1. John Wiley & Sons, Inc. Prepared by Karleen Nordquist.. The College of St. Benedict... and St. John’s University... with contributions by Dr. Jessica J. Frazier.. and Philip Li... Eastern Kentucky University…. Managerial Accounting Weygandt, Kieso, & Kimmel

2. Chapter 11 Statement of Cash Flows

3. After studying this chapter, you should be able to: 1Indicate the primary purpose of the statement of cash flows. 2Distinguish among operating, investing, and financing activities. 3Explain the impact of the product life cycle on a company’s cash flows. 4Prepare a statement of cash flows using one of two approaches: (a) the indirect method or (b) the direct method. 5Use the statement of cash flows to evaluate a company. Chapter 11 Statement of Cash Flows

4. Preview of Chapter 11 The Statement of Cash Flows: Purpose and Format Purpose Classifications Significant Noncash Activities Format Corporate Life Cycle Usefulness Preparation STATEMENT OF CASH FLOWS

5. Preview of Chapter 11 Section 1: Indirect Method Determining Net Increase/ Decrease in Cash Determining Net Cash Provided/ Used by Operating Activities Determining Net Cash Provided/ Used by Investing and Financing Activities Summary of Indirect Method STATEMENT OF CASH FLOWS

6. Preview of Chapter 11 Section 2: Direct Method Determining Net Increase/ Decrease in Cash Determining Net Cash Provided/ Used by Operating Activities Determining Net Cash Provided/ Used by Investing and Financing Activities STATEMENT OF CASH FLOWS

7. Preview of Chapter 11 Using Cash Flows to Evaluate a Company Free Cash Flow Capital Expenditure Ratio Assessing Liquidity, Solvency, and Profitability STATEMENT OF CASH FLOWS

8. Indicate the primary purpose of the statement of cash flows. Study Objective 1

9. The Primary Purpose of the Statement of Cash Flows  The primary purpose of the statement of cash flows is to provide information about cash receipts, cash payments, and the net change in cash resulting from the operating, investing, and financing activities of a company during the period.  These activities involving cash are reported in a format that reconciles the beginning and ending cash balances.

10. The Primary Purpose of the Statement of Cash Flows  Reporting the causes of changes in cash is useful because investors, creditors, and other interested parties want to know what is happening to a company's most liquid resource – its cash.  The statement of cash flows provides answers to the following important questions about an enterprise: – Where did the cash come from during the period? – What was the cash used for during the period? – What was the change in the cash balance during the period?

11. Distinguish among operating, investing, and financing activities. Study Objective 2

12. Classification of Cash Flows  The statement of cash flows classifies cash receipts and cash payments into – operating, – investing, and – financing activities.

13. Operating Activities  Operating activities include the cash effects of transactions that create revenues and expenses and thus enter into the determination of net income.  Operating activities is the most important category because it shows the cash provided or used by company operations.  Cash provided by operations is generally considered to be the best measure of whether a company can generate sufficient cash to continue as a going concern and to expand.

14. Investing Activities  Investing activities include – purchasing and disposing of investments and productive long-lived assets using cash, and – lending money and collecting the loans.

15. Financing Activities  Financing activities include – obtaining cash from issuing debt and repaying the amounts borrowed and – obtaining cash from stockholders and paying them dividends.

16. Typical Cash Receipts and Payments Classified by Activity Operating activities  Cash inflows: – From sale of goods or services – From returns on loans (interest received) and on equity securities (dividends received)  Cash outflows: – To suppliers for inventory – To employees for services – To government for taxes – To lenders for interest – To others for expenses Illustration 11-1a

17. Illustration 11-1b Typical Cash Receipts and Payments Classified by Activity Investing activities  Cash inflows: – From sale of property, plant, and equipment – From sale of debt or equity securities of other entities – From collection of principal on loans to other entities  Cash outflows: – To purchase property, plant, and equipment – To purchase debt or equity securities of other entities – To make loans to other entities

18. Typical Cash Receipts and Payments Classified by Activity Financing activities  Cash inflows: – From sale of equity securities (company's own stock) – From issuance of debt (bonds and notes)  Cash outflows: – To stockholders as dividends – To redeem long-term debt or reacquire capital stock Illustration 11-1c

19. Operating Activities  Some cash flows relating to investing or financing activities are classified as operating activities.  For example, receipts of investment revenue (interest and dividends) and payments of interest to lenders are classified as operating activities because these items are reported in the income statement.

20. Operating Activities As a general rule:  Operating activities involve income determination (income statement) items.  Investing activities involve cash flows resulting from changes in investments and long-term asset items.  Financing activities involve cash flows resulting from changes in long-term liability and stockholders' equity items. !

21. Significant Noncash Activities  Not all of a company's significant activities involve cash. Four examples of significant noncash activities are: – Issuance of common stock to purchase assets – Conversion of bonds into common stock – Issuance of debt to purchase assets – Exchanges of plant assets

22. Significant Noncash Activities  Significant noncash financing and investing activities are not reported in the body of the statement of cash flows. Rather, they are reported either in a separate schedule at the bottom of the statement of cash flows or in a separate note or supplementary schedule to the financial statements.  This reporting of these significant noncash activities in a separate note or supplementary schedule satisfies the full disclosure principle.

23. Format of the Statement of Cash Flows  The three activities (operating, investing, and financing), plus the significant noncash investing and financing activities make up the general format of the statement of cash flows.  The cash flows from operating activities section always appears first, followed by the investing activities, and the financing activities sections.  The individual inflows and outflows form investing and financing activities are reported separately.  The reported operating, investing, and financing activities result in net cash provided or used by each activity.

24. Format of the Statement of Cash Flows  The net cash provided or used by each activity is totaled to show the net increase (decrease) in cash for the period.  The net increase (decrease) in cash for the period is then added or subtracted from the beginning-of-period cash balance to obtain the end-of-period cash balance.  Any significant noncash investing and financing activities are (usually) reported in a separate schedule at the bottom of the statement.

