Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Statement of Cash Flows Chapter 13

13-2 Understanding the Business Positive cash flows permit a company to... Expand its operations. Replace needed assets. Take advantage of market opportunities. Pay dividends to owners. Wall Street analysts consider cash flow an important indicator of a company’s financial health.

13-3 Learning Objectives Classify cash flow statement items as part of net cash flows from operating, investing, and financing activities.

13-4 Cash Currency Cash Equivalents Short-term, highly liquid investments. Readily convertible into cash. So near maturity that market value is unaffected by interest rate changes (i.e., less than 3 months to maturity). Short-term, highly liquid investments. Readily convertible into cash. So near maturity that market value is unaffected by interest rate changes (i.e., less than 3 months to maturity). Classifications of the Statement of Cash Flows

13-5 Classifications of the Statement of Cash Flows Operating Activities Cash inflows and outflows directly related to earnings from normal operations. Investing Activities Cash inflows and outflows related to the acquisition or sale of productive facilities and investments in the securities of other companies. Financing Activities Cash inflows and outflows related to external sources of financing (owners and creditors) for the enterprise.

13-6 Investing ActivitiesOperating ActivitiesFinancing Activities Sale of operational assets Sale of investments Collections of loans Cash received from revenues Issuance of stock Issuance of bonds and notes CASH INFLOWS Business CASH OUTFLOWS Purchase of operational assets Purchase of investments Loans to others Cash paid for expenses Payment of dividends Repurchase of stock Repayment of debt

13-7 Cash Flows from Operating Activities Inflows Cash received from: Customers Dividends and interest on investments Inflows Cash received from: Customers Dividends and interest on investments + Outflows Cash paid for: Purchase of goods for resale and services (electricity, etc.) Salaries and wages Income taxes Interest on liabilities Outflows Cash paid for: Purchase of goods for resale and services (electricity, etc.) Salaries and wages Income taxes Interest on liabilities _

13-8 Direct Method vs. Indirect Method Two Formats for Reporting Operating Activities Reports the cash effects of each operating activity Direct Method Starts with accrual net income and converts to cash basis Indirect Method Note that no matter which format is used, the same amount of net cash flows from operating activities is generated.

13-9 Cash Flows from Investing Activities + Inflows Cash received from: Sale or disposal of property, plant and equipment Sale or maturity of investments in securities Inflows Cash received from: Sale or disposal of property, plant and equipment Sale or maturity of investments in securities _ Outflows Cash paid for: Purchase of property, plant and equipment Purchase of investments in securities Outflows Cash paid for: Purchase of property, plant and equipment Purchase of investments in securities

13-10 Cash Flows from Financing Activities + _ Inflows Cash received from: Borrowings on notes, mortgages, bonds, etc. from creditors Issuing stock to owners Inflows Cash received from: Borrowings on notes, mortgages, bonds, etc. from creditors Issuing stock to owners Outflows Cash paid for: Repayment of principal to creditors (excluding interest, which is an operating activity) Repurchasing stock from owners Dividends to owners Outflows Cash paid for: Repayment of principal to creditors (excluding interest, which is an operating activity) Repurchasing stock from owners Dividends to owners

13-11 Boston Beer uses the indirect method. The indirect method is used by 98.3% of companies. This ending cash balance should agree with the balance sheet.

13-12 Relationships to the Balance Sheet and the Income Statement Information needed to prepare a statement of cash flows: Comparative Balance Sheets. Income Statement. Additional details concerning selected accounts. Information needed to prepare a statement of cash flows: Comparative Balance Sheets. Income Statement. Additional details concerning selected accounts.

13-13 Relationships to the Balance Sheet and the Income Statement  Cash =  Liabilities  Stockholders’ Equity  Noncash Assets Derives from... Assets = Liabilities  Stockholders’ Equity

13-14 Relationships to the Balance Sheet and the Income Statement

13-15 Learning Objectives Report and interpret cash flows from operating activities using the indirect method.

13-16 Reporting Cash Flows from Operating Activities—Indirect Method Net Income Cash Flows from Operating Activities - Indirect Method +/- Changes in current assets and current liabilities. + Losses and - Gains + Noncash expenses such as depreciation and amortization. The indirect method adjusts net income by eliminating noncash items.

13-17 Use this table when adjusting Net Income to Operating Cash Flows using the indirect method. Reporting Cash Flows from Operating Activities—Indirect Method

13-18 Reporting Cash Flows from Operating Activities—Indirect Method Use the following financial statements for The Boston Beer Company and prepare the Statement of Cash Flows for the quarter ended on March 27, 2004.

13-19

13-20 The Statement of Cash Flows will begin with Boston Beer’s Net income from the Income Statement.

13-21 Step 1 Adjust net income for depreciation and amortization expense.

13-22 (Remember, we showed the comparative balance sheets a few slides earlier.) Step 2 Adjust net income for changes in current assets and current liabilities.

13-23

13-24 Learning Objectives Report and interpret cash flows from operating activities using the direct method.

