The Statement of Cash Flows Chapter 13 The Statement of Cash Flows

Amazon.com Founded in 1995, Amazon largest on-line merchandising company in the world one of the 500 largest companies in the US Strong cash flows to maintain growth and liquidity Cash provided by operations more than doubled from 2006 to 2007 Copyright © Cengage Learning. All rights reserved.

LO1 Statement of Cash Flows Shows how a company’s operating, investing, and financing activities have affected cash during an accounting period Explains the net increase or decrease in cash Cash may include: Cash Cash equivalents Money market accounts Commercial paper U.S. Treasury bills © Royalty Free PhotoDisc/ Getty Images Copyright © Cengage Learning. All rights reserved.

How Is the Statement of Cash Flows Used? Managers Investors and creditors assess the company’s ability to Evaluate financing decisions Evaluate investment decisions Determine dividend policy Assess liquidity Pay dividends and interest Pay its liabilities Generate positive future cash flows Manage cash flows Copyright © Cengage Learning. All rights reserved.

Classification of Cash Flows The statement of cash flows classifies cash receipts and cash payments into categories Operating Activities Investing Activities Financing Activities Copyright © Cengage Learning. All rights reserved.

Operating Activities Involve the cash inflows and outflows from activities that enter into the determination of net income Cash Inflows collect from customers Interest and dividends Cash Outflows Payments for: Purchase inventory Other expenses interest taxes Copyright © Cengage Learning. All rights reserved.

Investing Activities purchase and sale of property, plant, and equipment and other long-term assets, including investments (short-term and long-term), and the making and collecting of loans Cash Inflows sell investments Sell long-term assets Collections on loans Cash Outflows purchase assets Purchase investments lend to borrowers Copyright © Cengage Learning. All rights reserved.

Financing Activities Sell stock and provide stockholders with a return on their investments, and obtaining resources from creditors and repaying the amounts borrowed Cash Outflows Repayments of loans (excluding interest) cash dividends paid Purchase of treasury stock Cash Inflows sell stock issues borrowing Sale of treasury stock Copyright © Cengage Learning. All rights reserved.

Noncash Investing and Financing Transactions Significant transactions that involve only long-term assets, long-term liabilities, or stockholders’ equity Noncash examples: Exchange long-term asset for long-term liability convert debt to stock Purchase long-term asset with long-term debt Not reflected on the statement of cash flows; no cash inflows or outflows Future cash flows are affected, so required to disclose these transactions in a separate schedule or at the bottom of the statement Copyright © Cengage Learning. All rights reserved.

Format of the Statement of Cash Flows 1 Operating Activities section Indirect method starts with net income and ends with cash flows from operating activities 2 Investing Activities section Cash transactions involving capital expenditures 3 Financing Activities section Debt, cash stock transactions, dividends, and treasury stock transactions 4 Reconciliation of beg. and end. balances of cash Ties to cash balances of the balance sheet Copyright © Cengage Learning. All rights reserved.

Ethics and Cash Flows How might companies misrepresent cash flows? Managers are are often tempted to manipulate the presentation of certain transactions to make cash flow look better. By classifying payments of operating expenses as investments on the statement of cash flows, a company can show an improvement in cash flows from operations How might companies misrepresent cash flows? By not disclosing the financing of accounts receivables on the statement of cash flows, the company makes collections of account receivables look better than they actually are Copyright © Cengage Learning. All rights reserved.

Discussion: Ethics on the Job Boxcar Industries, a small upstart company, was having cash flow difficulties. Payroll was due to employees in one week, invoices were due to vendors, and there was not enough cash to cover both. The CEO considered telling employees that payroll would be late or slowing down payments to vendors. He also considered a more aggressive collection effort on the company’s accounts receivables. Q. What do you think of the options? Do any of the options strike you as more or less ethical than others? Copyright © Cengage Learning. All rights reserved.

Stop & Review Q. The proceeds from trading securities should be categorized in which section of the statement of cash flows? A. Operating activities Copyright © Cengage Learning. All rights reserved.

Stop & Review Q. In which section of the statement of cash flows would the payment of dividends be classified? A. Financing activities Copyright © Cengage Learning. All rights reserved.

Stop & Review Q. What are the three classifications of cash flows? A. Operating activities, investing activities, financing activities Copyright © Cengage Learning. All rights reserved.