25. Format of the Statement of Cash Flows Cash flows from operating activities (List of individual items)XX Net cash provided (used) by operating activitiesXXX Cash flows from investing activities (List of individual items)XX Net cash provided (used) by investing activitiesXXX Cash flows from financing activities (List of individual items)XX Net cash provided (used) by financing activitiesXXX Net increase (decrease) in cashXXX Cash at beginning of periodXXX Cash at end of periodXXX Noncash investing and financing activities (List of individual noncash transactions)XXX Company Name Statement of Cash Flows Period Covered Illustration 11-2

26. Explain the impact of the product life cycle on a company’s cash flows. Study Objective 3

27. The Corporate Life Cycle  All products go through a series of phases called the product life cycle.  The phases (in order of their occurrence) are often referred to as the introductory phase, growth phase, maturity phase, and decline phase.  We can characterize a company as being in one of these four phases because the majority of its products are usually in a particular phase. The phase a company is in affects its cash flows.

28. Corporate Life Cycle: Introductory Phase  The introductory phase occurs when the company is purchasing fixed assets and beginning to produce and sell.  When a company is in the introductory stage, one would expect that it will be spending considerable amounts to purchase productive assets, but will not be generating much (if any) cash from operations.  To support asset purchases the company may have to issue stock or debt.  One would expect cash from operations to be negative, cash from investing to be negative, and cash from financing to be positive.

29. Corporate Life Cycle: Growth Phase  During the growth phase, the company is striving to expand its production and sales.  Cash from operations continues to be less than net income during this phase because inventory must be purchased for future projected sales.  Cash needed for asset acquisitions will continue to exceed cash provided by operations, requiring that the company make up the deficiency by issuing new stock or debt.  Thus, the company continues to show negative cash from investing and positive cash from financing in this phase.

30. Corporate Life Cycle: Maturity Phase  In the maturity phase, sales and production level off.  Cash from operations and net income are approximately the same.  Cash generated from operations exceeds investing needs.  Thus, in the maturity phase the company can actually start to retire debt or buy back stock.

31. Corporate Life Cycle: Decline Phase  During the decline phase, sales of the product fall due to a weakening in consumer demand.  During this phase, cash from operations decreases.  Cash from investing might actually become positive as the firm sells off excess assets, and cash from financing may be negative as the company buys back stock and retires debt.

32. Usefulness of the Statement of Cash Flows  Many investors believe cash flow is less susceptible to management manipulation and fraud than traditional accounting measures such as net income.  Although reliance on cash flows to the exclusion of accrual accounting is inappropriate, comparing cash from operations to net income can reveal important information about the “quality” of reported net income — that is the extent to which net income provides a good measure of actual performance.

33. Usefulness of the Statement of Cash Flows The information in a statement of cash flows should help investors, creditors and others evaluate these aspects of the firm's financial position: – The entity's ability to generate future cash flows. – The entity's ability to pay dividends and meet obligations. – The reasons for the difference between net income and net cash provided (used) by operating activities. – The cash investing and financing transactions during the period.

34. Preparing the Statement of Cash Flows The statement of cash flows is prepared differently from other basic financial statements. – First, because the statement requires detailed information concerning the changes in account balances that occurred between two periods of time, an adjusted trial balance does not provide the data necessary for the statement. – Second, the statement of cash flows deals with cash receipts and payments. The accrual concept is not used in the preparation of a statement of cash flows.

35. Preparing the Statement of Cash Flows The information to prepare the statement of cash flows usually comes from three sources: – Comparative balance sheet. (Indicates the amount of change in assets, liabilities, and stockholders’ equities from the beginning to the end of the period.) – Current income statement. (Helps in determining cash provided or used by operations.) – Additional information. (Includes transaction data that helps determine how cash was provided or used.)

36. Preparing the Statement of Cash Flows: Steps Preparing the statement of cash flows involves the following steps: 1Determine the net increase/decrease in cash. 2Determine the net cash provided/used by operating activities. 3Determine the net cash provided/used by investing and financing activities.

37. Preparing the Statement of Cash Flows: Indirect and Direct Methods  In order to determine the cash provided/used by operating activities, net income must be converted from an accrual basis to a cash basis. This conversion may be done by either of two methods: indirect or direct.  Both methods arrive at the same total amount for “net cash provided by operating activities.”  The investing and financing sections are identical under both methods.

38. The Indirect Method  The indirect method is used extensively in practice.  Most companies favor the indirect method for the following three reasons: – it is easier to prepare, – it focuses on the differences between net income and net cash flow from operating activities, and – it tends to reveal less company information to competitors.

39. The Direct Method  Others favor the direct method, which is more consistent with the objective of a statement of cash flow because it shows operating cash receipts and payments.  The FASB prefers the direct method but allows the use of either method.  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.

40. Prepare a statement of cash flows using the indirect method Study Objective 4a

41. Statement of Cash Flows - Indirect Method  Transactions of Computer Services Company for two years will be used to explain and the illustrate the indirect method of preparing the statement of cash flows.  Computer Services Company started operations on January 1, 1999, when it issued 50,000 shares of $1 par value common stock for $50,000 cash.  The company rented its office space and furniture, and performed consulting services throughout the first year.  Information needed to prepare the 1999 statement of cash flows is shown on the following two slides.

