85.000 20

Dream Grades, Inc. Statement of Cash Flows For the Year Ended December 31, 2002 Cash Flows from Operating Activities Net Income 91.000 Adjustments to reconcile net income to net cash provided by operating activities Depreciation Expense 11.000 Decrease in Prepaid Insurance 4.000 Decrease in Account Receivable 30.000 Decrease in Unearned Revenue -10.000 Increase in Accounts Payable 24.000 59.000 Net cash flows provided by operating activities 150.000 Cash Flows from Investing Activities Purchase of land -15.000 Purchase of building -40.000 Purchase of equipment -30.000 Net cash flows used by investing activities -85.000 Cash Flows from Financing Activities Installment Payment on Long-Term Loan -9.000 Payment of cash dividend -31.000 Net cash flows used by financing activities -40.000 Net Increase (Decrease) in Cash 25.000 Cash, January 1, 2002 75.000 Cash, December 31, 2002 100.000 21

Dream Grades, Inc. Income Statement For the year ended December 31, 2002 Revenues 320.000 Operating expenses 180.000 Income before taxes 140.000 Income tax expense (35%) 49.000 Net income 91.000 Additional information 1 a cash dividend of 31.000 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 25.000 during the year. 22

Indirect Method Step 2 Determine net cash from operating activities Net income 91.000 Adjustments to reconcile net income to net cash provided by operating activities: Decrease in accounts receivable 30.000 Increase in accounts payable 24.000 Decrease in prepayments 4.000 Decrease in unearned revenue -10.000 Depreciation expense 11.000 59.000 Net cash provided by operating activities 150.000 23

Step 3 Determine net cash flows from investing and financing activities repayment on loan, 9.000 dividend payment of 31.000 purchase of land, building, and equipment, 85.000 24

Dream Grades, Inc. Statement of Cash Flows For the Year Ended December 31, 2002 Cash Flows from Operating Activities Net Income 91.000 Adjustments to reconcile net income to net cash provided by operating activities Depreciation Expense 11.000 Decrease in Prepaid Insurance 4.000 Decrease in Account Receivable 30.000 Decrease in Unearned Revenue -10.000 Increase in Accounts Payable 24.000 59.000 Net cash flows provided by operating activities 150.000 Cash Flows from Investing Activities Purchase of land -15.000 Purchase of building -40.000 Purchase of equipment -30.000 Net cash flows used by investing activities -85.000 Cash Flows from Financing Activities Installment Payment on Long-Term Loan -9.000 Payment of cash dividend -31.000 Net cash flows used by financing activities -40.000 Net Increase (Decrease) in Cash 25.000 Cash, January 1, 2002 75.000 Cash, December 31, 2002 100.000 25