LO2 Cash-Generating Efficiency (CGE) Shows the company’s ability to generate cash from its current or continuing operations used to calculate CGE: Cash flow yield Cash flows to sales Cash flows to assets Copyright © Cengage Learning. All rights reserved. 16

Cash Flow Yield Shows how much of net income actually results in operating cash inflows Amazon.com’s operating activities were generating about $3 of cash for every dollar of net income Copyright © Cengage Learning. All rights reserved. 17

Amazon.com generated positive cash flows to Cash Flows to Sales Shows how much of net sales actually results in cash inflows * * Rounded Amazon.com generated positive cash flows to sales of 9.5 percent or in other words that every dollar of sales generates 9.5 cents in cash Copyright © Cengage Learning. All rights reserved. 18

Cash Flows to Assets Shows how much cash is being generated by operations for each dollar of assets * *Rounded Copyright © Cengage Learning. All rights reserved. 19

Free Cash Flow Amount of cash that remains after deducting the funds a company must commit to continue operating at its planned level Net Cash Flows from Operating Activities – Dividends – Purchases of Plant Assets + Sales of Plant Assets Free Cash Flow Copyright © Cengage Learning. All rights reserved. 20

Free Cash Flow analysis If positive, the company Has met all of its planned cash commitments Has cash available to reduce debt or expand If negative, to continue at its planned level of operation, the company will have to Sell investments Borrow money Issue stock in the short term Copyright © Cengage Learning. All rights reserved. 21

Stop & Review Q. What does the cash flow yield ratio show? How is it calculated? A. Shows how much of net income actually results in operating cash inflows. Divide net cash flows from operating activities by net income. Copyright © Cengage Learning. All rights reserved. 22

Stop & Apply Q. Trentco Company demonstrated a cash flow to sales ratio of 9.4 percent. What does this mean? What amounts were needed to calculate this ratio? A. The company generated positive cash flows to sales of 9.4 percent. Net sales and net cash flows from operating activities were needed to make the calculation. Copyright © Cengage Learning. All rights reserved. 23

Stop & Review Q. Why is positive free cash flow important? The company has demonstrated that it can meet all planned cash commitments and has cash available to reduce debt or to expand. Copyright © Cengage Learning. All rights reserved. 24

LO3 Cash Flows from Operating Activities There are two methods of converting the income statement from an accrual basis to a cash basis: The direct method Adjusts each item on the income statement to its cash equivalent More easily understood by the average reader The indirect method Lists adjustments to net income to net cash flows Superior from an analyst’s perspective Used by most companies Both methods produce the same net figure Copyright © Cengage Learning. All rights reserved. 25

Depreciation expense added back to net income Depreciation expense appears on the income statement, but involves no outlay of cash Adjustment: Depreciation expense added back to net income for the period Copyright © Cengage Learning. All rights reserved. 26

Gain/Losses subtracted and added to net income Gains and Losses Do not affect cash flows from operating activities; should be removed from net income Adjustments: Gain/Losses subtracted and added to net income for the period Copyright © Cengage Learning. All rights reserved. 27

Treatment of Noncash Items Add to or Deduct from Net Income Depreciation Expense Add Amortization Expense Depletion Expense Losses Gains Deduct Copyright © Cengage Learning. All rights reserved. 28

Changes in Current Assets Example: Laguna Corporation’s Accounts Receivable decreased by $8,000 as illustrated below. Accounts Receivable Beg. Bal. 55,000 End. Bal. 47,000 Cash Receipts from Customers Sales to Customers 698,000 706,000 The $8,000 decrease in Accounts Receivable should be added to net income on the statement of cash flows. Changes Sales to collections from customers Copyright © Cengage Learning. All rights reserved. 29

Change net income into cash income Decreases in current liabilities are subtracted from net income < > Decreases in current assets are added to net income + Increases in current assets are subtracted from net income < > Increases in current liabilities are added to net income +

Changes in Current Liabilities Example: Laguna Corporation’s accounts payable increased by $7,000 as illustrated below. Accounts Payable Beg. Bal. 43,000 End. Bal. 50,000 547,000 Cash Payments to Suppliers 554,000 Purchases The $7,000 increase in Accounts Payable should be added to net income on the statement of cash flows because more money was paid out than COGS. Copyright © Cengage Learning. All rights reserved. 31

Net Income versus Cash Flows from Operating Activities A net income of $16,000, after adjustments, actually yielded $30,000 in positive cash flows from operating activities Copyright © Cengage Learning. All rights reserved. 32

Adjustments for Changes in Current Assets and Liabilities Add to Net Income Deduct from Current Assets: Accounts receivable (net) Decrease Increase Inventory Prepaid expenses Current Liabilities: Accounts payable Accrued liabilities Income taxes payable Copyright © Cengage Learning. All rights reserved. 33

Stop & Review Q. If New Horizons Company had a decrease in its Accounts Payable balance of $2,750, how should this amount be treated in the operating activities section of the statement of cash flows? A. The amount should be deducted from net income. Copyright © Cengage Learning. All rights reserved. 34

Stop & Review Q. Why is depreciation expense added back to net income in the operating activities section of the statement of cash flows? A. Depreciation expense is a noncash item that has reduced net income. Thus, it must be added back to arrive at a true amount for cash flows from operating activities. Copyright © Cengage Learning. All rights reserved. 35

LO4 Examining Investment Transactions To determine cash flows from investing activities, accounts involving cash receipts and cash payments from investing activities are examined individually investments Property, Plant & Equip intangibles Copyright © Cengage Learning. All rights reserved. 36