42. Statement of Cash Flows - Indirect Method Change AssetsDec. 31, 1999Jan. 1, 1999Increase/Decrease Cash$34,000$ - 0 - $34,000 increase Accounts receivable30,000- 0 - 30,000 increase Equipment 10,000 - 0 - 10,000 increase Total$74,000$ - 0 - Liabilities and Stockholders’ Equity Accounts payable$ 4,000$ - 0 - $ 4,000 increase Common stock50,000 - 0 - 50,000 increase Retained earnings 20,000 - 0 - 20,000 increase Total$74,000$ - 0 - Computer Services Company Comparative Balance Sheet December 31 Illustration 11-5

43. Statement of Cash Flows - Indirect Method Revenues$85,000 Operating expenses 40,000 Income before income taxes45,000 Income tax expense 10,000 Net income$35,000 Computer Services Company Income Statement For the Year Ended December 31, 1999 Illustration 11-6 Additional information: (a)Examination of selected data indicates that a dividend of $15,000 was declared and paid during the year. (b)The equipment was purchased at the end of 1999. No depreciation was taken in 1999.

44. Step 1: Determining the Increase/Decrease in Cash  Determining the increase/decrease in cash during the year is a simple computation.  As shown on the comparative balance sheet, Computer Services had no cash on hand at the beginning of 1999 and a balance of $34,000 at the end of 1999. Therefore, cash increased by $34,000.

45. Step 2: Determining Net Cash Provided/Used by Operating Activities  To determine net cash provided/used by operating activities under the indirect method, net income is adjusted for income items that did not affect cash. Accrual basis net income is converted to cash basis. This process is graphically illustrated on the next slide.  Net income must be converted because earned revenues may include credit sales that have not been collected in cash and incurred expenses that may not have been paid in cash.  A useful starting point in identifying the needed adjustments to net income is the current asset and current liability accounts.

46. Net Income Versus Net Cash Provided by Operating Activities Net Income Earned Revenues Incurred Expenses Accrual Basis of AccountingCash Basis of Accounting Net Cash Provided/Used by Operating Activities Adjustments to Reconcile Net Income to Net Cash Provided/Used by Operations Illustration 11-7

47. Operations of the period led to revenues. Not all of these revenues resulted in an increase in cash, however. When accounts receivable increase during the year, revenues on an accrual basis are higher than revenues on a cash basis.  Computer Services Company had revenues of $85,000 during its first year of operation, but collected only $55,000 in cash. On an accrual basis, revenue was $85,000, but on a cash basis, only $55,000 of revenue was received during the period.  To convert net income to net cash provided by operating activities, the $30,000 increase in accounts receivable must be deducted from net income. Step 2: Determining Net Cash Provided/Used by Operating Activities

48. Operations of the period also led to expenses. Not all of these expenses resulted in a decrease in cash. When accounts payable increase during the year, expenses on an accrual basis are higher than expenses on a cash basis.  Computer Services shows $40,000 of operating expenses on its income statement. However, since accounts payable increased by $4,000 during the year, only $36,000 of those expenses were paid in cash ($40,000 - $4,000).  To convert net income to net cash provided by operating activities, the $4,000 increase in accounts payable must be added to net income. Step 2: Determining Net Cash Provided/Used by Operating Activities

49. T-account Analysis of Accounts The T-accounts shown below may help illustrate the preceding discussion. Balance, Jan. 10Receipts from customers55,000 Revenues85,000 Balance, Dec. 3130,000 Accounts Receivable Payments to creditors36,000Balance, Jan. 10 Operating expenses40,000 Balance, Dec. 314,000 Accounts Payable Illustrations 11-8 & 9 Cash amounts for statement of cash flows Accrual amounts on income statement

50. Step 2: Determining Net Cash Provided/Used by Operating Activities  For Computer Services, the changes in accounts receivable and accounts payable were the only changes in current assets and current liability accounts.  Therefore, any other revenues or expenses reported in the income statement were received or paid in cash, and no other adjustment of net income is necessary.  The operating activities section of the statement of cash flows for Computer Services Company is shown on the next slide.

51. Step 2: Determining Net Cash Provided/Used by Operating Activities Cash flows from operating activities Net income$ 35,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable$(30,000) Increase in accounts payable 4,000 (26,000) Net cash provided by operating activities$ 9,000 Computer Services Company Partial Statement of Cash Flows - Indirect Method For the Year Ended December 31, 1999 Illustration 11-10

52. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities To find net cash provided/used by investing and financing activities, determine the changes in the noncurrent accounts on the balance sheet. Those changes are then analyzed using selected transaction data to determine the effect, if any, the changes had on cash.  Computer Service Company's three noncurrent accounts are Equipment, Common Stock, and Retained Earnings, all three of which had increases during the year.

53. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities  No transaction data are given for the increases in Equipment of $10,000, and Common Stock of $50,000. When other explanations are lacking, assume any differences involve cash.  The increase in equipment is assumed to be a purchase of equipment for $10,000 cash. This purchase is reported as a cash outflow in the investing activities section.  The increase of common stock is assumed to result from the issuance of common stock for $50,000 cash. It is reported as an inflow of cash in the financing section.

54. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities The reasons for the net increase of $20,000 in the Retained Earnings account are determined by analysis.  First, net income increased retained earnings by $35,000.  Second, the additional information indicates that a cash dividend of $15,000 was declared and paid.  The $35,000 increase due to net income is reported in the operating activities section.  The cash dividend paid is reported in the financing activities section.

55. Statement of Cash Flows – 1999 Cash flows from operating activities Net income$ 35,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable$(30,000) Increase in accounts payable 4,000 (26,000) Net cash provided by operating activities 9,000 Cash flows from investing activities Purchase of equipment (10,000) Net cash used by investing activities(10,000) Cash flows from financing activities Issuance of common stock50,000 Payment of cash dividends (15,000) Net cash provided by financing activities 35,000 Net increase in cash34,000 Cash at beginning of period 0 Cash at end of period$34,000 Computer Services Company Statement of Cash Flows - Indirect Method For the Year Ended December 31, 1999 Illustration 11-12

56. Statement of Cash Flows – 1999  Computer Services Company's statement of cash flows for 1999 on the previous slide shows that operating activities provided $9,000 cash; investing activities used $10,000 cash; and financing activities provided $35,000 cash.  The increase in cash of $34,000 reported in the statement of cash flows agrees with the increase of $34,000 shown as the change in the cash account in the comparative balance sheet.

