cornerstones of Financial Accounting, 3e

Chapter 11: The Statement of Cash Flows Cornerstones of Financial Accounting, 3e

The Role of the Statement of Cash Flows Information in a statement of cash flows helps investors, creditors, and others in the following ways: Assessing a company’s ability to produce future net cash inflows; Judging a company’s ability to meet its obligations and pay dividends LO-1

The Role of the Statement of Cash Flows Estimating the company’s needs for external financing; Understanding the reasons for the differences between net income and related cash receipts and cash payments; and Evaluating the balance sheet effects of both cash and noncash investing and financing transactions. LO-1

Cash Flow Classifications Because our focus is on cash flows, it is important to have a clear understanding of what is included in the term cash. For purposes of the statement of cash flows, cash includes both funds on hand (coins and currency) and cash equivalents. Cash equivalents are short-term, highly liquid investments that are readily convertible to cash and have original maturities of three months or less. LO-2

Cash Flow Classifications (cont.) Examples: Money market funds, investments in U.S. government securities (treasury bills) Cash equivalents are treated as cash in the statement of cash flows. During an accounting period, a company engages in the three fundamental business activities—operating activities, investing activities, and financing activities. Each of these activities can contribute to (a cash inflow) or reduce (a cash outflow) a company’s cash balance. LO-2

How the Statement of Cash Flows Links the Two Balance Sheets

Summary of the Classification of Cash Flows

Analyzing the Accounts for Cash Flow Data Unlike the balance sheet and the income statement, the statement of cash flows cannot be prepared by simply using information obtained from an adjusted trial balance prepared using the accrual basis of accounting. The accrual-basis numbers in the balance sheet and the income statement must be adjusted to a cash basis to understand why cash changed. LO-3

Cash Flow Classifications and Changes in the Balance Sheet Accounts

Preparing a Statement of Cash Flows To prepare a statement of cash flows, you need: Comparative balance sheets: Used to determine the changes in assets, liabilities, and stockholders’ equity during a period Current income statement: Used to determine cash flows from operating activities Additional information about selected accounts: Used to determine the reason why cash was received or paid LO-3

Preparing a Statement of Cash Flows (cont.) Five basic steps are required to prepare the statement of cash flows. Step 1: Compute the net cash flow from operating activities. Step 2: Compute the net cash flow from investing activities. Step 3: Compute the net cash flow from financing activities. LO-3

Preparing a Statement of Cash Flows (cont.) Step 4: Combine the net cash flows from operating, investing, and financing activities to obtain the net increase (decrease) in cash for the period. Step 5: Compute the change in cash for the period and compare this with the change in cash from Step 4. LO-3

Preparing Cash Flows from Operating Activities The cash flows from operating activities section of the statement of cash flows may be prepared using either of two methods: the direct method or the indirect method. LO-4

Preparing Cash Flows from Operating Activities In the direct method, cash inflows and cash outflows are listed for each type of operating activity that a company performs. These cash flows are generally computed by adjusting each item on the income statement by the changes in the related current asset or liability accounts. LO-4

Preparing Cash Flows from Operating Activities (cont.) The indirect method does not report individual cash inflows and outflows. Instead, it focuses on the differences between net income and operating cash flow. The indirect method begins with net income and then adjusts it for noncash items to produce net cash flow from operating activities. LO-4

Preparing Cash Flows from Operating Activities (cont.) Adjustments to net income are necessary for two reasons under the indirect method: to eliminate income statement items that do not affect cash (such as depreciation and gains/losses on sales of assets) and to adjust accrual-basis revenues and expenses to cash receipts and cash payments. LO-4

Preparing the Statement of Cash Flows Using The Indirect Method Under the indirect method, four types of adjustments must be made to net income to adjust it to net cash flow from operating activities: Add to net income any noncash expenses and subtract from net income any noncash revenues. Add to net income any losses and subtract from net income any gains. LO-4

Preparing the Statement of Cash Flows Using The Indirect Method Add to net income any decreases in current assets or increases in current liabilities that are related to operating activities. Subtract from net income any increases in current assets and decreases in current liabilities that are related to operating activities. LO-4

Calculate Cash Flow from Operating Activities/Indirect Method

Preparing Cash Flows from Investing Activities The second major section of the statement of cash flows reports the net cash flow from investing activities. Information for preparing the investing activities portion of the statement of cash flows is obtained from the investment and long-term asset accounts. LO-5

Preparing Cash Flows from Financing Activities The intent of the financing activities section of the statement of cash flows is to identify inflows and outflows of cash arising from business activities that either produced capital (long-term debt or stockholders’ equity) for the company or repaid capital supplied to the company. LO-6

Preparing Cash Flows from Financing Activities (cont.) Three basic steps are used to analyze financing activities: Step 1: Recreate the journal entries to describe the activities that took place during the period. Step 2: Record the cash flows as inflows or outflows of cash in the financing activities section of the statement of cash flows. Step 3: Analyze the account to make sure the account activity has been completely explained. LO-6

Using the Statement of Cash Flows Effective analysis of the statement of cash flows requires the following: an examination of the statement of cash flows itself, a comparison of the information on the current statement of cash flows with earlier statements, and a comparison of the information in the current statement of cash flows with information from other companies’ statements of cash flow. LO-7

Comparing the Statement of Cash Flows from Several Periods An analysis of the statement of cash flows also requires a comparison of the company’s current statement of cash flows with earlier statements of cash flow. Typically, several consecutive years should be analyzed in order to determine trends in cash inflows and cash outflows. Financial statement users rely on summary cash flow measures to help them make assessments. Free cash flow Cash flow adequacy LO-7

Free Cash Flows A company’s free cash flow represents the cash flow that a company is able to generate after considering the maintenance or expansion of its assets (capital expenditures) and the payment of dividends. Free Cash Flow = Net Cash Flow from Operating Activities – Capital Expenditures – Cash Dividends LO-7

Free Cash Flows (cont.) Free cash flow allows a company to pursue profit-generating opportunities. However, negative free cash flow is not necessarily a bad thing, but may indicate large investments in productive assets, which is good for a long-run strategy. LO-7

Cash Flow Adequacy Ratio A second useful measure is the cash flow adequacy ratio. The cash flow adequacy ratio provides a measure of the company’s ability to meet its maturing debt obligations and is calculated as: Cash Flow Adequacy = Free Cash Flow / Average Amount of Debt Maturing over the next 5 Years The cash flow adequacy ratio is also an indicator of whether the company has the capacity to borrow additional debt. LO-7

Comparing the Statement of Cash Flows to Similar Companies Finally, the analysis of the statement of cash flows requires comparisons with similar companies. Such comparisons provide good reference points because similar companies generally secure cash from similar sources and are likely to spend cash for similar activities. LO-7

Comparing the Statement of Cash Flows to Similar Companies (cont.) Comparative analysis can reveal significant deviations in the amounts of cash inflows, the source of those inflows, and the types of activities to which cash is applied. When significant differences are found among similar companies, explanations should be searched for in the other financial statements, notes accompanying the statements, or from management. LO-7

Appendix 11A: The Direct Method In the direct method of computing net cash flow from operating activities, inflows and outflows of cash are listed for each type of operating activity that a company performs. This involves adjusting each item on the income statement by the changes in the related current asset or liability accounts. Typical operating cash flows and adjustments necessary to compute them follow. LO-8

Appendix 11B: Using a Spreadsheet to Prepare The Statement of Cash Flows The use of a spreadsheet provides a means of systematically analyzing changes in the balance sheet amounts, along with the information from the income statement and any additional information, to produce a statement of cash flows. LO-9