1 Chapter 12 2 The statement of cash flows is a major financial statement as are the income statement, balance sheet, and statement of stockholders' equity. The statement of cash flows is required whenever an income statement is prepared. The statement of cash flows shows the effects on cash of the operating, investing, and financing activities of a company for an accounting period. 3 The principal purpose of the statement of cash flows is to provide information about a company's cash receipts and cash payments during an accounting period. It also provides information about a company's operating, investing, and financing activities during the period. 4 The statement of cash flows categorizes cash receipts and cash payments as operating, investing, and financing activities. Operating activities include receiving cash from customers for the sale of goods and services, receiving interest and dividends on loans and investments, and making cash payments for wages, goods and services purchased, interest, and taxes. 5 activities include purchasing and selling long-term assets and marketable securities (other than cash equivalents), as well as making and collecting on loans. activities include issuing and buying back capital stock, as well as borrowing and repaying loans on a short- or long-term basis (issuing bonds and notes). Dividends paid are also included in this category, but the repayment of accounts payable or accrued liabilities is not. 6 The statement of cash flows should be accompanied by a schedule of non-cash investing and financing transactions. Such transactions represent simultaneous investing and financing activities that do not, however, result in an inflow or outflow of cash. These activities include: the issuance of stock for assets; the conversion of bonds into stock; the issuance of debt for assets; and the exchange of plant assets. 1
7 All products go through a series of phases called the product life cycle, and a corporation s cash flow reflects these phases. The phases (in order of their occurrence) are often referred to as follows: Introductory Phase. During this phase, the corporation is likely to have a cash deficit in its operations because the product s sales are small and the promotional expenses are great. There may also be a great deal of expenditures for research and development activities. During this phase, the corporation is likely to have a deficit in its investing activities because it is spending a great deal on investing in plant assets. These deficits will be covered through financing transactions. 8 Growth Phase. During this phase: the sales revenue will increase. Despite this, the growth in its inventories and supplies and the need to increase the amount of credit offered to customers represent a significant need for cash in a corporation s operations. This phase is usually characterized by additional spending on research and development activities. During this phase, there is still a significant need for investments in plant assets. All of these needs will still require a cash infusion from financing transactions. 9 Maturity Phase. A product in this phase is often referred to as a cash cow. A company s operations should produce cash flow, and there is a shrinking demand for investments in plant assets. As a result of the foregoing, there is little need for a cash infusion from financing transactions. 10 Decline Phase. During this phase: cash from operations decreases. from investing may become positive as the company liquidates unneeded plant assets. Again there is little need for cash infusions from financing transactions. 11 Investors and creditors may use the statement of cash flows to assess such things as: the company's ability to generate positive future cash flows, its ability to pay its liabilities, its ability to pay dividends, and its need for additional financing. Management uses the statement of cash flows (among other things) to: assess the business's debt-paying ability, determine its dividend policy, and plan its investing and financing needs. 12 The Statement of Flows also provides useful information to investors regarding the following: The Quality of Income. Corporations may appear to be very profitable, but the accruals may not be accompanied by the receipt of cash. Investments. The Statement of Flows is the only place where a corporation s investment in plant assets is detailed. This can be very important in determining whether a corporation is poised to continue to grow in the future. 2
13 To prepare the statement of cash flows, one needs a comparative balance sheet, the current income statement, and additional information about transactions affecting non-current accounts during the period. 14 flows from operating activities may be determined using either the direct method or the indirect method. The choice of which method to use only affects the calculation of the Flow From. There is no difference in the Flow From Activities and the Flow From Activities. 15 The direct and indirect methods produce the same results, and both are considered GAAP. The FASB, however, recommends the direct method, accompanied by a separate schedule (the indirect method) reconciling net income to net cash flows. Despite this, the indirect method is used by approximately 99% of all companies. When the direct method is used, the net cash flow from operating activities as computed using the indirect method must also be reported in a separate schedule. 