57. Second Year of Operations – 2000 The comparative balance sheet, income statement, and additional information for Computer Services Company’s second year of operation are presented on the next two slides.

58. Statement of Cash Flows - Indirect Method Change Assets 2000 1999 Increase/Decrease Cash$ 56,000 $34,000$ 22,000 increase Accounts receivable20,000 30,00010,000 decrease Prepaid expenses 4,000 04,000 increase Land130,000 0130,000 increase Building160,000 0160,000 increase Acc Depr - building(11,000)011,000 increase Equipment27,000 10,00017,000 increase Acc Depr - equipment (3,000) 03,000 increase Total$383,000 $74,000 Liabilities and Stockholders’ Equity Accounts payable$ 59,000 $4,000$ 55,000 increase Bonds payable 130,000 0130,000 increase Common stock50,000 50,000 0 change Retained earnings 144,000 20,000124,000 increase Total$383,000 $74,000 Computer Services Company Comparative Balance Sheet December 31 Illustration 11-13

59. Statement of Cash Flows - Indirect Method Revenues$507,000 Operating expenses $261,000 Depreciation expense15,000 Loss on sale of equipment 3,000 279,000 Income from operations228,000 Income tax expense 89,000 Net income$139,000 Computer Services Company Income Statement For the Year Ended December 31, 1999 Illustration 11-14 Additional information: (a)In 2000 the company declared and paid a $15,000 cash dividend. (b)The company obtained land through the issuance of $130,000 of long-term bonds. (c)An office building costing $160,000 was purchased for cash; equipment costing $25,000 was also purchased for cash. (d)During 2000 the company sold equipment with a book value of $7,000 (cost $8,000 less accumulated depreciation $1,000) for $4,000 cash.

60. Step 1: Determining the Increase/Decrease in Cash  As shown on the comparative balance sheet, Computer Service Company’s cash increased $22,000 ($56,000 - $24,000) during 2000.

61. Step 2: Determining Net Cash Provided/Used by Operating Activities Once again, to determine net cash provided/used by operating activities under the indirect method, net income is adjusted for income items that did not affect cash.  Explanations for the adjustments to net income for Computer Services Company in 2000 are discussed on the following four slides.

62. Step 2: Determining Net Cash Provided/Used by Operating Activities  Accounts Receivable: Accounts receivable decreases during the period because cash receipts are higher than revenues reported on an accrual basis. – The decrease of $10,000 must be added to net income.  Prepaid Expenses: Prepaid expenses increase during a period because cash paid for expenses is greater than expenses reported on an accrual basis. Cash payments have been made in current period, but expenses have been deferred to future periods. – The increase of $4,000 in prepaid expenses must be deducted from net income.

63. Step 2: Determining Net Cash Provided/Used by Operating Activities  Accounts Payable : Like the increase in 1999, the 2000 increase of $55,000 in accounts payable must be added to net income to convert to net cash provided by operating activities.

64. Step 2: Determining Net Cash Provided/Used by Operating Activities  Depreciation Expense : During 2000 Computer Services Company reported depreciation expense of $15,000. An analysis of the accumulated depreciation accounts reveals that $11,000 related to the building and $4,000 related to the equipment. – Depreciation and other charges that do not require the use of cash, such as amortization of intangible assets are added to net income.

65. Step 2: Determining Net Cash Provided/Used by Operating Activities  Loss on Sale of Equipment : Computer Services Company reported a $3,000 loss on the sale of equipment (book value $7,000 less cash proceeds $4,000). The loss reduced net income but did not reduce cash. – Thus, the $3,000 loss is added to net income in determining net cash provided by operating activities.  As a result of the previous adjustments, net cash provided by operating activities is $218,000.

66. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities Once again, to find net cash provided/used by investing and financing activities, determine the changes in the noncurrent accounts on the balance sheet. Those changes are then analyzed using selected transaction data to determine the effect, if any, the changes had on cash.

67. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities  Land: Land of $130,000 was purchased through the issuance of long-term bonds. – Although the exchange of bonds payable for land has no effect on cash, it is a significant noncash investing and financing activity that must be disclosed.  Building: An office building was acquired using cash of $160,000. – This transaction is a cash outflow reported in the investing activities section.

68. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities  Equipment: The Equipment account increased $17,000. The additional information provided, reveals that this was a net increase resulting from two transactions: (1) a purchase of equipment for $25,000, and (2) a sale of equipment costing $8,000 for $4,000. – These are investing activities. The purchase of equipment should be shown as a $25,000 outflow of cash, and the sale of equipment should be shown as a cash inflow of $4,000.

69. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities  Bonds Payable: The Bonds Payable account increased by $130,000 when bonds were issued to acquire land. – As indicated earlier this is a noncash investing and financing activity reported in a separate schedule at the bottom of the statement of cash flows.

70. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities  Retained Earnings: Retained Earnings increased by $124,000. The increase is the result of (1) net income of $139,000 that increased RE, and (2) dividends of $15,000 that decreased RE. – Net income is converted to net cash provided by operations in the operating activities section. – Payment of the dividends is a cash outflow that is reported as a financing activity.  Computer Services Company’s cash flow statement for 2000 is shown on the next slide.

