Statement of Cash Flows Learning Objectives 1. Understand the different activities of a business and how this influences the cash flow statement 2. Understand the direct and indirect methods for preparation of the Operating Section of the Cash Flow Statement 3. Prepare a full statement of cash flows 4. Use cash flows to analyze liquidity and risk 1 Statement of Cash Flows Financial statement that shows the amount of cash collected and disbursed by a firm over a specified period for operating, investing, and financing activities Provides financial statement users with the information necessary to reconcile the change in a company s cash and cash equivalents 2 Classification of Business Activities Operating Activities: Cash received from: Sale of goods/ services Interest Dividends Cash paid for: Salaries Inventory Taxes Other expenses Investing Activities: Cash received from: Sale of property, investments, or marketable securities Cash paid for: Purchase of investments or property Financing Activities: Cash received from: Sale of capital stock Issuance of debt Cash paid for: Repayment of debt Purchase of treasury stock Payment of dividends 3 1
Other Cash Flows Disclosures In addition to the statement of cash flows, companies must provide information concerning significant noncash transactions and events: Acquisition of assets by issuing equity securities or issuing debt Exchanges of nonmonetary assets Refinancing of long-term debt Retirement of long-term debt by issuing equity Conversion of debt or preferred stock into common stock Companies should also disclose the amount of cash paid for interest and taxes. 4 Cash Flows from Operating Activities This section of the statement of cash flows may be prepared using the direct method or the indirect method. Direct Method - Each item within the income statement s income from continuing operations section is converted into its cash equivalent Indirect Method - Net income is adjusted for items that do not affect cash flows, such as depreciation, amortization, gains, and losses 5 Direct Method Versus the Indirect Method Direct Method Indirect Method Shows the full amount of cash inflows and outflows that arise from operating activities Provides information about the amount of sales that resulted in actual cash inflows Reconciliation of net income and the cash provided or used by activities is important to understand, as it demonstrates the connection between economic activities and the generation and use of cash. May involve significant costs compared to the direct method Most companies use the indirect method because of its simplicity. 6 2
The Indirect Method The indirect method requires that three general types of adjustments be made to net income to arrive at cash provided or used by operating activities: 1. Adjustments for noncash income items 2. Adjustments for realized gains and losses recognized in the income statement 3. Adjustments for changes in current operating asset and liability accounts, excluding the Cash account 7 The Indirect Method Examples of noncash operating items that will be added back to net income under the indirect method are: Depreciation expense Losses due to impairment Net loss from investments accounted for under the equity method Amortization expense Unrealized losses on trading security investments Compensation expense related to stock option plans Examples of noncash operating items that will be subtracted from net income under the indirect method are: Amortization of premium on notes or bonds payable Unrealized gain on trading securities Net revenue from investments accounted for under the equity method 8 The Direct Method When preparing the operating activities section using the direct method, the income from continuing operations section of the income statement and the two most recent balance sheets are needed. Each line in the income from continuing operations will be transformed into its related cash flows. Sales Cash collected from customers Cost of goods sold Expenses Cash paid for inventory Cash paid Interest expense Cash paid for interest 9 3
Sales Transformed to Cash Collected from Customers In order to transform sales into cash collected from customers, information on sales is needed along with the beginning and ending balances for Accounts Receivable. Beginning balance of Accounts Receivable Plus: Sales Cash available for collection Less: Ending balance of Accounts Receivable Less: Accounts receivable written off as uncollectible Cash collected from customers 10 Cost of Goods Sold Transformed to Cash Paid for Inventory Examine Accounts Payable and Inventory to determine how much cash was paid for inventory: Ending balance of Inventory Plus: Cost of goods sold Available inventory Less: Beginning balance of Inventory Inventory purchased Plus: Beginning balance of Accounts Payable Inventory obligations outstanding Less: Ending balance of Accounts Payable Cash paid for inventory 11 Expenses Transformed to Cash Paid First, determine whether the expense is an accrued expense or a prepaid expense. To transform accrued expenses into cash paid, begin with the liability account s beginning balance and add the expense for the period, then subtract the beginning balance of the liability account. This yields the actual cash paid. To transform prepaid expenses into cash paid, begin with the ending balance of the related asset account, add the expense for the period, then subtract the ending balance of the asset account. 12 4