13-25 Reporting Cash Flows from Operating Activities—Direct Method

13-26 Reporting Cash Flows from Operating Activities—Direct Method

13-27 Remember that when we prepared the operating section using the indirect method, we also arrived at net cash inflow of $2,770.

13-28 Interpreting Cash Flows from Operating Activities Accounts Receivable Changes Managers sometimes attempt to boost declining sales by extending credit terms or by lowering credit standards. The resulting increase in accounts receivable can cause net income to outpace cash flows from operations. Inventory Changes Inventory growth can be a sign that planned sales growth did not materialize. A decline in inventory can be a sign that the company is anticipating lower sales in the next quarter.

13-29 Learning Objectives Analyze and interpret the quality of income ratio.

13-30 Quality of Income Ratio In general, this ratio measures the portion of income that was generated in cash. All other things equal, a higher quality of income ratio indicates greater ability to finance operating and other cash needs from operating cash inflows. Cash Flow from Operating Activities Net Income Quality of Income Ratio =

13-31 Learning Objectives Report and interpret cash flows from investing activities.

13-32 Here is the balance sheet we looked at earlier. Let’s focus on the investing accounts.

13-33 The balance sheet indicates that Equipment decreased by $170 during the quarter. If you had access to additional company information, you would discover that the company purchased $2,373 of new equipment. This is offset by $2,543 in depreciation expense (see the Cash Flows from Operating Activities). The balance sheet indicates that Equipment decreased by $170 during the quarter. If you had access to additional company information, you would discover that the company purchased $2,373 of new equipment. This is offset by $2,543 in depreciation expense (see the Cash Flows from Operating Activities).

13-34 Short-term investments increased by $4,627 during the quarter. Although short-term investments is a current asset, it is reported in the investing section on the statement of cash flows. Short-term investments increased by $4,627 during the quarter. Although short-term investments is a current asset, it is reported in the investing section on the statement of cash flows.

13-35 Learning Objectives Analyze and interpret the capital acquisition ratio.

13-36 In general, this ratio reflects the portion of purchases of property, plant and equipment financed from operating activities. A high ratio indicates less need for outside financing for current and future expansions. Capital Acquisition Ratio Cash Flow from Operating Activities Cash Paid for Property, Plant, and Equipment Capital Acquisition Ratio =

13-37 In general, this measures a firm’s ability to pursue long-term investment opportunities. Free Cash Flow Cash Flow from Operating Activities – Dividends – Capital Expenditures

13-38 Learning Objectives Report and interpret cash flows from financing activities.

13-39 Here is the balance sheet we looked at earlier. Let’s focus on the financing account.

13-40 The net increase in Contributed Capital of $1,184 was caused by two transactions. First, Boston Beer repurchased $4,409 of outstanding stock, which is a cash outflow. Second, the company issued common stock to employees for $5,593, which is a cash inflow. The net increase in Contributed Capital of $1,184 was caused by two transactions. First, Boston Beer repurchased $4,409 of outstanding stock, which is a cash outflow. Second, the company issued common stock to employees for $5,593, which is a cash inflow.

13-41 Interpreting Cash Flows from Financing Activities The long-term growth of a company is normally financed from three sources: internally generated funds, the issuance of stock, and money borrowed on a long- term basis. The statement of cash flows shows how management has elected to fund its growth. This information is used by analysts who wish to evaluate the capital structure and growth potential of a business.

13-42 Learning Objectives Explain the impact of additional cash flow disclosures.

13-43 Required Supplemental Information 1. Reconciliation of net income to cash flow from operations. 2. Cash paid for income taxes and interest. 3. Significant noncash investing and financing activities. Required Supplemental Information 1. Reconciliation of net income to cash flow from operations. 2. Cash paid for income taxes and interest. 3. Significant noncash investing and financing activities. Additional Cash Flow Disclosures Significant noncash investing and financing transactions do not involve cash. Example: Purchase of a building with a mortgage.

13-44 Chapter Supplement A Adjustment for Gains and Losses: Indirect Method

13-45 Adjustment for Gains and Losses Gains Gains must be subtracted from net income to avoid double counting the gain. Losses Losses must be added to net income to avoid double counting the loss. Transactions that cause gains and losses should be classified on the cash flow statement as operating, investing, or financing activities, depending on their dominate characteristics. For example, if the sale of equipment produced a gain, it would be classified as an investing activity.

13-46 Chapter Supplement B Spreadsheet Approach—Statement of Cash Flows: Indirect Method

13-47 Spreadsheet Approach The spreadsheet approach offers a systematic way to keep track of data. A spreadsheet is organized as follows: 1.Four columns to record dollar amounts are established (beginning balance, debit changes, credit changes, and ending balance). 2.On the far left of the top half of the spreadsheet, each account name from the balance sheet is entered. 3.On the far left of the top half of the spreadsheet, the name of each item that will be reported on the statement of cash flows is entered.

13-48 After entering all the transactions illustrated in the textbook, this is what the spreadsheet looks like.

13-49 End of Chapter 13