71. Computer Services Company Statement of Cash Flows - Indirect Method For the Year Ended December 31, 2000 Cash flows from operating activities Net income$139,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense$ 15,000 Loss on sale of equipment3,000 Decrease in accounts receivable10,000 Increase in prepaid expenses (4,000) Increase in accounts payable 55,000 79,000 Net cash provided by operating activities 218,000 Cash flows from investing activities Purchase of building(160,000) Purchase of equipment (25,000) Sale of equipment 4,000 Net cash used by investing activities(181,000) Cash flows from financing activities Payment of cash dividends (15,000) Net cash provided by financing activities (15,000) Net increase in cash22,000 Cash at beginning of period 34,000 Cash at end of period$ 56,000 Noncash investing and financing activities: Issuance of bonds payable to purchase land$130,000 Illustration 11-18

72. Summary of Conversion to Net Cash Provided by Operating Activities - Indirect Method As shown in the previous illustrations, the statement of cash flows prepared by the indirect method starts with net income and adds or deducts items not affecting cash, to arrive at net cash provided by operating activities. The additions and deductions consist of – changes in specific current assets and current liabilities, and – noncash charges reported on the income statement.

73. Prepare a statement of cash flows using the direct method. Study Objective 4b

74. Statement of Cash Flows - Direct Method  Transactions of Juarez Company for two years will be used to explain and the illustrate the direct method of preparing the statement of cash flows.  Juarez Company began business on January 1, 1999, when it issued 300,000 shares of $1 par value common stock for $300,000 cash.  The company rented its office and sales space, as well as its equipment.  Information needed to prepare the 1999 statement of cash flows is shown on the following two slides.

75. Statement of Cash Flows - Direct Method Change AssetsDec. 31, 1999Jan. 1, 1999Increase/Decrease Cash$159,000$ - 0 - $159,000 increase Accounts receivable15,000- 0 - 15,000 increase Inventory160,000 - 0 - 160,000 increase Prepaid expenses8,000- 0 - 8,000 increase Land 80,000 - 0 - 80,000 increase Total$422,000$ - 0 - Liabilities and Stockholders’ Equity Accounts payable$ 60,000$ - 0 - $ 60,000 increase Accrued expenses payable20,000- 0 - 20,000 increase Common stock300,000 - 0 - 300,000 increase Retained earnings 42,000 - 0 - 42,000 increase Total$422,000$ - 0 - Juarez Company Comparative Balance Sheet December 31 Illustration 11-21

76. Statement of Cash Flows - Direct Method Revenues from sales$780,000 Cost of goods sold 450,000 Gross profit330,000 Operating expenses 170,000 Income before income taxes160,000 Income tax expense 48,000 Net income$112,000 Juarez Company Income Statement For the Year Ended December 31, 1999 Illustration 11-22 Additional information: (a)Dividends of $70,000 were declared and paid in cash. (b)The accounts payable increase resulted from the purchase of merchandise.

77. Step 1: Determining the Increase/Decrease in Cash  Determining the increase/decrease in cash during the year is a simple computation.  As shown on the comparative balance sheet, Juarez Company had no cash on hand at the beginning of 1999 and a balance of $159,000 at the end of 1999. Therefore, cash increased by $159,000.

78. Step 2: Determining Net Cash Provided/Used by Operating Activities  To determine net cash provided/used by operating activities under the direct method, adjust each item in the income statement from the accrual basis to the cash basis.  An efficient way to apply the direct method is to analyze the revenues and expenses reported in the income statement in the order in which they are listed and then determine the cash receipts and cash payments related to these revenues and expenses.  Only major classes of operating cash receipts and cash payments are reported in the operating activities section, as illustrated on the next slide.

79. Major Classes of Cash Receipts and Payments Illustration 11-23 From sales of goods and services to customers From receipts of interest on loans and dividends on investments Cash Receipts Net Cash Provided by Operating Activities Net Cash Provided/Used by Operating Activities – Cash Payments = To suppliers To employees For operating expenses For interest For taxes –=

80. Operations of the period led to revenues. Not all of these revenues resulted in an increase in cash, however. When accounts receivable increase during the year, revenues on an accrual basis are higher than revenues on a cash basis.  Juarez Company had revenues of $780,000 during its first year of operation. To determine cash receipts from customers, it is necessary to consider the change in accounts receivable during the year. Specifically, the increase in accounts receivable is deducted from sales revenues.  For Juarez, accounts receivable increased $15,000. Thus, cash receipts from customers were $765,000 ($780,000 revenue - $15,000 increase in accounts receivable). Step 2: Determining Net Cash Provided/Used by Operating Activities

81.  The relationships among cash receipts from customers, revenues from sales, and changes in accounts receivable are shown below.  Cash receipts from customers may also be determined from an analysis of the Accounts Receivable account as shown below. Cash receipts from customers = Revenues from sales + Decrease in accounts receivable or - Increase in accounts receivable Illustration 11-26 Balance, Jan. 10Receipts from customers765,000 Revenues from sales780,000 Balance, Dec. 3115,000 Accounts Receivable Illustration 11-25

82. To determine cash payments to suppliers, it is first necessary to find purchases for the year. To find purchases, cost of goods sold is adjusted for the change in inventory. When inventory increases during the year, it means that purchases this year exceed cost of goods sold. As a result, the increase in inventory is added to cost of goods sold to arrive at purchases.  In 1999, Juarez Company’s Cost of Goods Sold was $450,000 and its inventory increased $160,000. Purchases, therefore are $610,000 ($450,000 + 160,000). Step 2: Determining Net Cash Provided/Used by Operating Activities

83. After purchases are computed, cash payments to suppliers are determined by adjusting purchases for the change in accounts payable. When accounts payable increase during the year, purchases on an accrual basis are higher than purchases on a cash basis. Step 2: Determining Net Cash Provided/Used by Operating Activities  In 1999, Juarez Company’s Accounts Payable increased by $60,000. Thus, cash payments to suppliers were $550,000 ($610,000 purchases - $60,000 increase in accounts payable).