Investment Transactions Cash Flows Illustrated Laguna Corporation’s purchases of investments totaled $78,000 during 2010. These transactions, caused a $78,000 decrease in cash flows (cash paid). Laguna sold investments that cost $90,000 for $102,000. This transaction resulted in a gain of $12,000 and caused an increase in cash flows of $102,000 (cash received) . Investing activities section, statement of cash flows: Purchase of investments ($78,000) Sale of investments 102,000 Copyright © Cengage Learning. All rights reserved. 37

Plant Asset Transactions Cash Flows Illustrated Laguna Corporation purchased plant assets totaling $1200,000. These transactions, caused a $120,000 decrease in cash flows (cash paid). Laguna sold plant assets that cost $10,000 and that had accumulated depreciation of $2,000 for $5,000. This transaction resulted in a loss of $3,000 and caused an increase in cash flows of $3,000 (cash received) . Investing activities section, statement of cash flows: Purchase of plant assets ($120,000) Sale of plant assets 5,000 Copyright © Cengage Learning. All rights reserved. 38

Cash Flows from Investing Activities The transactions for Laguna Corporation we have examined are listed below on its statement of cash flows in the investing activities section: Copyright © Cengage Learning. All rights reserved. 39

Noncash Transaction Illustrated Laguna Corporation issued bonds at face value ($100,000) for plant assets. There are no cash inflows or outflows, but it is a significant transaction. © Royalty Free/ Corbis Schedule of Noncash Investing and Financing Transactions: Issue of bonds payable for plant assets $100,000 Copyright © Cengage Learning. All rights reserved. 40

Stop & Review Q. What types of accounts should be examined when determining the cash flows related to investments? A. Long-term investments, short-term investments, plant assets, investment gains or losses, depreciation accounts Copyright © Cengage Learning. All rights reserved. 41

Stop & Apply Q. If a company purchases a plant asset for $25,000, how will this be reflected on the statement of cash flows? Investing activities section: Purchase of plant asset ($ 25,000) Copyright © Cengage Learning. All rights reserved. 42

LO5 Examining Financing Transactions To determine cash flows from financing activities, accounts involving cash receipts and cash payments from financing activities are examined individually Short-term borrowings Long-term liabilities Stockholders’ equity Copyright © Cengage Learning. All rights reserved. 43

Bonds Payable Transactions Cash Flows Illustrated Laguna Corporation repaid $50,000 of bonds at face value at maturity. This transaction caused a $50,000 decrease in cash flows (cash paid). © Royalty Free PhotoDisc/ Getty Images Financing activities section, statement of cash flows: Repayment of bonds ($50,000) Copyright © Cengage Learning. All rights reserved. 44

Common Stock Transactions Cash Flows Illustrated Laguna Corporation issued 15,200 shares of $5 par value common stock for $175,000. The Common Stock account increased by $76,000, and the Additional Paid-in Capital account increased by $99,000. This transaction caused an $175,000 increase in cash flows (cash received). Financing activities section, statement of cash flows: Issue of common stock $175,000 Copyright © Cengage Learning. All rights reserved. 45

Dividend Transactions Cash Flows Illustrated Laguna Corporation paid cash dividends in the amount of $8,000. This amount decreased Retained Earnings. This transaction caused a $8,000 decrease in cash flows (cash paid). © Royalty Free PhotoDisc/ Getty Images Only the payment of dividends appears on the statement of cash flows, not the declaration of dividends. Financing activities section, statement of cash flows: Payment of dividends ($8,000) Copyright © Cengage Learning. All rights reserved. 46

Treasury Stock Transactions Cash Flows Illustrated Laguna Corporation purchased treasury stock for $25,000. This transaction created a cash outflow of $25,000. Financing activities section, statement of cash flows: Purchase of treasury stock ($25,000) Copyright © Cengage Learning. All rights reserved. 47

Cash Flows from Financing Activities The transactions of Laguna Corporation that we have examined are presented in the financing section of the statement of cash flows: Copyright © Cengage Learning. All rights reserved. 48

Statement of Cash Flows All three sections are presented in summary form here, followed by the net increase or decrease in cash: Copyright © Cengage Learning. All rights reserved. 49

Stop & Review Q. Name at least three types of transactions that would be considered financing activities. A. Repayment of bonds payable, issuance of stock, purchase of treasury stock, payment of dividends Copyright © Cengage Learning. All rights reserved. 50

Chapter Review Problem Taylor Corporation had net income of $122,435 for the year ended Dec. 31, 20x7. The following data was taken from the company’s income statement: Depreciation expense, $1,400; Loss on sale of plant asset, $1,500. The general ledger reflected an increase in Accounts Payable of $4,000 and a decrease in Accounts Receivable of $1,200 during the year. Taylor sold a plant asset that cost $4,000 with accumulated depreciation of $500 for $2,000. The company also issued 5,000 shares of $5 par value common stock for $32,000. Cash and cash equivalents at the beginning of the year were $14,459. Required: Prepare the statement of cash flows using the indirect method. Copyright © Cengage Learning. All rights reserved. 51

Taylor Corporation Statement of Cash Flows for the Year Ended December 31, 20x7 Copyright © Cengage Learning. All rights reserved. 52