16 With the Direct Method, the cash flow from operations is calculated directly (from scratch). With the Indirect Method, however, the cash flow from operations is calculated by taking the net income of the company and then making adjustments. These adjustments are required because net income is calculated using the accrual method, and we are interested only in cash receipts reduced by cash disbursements (the cash method). 17 These adjustments include: Adding back expenses that were deducted from net income but did not cost anything (e.g., depreciation expense, amortization expense, and depletion expense); Taking out capital gains and losses that do not relate to operations (e.g., sale of plant assets); Taking out expenses that were accrued but not yet paid (e.g., income taxes accrued but not paid in the current year) 18 Taking out expenditures that cost cash but were not expensed this year (e.g., the purchase of inventory that was not sold or supplies that were not used up, and the payment of prepaid expenses still outstanding at the end of the year); Taking out income that was accrued but not yet received (e.g., credit sales where the account receivable is still outstanding, accrued interest not yet received); 3
19 Adding back cash receipts that were not treated as income (e.g., customers payments of accounts receivable that were generated in a prior year) Because of its widespread use, we will focus on the Indirect Method. 20 Consider the balance sheet equation: Assets = Liabilities + Owner s Equity + Curr. Assets + LT Assets = Curr. Liab. + LT Liab. + Equity + Curr. Assets + LT Assets = Curr. Liab. + LT Liab. + Equity = - Curr. Assets - LT Assets + Curr.Liab.+ LT Liab. + Equity So cash changes in the opposite way from other assets and the same way as liabilities and equity. 21 With the Indirect Method we assume that a change in a balance sheet account is matched by a change in cash. This is true for every change in the balance sheet accounts except for changes due to non-cash transactions (e.g., the purchase of an asset in exchange for stock). 22 As a general rule, the changes for the following balance sheet accounts are assumed to affect the following activities: Activity Changes In These Accounts Fall Within This Activity Current Assets Current Liabilities Net Income and Loss Also add back non cash expenses like depreciation Long Term Assets Long Term Liabilities Stockholder s Equity (excluding Net Income) 23 We are going to use the T-Account approach to the Indirect Method. It is a very simple approach to use because: You mechanically go through every balance sheet account; and You note every change with an equal amount of debits and credits. Because of these characteristics, it is difficult to skip an item. 24 Look At The Handout For Problem We Will Discuss. 4
25 26 Retained Earnings Retained Earnings $5,000 Net Income Net Income $5,000 $6,000 = = Pay Dividends $6,000 27 28 D. Bonds Payable Bonds Payable Common Stock Cr. Common Stock Additional Paid-In Capital 60,000 Additional Paid-In Capital $60,000 = $60,000 == 29 30 Notes Payable Notes Payable =========== ========== 5
31 32 Furniture & Fixtures Accumulated Depreciation $4,000 $18,000 Plus $39,600 $46,800 33 34 D. $13,800 Accumulated Depreciation Cr. Furniture and Fixtures 28,800 $35,600 Plus Furniture & Fixtures $4,000 Gain 7,000 $39,600 $35,600 ============ Accumulated Depreciation $18,000 Issue Notes Payable $28,800 $46,800 ============ 35 Merchandise Inventory 36 Prepaid Rent $1,000 Decrease in A/P $57,000 $1,000 = Decrease in Inven. =========== Decrease in Inven. Decrease in Prep. Rent $1,000 Accounts Payable Accounts Receivable $57,000 $34,800 $57,000 $34,800 =========== == 6
37 38 Decrease in A/P $57,000 Decrease in A/P $57,000 Income Taxes Payable Decrease in Tax Pay $3,000 Decrease in Tax Pay $3,000 $3,000 Decrease in Inven. Decrease in Prep. Rent $1,000 Flow From $126,600 Decrease in Inven. $3,000 Decrease in Prep. Rent $1,000 ============ ========== Flow From : -$25,800 Flow From : $14,000 39 The Direct Method Under the direct method, (net) cash flows from operating activities are determined by taking cash receipts from sales, adding interest and dividends received, and deducting cash payments for purchases, operating expenses, interest, and income taxes. 40 Free Flow Interpreting the Statement of Flows includes examining important relationships such as cash-generating efficiency and free cash flow. -generating efficiency is the ability of a company to generate cash from operations. Free cash flow is the cash available for new projects. Free Flow = From - Capital Expenditures.- Dividends 41 Current Debt Coverage Ratio When examining a corporation s ability to pay its debts in the short term (liquidity), financial analysts look at the Current Debt Coverage Ratio. In this ratio, you divide a corporation s cash from operations by average current liabilities: 42 Debt Coverage Ratio When examining a corporation s ability to pay its debts in the long-term (solvency), financial analysts look at the Debt Coverage Ratio. In this ratio, you divide a corporation s cash from operations by average total liabilities: Flow From -------------------------------------- Average Current Liabilities Flow From -------------------------------------- Average Total Liabilities 7