84. Step 2: Determining Net Cash Provided/Used by Operating Activities  The relationships among cash payments to suppliers, cost of goods sold, changes in inventory, and changes in accounts payable are shown below.  Cash payments to suppliers may also be determined from an analysis of the Accounts Payable account as shown below. Payments to suppliers550,000Balance, Jan. 10 Purchases610,000 Balance, Dec. 3160,000 Accounts Payable Illustration 11-29 Illustration 11-30 Cash payments to suppliers = Cost of goods sold + Decrease in accounts payable or - Increase in accounts payable + Increase in inventory or - Decrease in inventory

85. To determine the cash paid for operating expenses, the income statement amount must be adjusted for any changes in prepaid expenses and accrued expenses payable. When prepaid expenses increase, accrual basis operating expenses are lower than cash basis operating expenses. Similarly, when accrued expenses payable increases, accrual basis operating expenses are higher than cash basis operating expenses. Step 2: Determining Net Cash Provided/Used by Operating Activities  Juarez Company’s cash payments for operating expenses are computed as shown below. Operating Expenses$170,000 Add: Increase in prepaid expenses8,000 Deduct: Increase in accrued expenses payable (20,000) Cash payments for operating expenses$158,000 Illustration 11-31

86. Step 2: Determining Net Cash Provided/Used by Operating Activities  The relationships among cash payments for operating expenses, changes in prepaid expenses, and changes in accrued expenses payable are shown below. Illustration 11-31 Cash payments for operating expenses = Operating Expenses + Decrease in accrued expenses payable or - Increase in accrued expenses payable + Increase in prepaid expense or - Decrease in prepaid expense

87. Step 2: Determining Net Cash Provided/Used by Operating Activities  The income statement for Juarez Company shows income tax expense of $48,000. This amount equals the cash paid because the comparative balance sheet indicates no income taxes payable at either the beginning or the end of the year.  All of the revenues and expenses on the 1999 income statement have now been adjusted to a cash basis. The operating activities section of the statement of cash flows for Juarez Company is shown on the next slide.

88. Step 2: Determining Net Cash Provided/Used by Operating Activities Cash flows from operating activities Cash receipts from customers$765,000 Cash payments: To suppliers$550,000 For operating expenses158,000 For income taxes 48,000 756,000 Net cash provided by operating activities$ 9,000 Juarez Company Partial Statement of Cash Flows - Direct Method For the Year Ended December 31, 1999 Illustration 11-10

89. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities To find net cash provided/used by investing and financing activities, determine the changes in the noncurrent accounts on the balance sheet. Those changes are then analyzed using selected transaction data to determine the effect, if any, the changes had on cash.  Juarez Company's three noncurrent accounts are Land, Common Stock, and Retained Earnings, all three of which had increases during the year.

90. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities  No transaction data are given for the increase in Land of $80,000. When other explanations are lacking, assume any differences involve cash. – The purchase of land for $80,000 cash is reported as a cash outflow in the investing activities section.  The increase of common stock results from the issuance of common stock for $300,000 cash. – It is reported as an inflow of cash in the financing section.

91. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities The reasons for the net increase of $42,000 in the Retained Earnings account are determined by analysis.  First, net income increased retained earnings by $112,000.  Second, the additional information indicates that a cash dividend of $70,000 was declared and paid. – The adjustment of revenues and expenses to arrive at net cash provided by operations was done in step 2 earlier. – The cash dividend paid is reported in the financing activities section.

92. Statement of Cash Flows – 1999 Cash flows from operating activities Cash receipts from customers$765,000 Cash payments: To suppliers$550,000 For operating expenses158,000 For income taxes 48,000 756,000 Net cash provided by operating activities 9,000 Cash flows from investing activities Purchase of land (80,000) Net cash used by investing activities(80,000) Cash flows from financing activities Issuance of common stock300,000 Payment of cash dividends (70,000) Net cash provided by financing activities 230,000 Net increase in cash159,000 Cash at beginning of period 0 Cash at end of period$159,000 Juarez Company Statement of Cash Flows - Direct Method For the Year Ended December 31, 1999 Illustration 11-35

93. Statement of Cash Flows – 1999  Juarez Company's statement of cash flows for 1999 on the previous slide shows that operating activities provided $9,000 cash; investing activities used $80,000 cash; and financing activities provided $230,000 cash.  The increase in cash of $159,000 reported in the statement of cash flows agrees with the increase of $159,000 shown as the change in the cash account in the comparative balance sheet.

94. Second Year of Operations – 2000 The comparative balance sheet, income statement, and additional information for Juarez Company’s second year of operation are presented on the next two slides.

95. Statement of Cash Flows - Direct Method Change Assets 2000 1999 Increase/Decrease Cash$191,000 $159,000$ 32,000 increase Accounts receivable12,000 15,0003,000 decrease Inventory130,000 160,00030,000 decrease Prepaid expenses 6,000 8,0002,000 decrease Land180,000 80,000100,000 increase Equipment160,000 0160,000 increase Acc Depr - equipment (16,000) 016,000 increase Total$663,000 $422,000 Liabilities and Stockholders’ Equity Accounts payable$ 52,000 $60,000$ 8,000 decrease Accrued expenses payable15,000 20,0005,000 decrease Income taxes payable12,000 012,000 increase Bonds payable 90,000 090,000 increase Common stock400,000 300,000 100,000 increase Retained earnings 94,000 42,00052,000 increase Total$663,000 $422,000 Juarez Company Comparative Balance Sheet December 31 Illustration 11-36

96. Statement of Cash Flows - Direct Method Illustration 11-37 Revenues from sales$975,000 Cost of goods sold$660,000 Operating expenses 176,000 Depreciation expense18,000 Loss on sale of equipment 1,000 855,000 Income before income taxes120,000 Income tax expense 36,000 Net income$84,000 Juarez Company Income Statement For the Year Ended December 31, 1999 Additional information: (a)In 2000 the company declared and paid a $32,000 cash dividend. (b)Bonds were issued at face value for $90,000 in cash. (c)Equipment costing $180,000 was purchased for cash. (d)Equipment costing $20,000 was sold for $17,000 cash when the book value of the equipment was $18,000. (e)Common stock of $100,000 was issued to acquire land.