Interest Expense Transformed to Cash Paid for Interest To obtain the amount of cash paid for interest, the expense must be adjusted for the amount of premium or discount amortized during the period. If a discount is involved, begin with interest expense for the period and subtract the discount amortized to obtain the cash paid for interest. If a premium is involved, begin with interest expense for the period and add the premium amortized to obtain the cash paid for interest. 13 Preparing the Investing Activities Section Requires an analysis of the accounts associated with investing activities like the following: Equipment Accumulated Depreciation Land Available-for-Sale Securities Note that cash proceeds and payments should be shown independently in the investing activities section. 14 Investing Activities:Equipment and Accumulated Depreciation Examine any sales of equipment and recognize the full amount of cash proceeds of a sale. Also examine any purchases of equipment. To determine actual cash paid for equipment sales, use the following formula: Ending balance of Equipment Less: Beginning balance of Equipment Plus: Sale of equipment Purchase of equipment 15 5
Investing Activities: Land Analyze the balance sheet for changes in the Land account If changes in the Land account involved cash, report this amount as an increase or decrease in cash as applicable. If cash is not involved in a significant change in the Land account (such as purchase of land for a long-term note payable), this information can be reported in an accompanying schedule or report or at the end of the statement of cash flows in a section called Significant noncash transactions. 16 Investing Activities: Investments The purchase or sale of investments (available-for-sale, held-to-maturity, and investments accounted for under the equity method) should be reported in the investing activities section. Note that transactions involving trading securities should be part of operating activities. Loans made by the company to others should also be reported in the investing activities section. (Examine changes in the Notes Receivable account.) 17 Preparing the Financing Activities Section Requires an analysis of accounts associated with financing activities such as: Long-Term Notes Payable Common Stock Preferred Stock Retained Earnings Treasury Stock Dividends Note that cash proceeds and payments should be shown independently in the financing activities section. 18 6
Financing Activities: Common Stock and Treasury Stock Examine the Common Stock account. Increases reflect issuances of stock, and are usually a source of cash provided by financing activities. Examine the Treasury Stock account. Increases in this account reflect repurchases of a company s own stock and usually indicates an outflow of cash for the purchase. 19 Financing Activities: Dividends Examine the Retained Earnings account to determine the amount of cash paid for dividends. 20 Product Life Cycles and Cash Flows Product life cycle the stages that a product goes through from concept to use to eventual withdrawal from the marketplace Four phases of the cycle: Introductory Growth Maturity Decline Each phase has unique cash flow implications. 21 7
Product Life Cycle: Introductory Phase Operating activities: operating activities are negative because of the costs of developing and introducing the product. investing activities: Acquisition of physical assets needed to manufacture products result in negative cash flows. financing activities: Because the company is not generating adequate cash from operations, it must usually engage in financing activities, often by issuing equity. 22 Product Life Cycle: Growth Phase Operating activities: Sales begin to accelerate and generate positive cash flows. investing activities: Companies in this phase may still have negative cash flows from investing activities because they will need to make investments to increase capacity. financing activities: While companies in this phase may still require cash from financing activities, they may be in a place to begin issuing debt. 23 Product Life Cycle: Maturity Phase Operating activities: Net income is positive and reaching its peak. Product sales are reaching maximum levels. investing activities: The company is now paying for investing activities with the cash flow generated from operations. financing activities: The company does not need to obtain cash from financing activities and may begin to pay dividends or repurchase treasury stock. 24 8
Product Life Cycle: Decline Phase Operating activities: Net income is beginning to decline. operations are still positive, but declining as well. investing activities: The company has excess manufacturing capacity and may begin to sell off excess plant and equipment, generating cash. financing activities: The company will repay debt and pay dividends, using cash. 25 Liquidity Measurement Operating Cash Flow Ratio = Cash Flows from Operating Activities Current Liabilities Measures resources generated over a period of time that are available to meet current liabilities 26 Risk Assessment Cash Current Debt Coverage Ratio = Cash Flows from Operating Activities Current Dividends Current Interest-Bearing Debt Measures risk associated with repayment of debt after dividends are paid to stockholders 27 9