97. Step 1: Determining the Increase/Decrease in Cash  As shown on the comparative balance sheet, Juarez Company’s cash increased $32,000 ($191,000 - $159,000) during 2000.

98. Step 2: Determining Net Cash Provided/Used by Operating Activities Once again, to determine net cash provided/used by operating activities under the direct method, adjust each item in the income statement from the accrual basis to the cash basis.  Explanations for the adjustments to revenues and expenses for Juarez Company in 2000 are discussed on the following five slides.

99. Step 2: Determining Net Cash Provided/Used by Operating Activities  Cash Receipts from Customers: Revenues from sales were $975,000. Since accounts receivable decreased $3,000 cash receipts from customers were greater than sales revenues. – Cash receipts from customers were $978,000 ($975,000 + $3,000).  Cash Payments to Suppliers: For 2000, purchases are computed using cost of goods sold of $660,000 and the decrease in inventory of $30,000. Purchases are then adjusted by the decrease in accounts payable of $8,000. – Cash payments to suppliers were $638,000 ($660,000 - $30,000 + $8,000).

100. Step 2: Determining Net Cash Provided/Used by Operating Activities  Cash Payments for Operating Expenses: Operating expenses for 2000 were $176,000. This amount is then adjusted for changes in prepaid expenses and accrued expenses payable. Prepaid expenses decreased $2,000 during the year. This means that $2,000 was allocated to expenses, but cash payments did not increase by that amount. Accrued expenses payable decreased $5,000. As a result, cash payments were $5,000 higher than reported for operating expenses. – Cash payments for operating expenses were $179,000 ($176,000 - $2,000 + 5,000).

101. Step 2: Determining Net Cash Provided/Used by Operating Activities  Depreciation Expense: Depreciation expense is not shown on a statement of cash flows under the direct method because it is a noncash charge. – If the amount for operating expenses had included depreciation, operating expenses must be reduced by the amount of depreciation to determine cash payment for operating expenses. – Other charges to expense that do not require the use of cash, such as the amortization of intangible assets and depletion expense are treated in the same manner as depreciation.

102. Step 2: Determining Net Cash Provided/Used by Operating Activities  Loss on Sale of Equipment: The loss on sale of equipment of $1,000 is also a noncash charge. The loss on sale of equipment reduces net income, but it does not reduce cash. Thus, the loss on sale of equipment is not reported on a statement of cash flows prepared using the direct method.

103. Step 2: Determining Net Cash Provided/Used by Operating Activities  The relationships among cash payments for income taxes, income tax expense and changes in income taxes payable is shown below. Cash payments for income taxes = Income tax expense + Decrease in income taxes payable or - Increase in income taxes payable Illustration 11-42  Cash Payments for Income Taxes: Income tax expense on the income statement was $36,000. Income taxes payable, however, increased $12,000, which means that $12,000 of the income taxes have not been paid. – Cash payments for income taxes were therefore $24,000 ($36,000 - $12,000).

104. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities Once again, to find net cash provided/used by investing and financing activities, determine the changes in the noncurrent accounts on the balance sheet. Those changes are then analyzed using selected transaction data to determine the effect, if any, the changes had on cash.

105. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities  Land: Land increased $100,000. The additional information indicates that common stock was issued to purchase the land. – Although the exchange of common stock for land has no effect on cash, it is a significant noncash investing and financing activity that must be disclosed.

106. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities  Equipment: The Equipment account increased $160,000 in 2000. The additional information provided, reveals that this was a net increase resulting from two transactions: (1) a purchase of equipment for $180,000 cash, and (2) a sale of equipment costing $20,000 for $17,000 cash when its book value was $18,000. – These are investing activities. The purchase of equipment should be shown as a $180,000 outflow of cash, and the sale of equipment should be shown as a cash inflow of $17,000. The two amounts should be shown separately, not netted.

107. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities  Bonds Payable: The Bonds Payable account increased by $90,000 when bonds were issued for cash. – This inflow of cash will be shown as a financing activity on the statement of cash flows.  Common Stock: The Common Stock account increased $100,000. As indicated earlier, land was acquired from this stock issuance. – This is a significant noncash financing and investing transaction that must be disclosed.

108. Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities  Retained Earnings: Retained Earnings increased by $52,000. The increase is the result of (1) net income of $84,000 that increased RE, and (2) dividends of $32,000 that decreased RE. – Net income is not reported on the cash flows statement under the direct method. – Payment of the dividends is a cash outflow that is reported as a financing activity.  Juarez Company’s cash flow statement for 2000 is shown on the next slide.

109. Juarez Company Statement of Cash Flows - Direct Method For the Year Ended December 31, 2000 Illustration 11-44 Cash flows from operating activities Cash receipts from customers$978,000 Cash payments: To suppliers$638,000 For operating expenses179,000 For income taxes 24,000 841,000 Net cash provided by operating activities 218,000 Cash flows from investing activities Purchase of equipment (180,000) Sale of equipment 17,000 Net cash used by investing activities(163,000) Cash flows from financing activities Issuance of bonds payable90,000 Payment of cash dividends (32,000) Net cash provided by financing activities 58,000 Net increase in cash32,000 Cash at beginning of period 159,000 Cash at end of period$ 191,000 Noncash investing and financing activities: Issuance of common stock to purchase land$100,000

110. Use the statement of cash flows to evaluate a company. Study Objective 5

111. Using Cash Flows to Evaluate a Company Traditionally, the ratios most commonly used by investors and creditors have been based on accrual accounting. In this section, some cash-based ratios that are gaining increased acceptance among analysts are introduced.

112. Using Cash Flows To Evaluate A Company Microsoft Corporation’s 1998 statement of cash flows provides information for the computations of these measures: Net cash provided by operating activities$6,880 Cash flows from investing activities Additions to PP&E$ (656) Other assets(190) Short-term investments (6,426) Net cash used by investing activities(7,272) Net cash provided by financing activities554 Microsoft Corporation Partial Statement of Cash Flows For the Year Ended 1998 ($ in millions) Illustration 11-46

113. Free Cash Flow  In the statement of cash flows, cash from operations is intended to indicate the cash-generating capability of the company.  However, cash from operations fails to take into account that a company must invest in new fixed assets just to maintain its current level of operations and it must at least maintain dividends at current levels to satisfy investors.  Free cash flow is the term used to describe the cash left from operations after adjustment for capital expenditures.

114. Free Cash Flow Free cash flow is often computed with the following formula (alternative definitions also exist): Net Cash Provided by Operating Activities Capital Expenditures Dividends Paid Free Cash Flow ––= Illustration 11-45 Microsoft’s free cash flow is calculated as shown below. (In as much detail as is available.) Net cash provided by operating activities$6,880 Less: Expenditures on PP&E(656) Dividends paid 0 Free cash flow$6,224 Illustration 11-47

115. Capital Expenditure Ratio  Another indicator of a company's ability to generate sufficient cash to finance new fixed asset purchases is the capital expenditure ratio.  It is computed with the formula shown below. Once again, Microsoft is used as an example. Net Cash Provided by Operating Activities Capital Expenditures Capital Expenditure Ratio  = $6,880 $656 10.49 times  =  Microsoft’s ratio of 10.49 times suggests that it could have purchased 10 times as much PP&E as it did without requiring any outside financing.

116. Assessing Liquidity, Solvency, and Profitability Using Cash Flows  Chapter 12 will present ratios used to analyze a company's liquidity, solvency, and profitability using accrual-based numbers from the income statement and balance sheet.  In this chapter we introduce ratios that are cash-based rather than accrual- based.  These ratios use numbers from the statement of cash flows instead of the income statement.

117. Assessing Liquidity, Solvency, and Profitability Using Cash Flows  Many analysts are critical of accrual- based numbers because they feel that the adjustment process allows too much management discretion.  One disadvantage to the cash-based measures is that, unlike the more commonly employed accrual-based measures, there are no readily available published industry averages for comparison.

118. Assessing Liquidity, Solvency, and Profitability Using Cash Flows  In the following discussion, Microsoft will be analyzed with cash-based ratios. The following information will be needed in addition to the cash flow information provided earlier: ($ in millions) 1998 1997 Current liabilities$ 5,730$ 3,610 Total liabilities5,7303,610 Sales14,48411,358 Illustration 11-49

119. Liquidity  Liquidity is the ability of a business to meet its immediate obligations.  You may be familiar with one measure of liquidity called the current ratio. (It will also be covered in Chapter 12.) – Current ratio equals current assets divided by current liabilities.  A disadvantage of the current ratio is that it uses year-end balances of current assets and current liabilities, which may not be representative of a company's position during most of the year.

120. Current Cash Debt Coverage Ratio  A ratio that partially corrects this problem is the current cash debt coverage ratio, computed by dividing cash flow from operations by average current liabilities.  Because cash from operations involves the entire year rather than a balance at one point in time, it is often considered a better representation of liquidity on the average day.

121. Current Cash Debt Coverage Ratio The current cash debt coverage ratio for Microsoft and Oracle (for comparison purposes) are given below. Each company's current ratio is also shown for comparative purposes. Net Cash Provided by Operating Activities Average Current Liabilities Current Cash Debt Coverage Ratio  = $6,880($5,730 + $3,610)/21.47 times  = ($ in millions) Microsoft Oracle Current ratio 2.77:1 1.74.1.73 times Microsoft’s net cash provided by operations is nearly 1- ½ times its average current liabilities. Oracle’s ratio of.73 times, though not a cause for concern, is substantially lower than Microsoft’s.

122. Solvency  Solvency is the ability of a firm to survive over the long term.  A measure of solvency that uses cash figures is the cash debt coverage ratio: the ratio of cash provided by operations to total debt as represented by average total liabilities.  This ratio measures a company's ability to repay its liabilities from cash generated from operations.

123. Cash Debt Coverage Ratio The cash debt coverage for Microsoft and Oracle for 1998 are given below. The debt to total assets ratio (an accrual-based solvency ratio) is also shown for comparison purposes. Net Cash Provided by Operating Activities Average Total Liabilities Cash Debt Coverage Ratio  = $6,880($5,730 + $3,610)/21.47 times  = ($ in millions) Microsoft Oracle Debt to total assets 26% 49%.56 times Microsoft has no long-term obligations so its cash debt coverage ratio is the same as its current cash debt coverage ratio. Oracle has long-term debt so its ratios are not as good as Microsoft’s. Neither company has a solvency problem, however.

124. Profitability  Profitability refers to a company's ability to generate a reasonable return.  Chapter 12 will introduce accrual-based ratios that measure profitability, such as gross profit rate, profit rate margin, and return on assets, if they are not already familiar to you.  A cash-based measure of performance is the cash return on sales ratio.

125. Cash Return on Sales Ratio  The cash return on sales ratio is computed by dividing cash from operations by sales.  The cash return on sales ratio indicates the company's ability to turn sales into dollars.  A low cash return on sales ratio should be investigated because it might indicate the company is recognizing sales that are not really sales – that is, sales it will never collect.

126. Cash Debt Coverage Ratio The cash return on sales ratios for Microsoft and Oracle for 1998 are given below. Oracle’s cash return on sales ratio of 22% is substantially less than Microsoft’s at 48%. This indicates that Microsoft is more efficient in turning sales into cash. Yet Oracle’s cash return on sales ratio is quite respectable. Net Cash Provided by Operating Activities Net Sales Cash Return on Sales Ratio  = $6,880$14,48448%  = ($ in millions) Microsoft Oracle 22% Illustration 11-52

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128. Chapter 11 Statement of Cash Flows