STATEMENT OF CASH FLOW1 A Teaching Note

The Statement of Cash Flow (SCF) contains a summary of the transactions entered into by a company over a period of time that involve the cash account. The SCF provides information about a companys ability to generate cash and the effectiveness of its cash management by explaining the change in the cash balance over a period of time. The Statement of Cash Flow (SCF) is a derivative financial statement. This statement is derived from an income statement and (at least) the two balance sheets surrounding the period covered by the income statement. Since cash is the life blood! of the firm" the SCF is an important diagnostic tool for the financial manager. #mportantly" this statement provides important insights into which financial ratios need to be calculated to assess the strengths and wea$nesses of the firm The SCF is a relatively new addition to the set of financial accounting statements re%uired under generally accepted accounting principles. The statement was established as a standard of financial reporting in &'() and modified the statement of changes in financial position (the sources and uses of funds statement) which had been re%uired since &')&. Cash in the context of the SCF is defined as coin" currency" and available funds on deposit at the ban$. #n addition" negotiable instruments li$e money orders" certified chec$s" cashiers chec$s" personal chec$s" commercial paper and other debt investments with maturities of less than three months are also considered as cash. These accounts are aggregated and appear as cash! on the firms balance sheet. The SCF is designed to highlight the cash flows associated with three critical aspects of a companys economic activities* +perations" #nvestments" and Financing.

,uestions li$e the following can be answered by referring to the SCF* -hy is the companys cash balance increasing. +r why is it decreasing. -hat portion of the companys cash was generated through operations" the sale of investments" or the issuance of debt and/or e%uity securities. -hat portions of the companys cash payments go toward supporting operations" capital investments" repayment of debt" purchasing treasury stoc$" and dividends.

An important source of material for this teaching note is Intermediate Accounting , Revised Edition, Chapter 23, by Dyckman, Dukes and Davis.
1

2 The economic conse%uences associated with the SCF results primarily from investors" creditors" and other interested parties using it to assess the investment potential and creditworthiness of a company and the e%uity and debt securities they issue. 0 recent Forbes maga1ine article suggests that many analysts feel cash flow information is a (the) critical parameter in firm evaluation and even more important than net income. Forbes also noted that financial advisers are basing their analysis increasingly on cash flow. 0n investor who ignores cash flow in analy1ing stoc$s is being deprived of one of the most valuable tools in an arsenal of information. #f investors had relied more heavily on cash flow numbers" famous ban$ruptcies such as -.T. 2rant" 3enn Central" Sambos 4estaurants" 05 #nternationals" and -ic$s might have been foreseen much earlier than they were. The basic structure of the SCF is as follows* Cash provided (used) by operating activities. Cash provided (used) by investing activities. Cash provided (used) by financing activities. #ncrease (decrease) in cash. Cash6beginning of the period. Cash6end of period.

#n the philosophy that a picture is worth a thousand words"! lets go through the exercise of constructing a SCF.

EXAMPLE: STATEMENT OF CASH FLOW FOR THE ABC CORP. THE ABC CORPORATION BALANCE SHEETS

0ssets Cash 0ccounts 4eceivable #nventories Fixed 0ssets Bess* ;epreciation T+T0B 0SS9TS Biabilities and Det -orth 0ccounts 3ayable 0ccrued Taxes 7an$ Boan BongEterm ;ebt (i.e." 7onds) Common Stoc$ at 3ar (?> shares) Capital Surplus 4etained 9arnings T+T0B B#07#B#T#9S 0D; D9T -+4TF

7egin 8ear :anuary & = (>> &"?>> ?">>> @">>> (?")>>) = C"<>>

9nd 8ear ;ecember <& = &"&>> &">>> &"(>> <"A>> (?"C>>) = C">>>

= &"&>> @>> C>> &"?>> &>> &>> &"'>> = C"<>>

'>> <>> <>> &">>> &C> &C> ?"?>>

= C">>>

4 EXAMPLE: STATEMENT OF CASH FLOW THE ABC CORPORATION INCOME STATEMENT

Sales 9xpenses including ;epreciation and #nterest +perating 3rofit before Taxes +ther #ncome 9arnings before Taxes Tax Biability Det #ncome after Taxes ;ividends (=A>/share) 4etentions Dotes*

= C">>> (<">>>) ?">>> C>> ?"C>> (&">>>) &"C>> (&"?>>) = <>>

(&) +ther income arose from the sale of a capital asset originally valued at =(>>" which had been depreciated to the extent of =@>>. 0 tax liability of =&>> arose from this transaction. (?) ;epreciation expense for the year was =?>>. (<) Ten shares of =C par value common stoc$ were issued during the year. (@) ;ividends were paid prior to the issue of new stoc$.

5 STATEMENT OF CASH FLOW THE ABC CORPORATION Operating Activitie : Det 9arnings from +perations (or +perating #ncome) ;epreciation ;eferred Taxes (or Tax 0ccruals) Changes in -or$ing Capital 0ccounts 0ccounts 4eceivable #nventory 0ccounts 3ayable 0ccrued 9xpenses T!ta" Ca # $r!% Operati!n Inve ting Activitie : 0c%uisition of Fixed 0ssets Sale of Fixed 0ssets" Det of Tax T!ta" Ca # $r!% Inve ting Activitie Financing Activitie : 4etirement of BongEterm ;ebt 4etirement of 7an$ Boan #ssuance of BongEterm ;ebt #ssuance of ShortEterm Dotes (including ban$ loans) ;ividends 4epurchase of Stoc$ #ssuance of Stoc$ T!ta" Ca # F"!& $r!% Financing Activitie C#ange in Ca # (?>>) (?>>) EEE EEE (&?>>) EEE &>> (&C>>) <>> (@>>) (>> GGGGGG @>> &&>> ?>> (&>>) ?>> ?>> (?>>) EEE GGGGGG &@>>

NOTES: 7efore Tax 9arnings from +perations Tax on +perating 9arnings 0fter Tax 9arnings from +perations Fixed 0ssets 7eginning 2ross Fixed 0sset Bess* -riteEoff of 7H of +ld Fixed 0sset 2ross Fixed 0ssets without 9xpenditures 9nding 2ross Fixed 0sset 9xpenditure ;epreciation 7eginning ;epreciation -riteEoff of 0ssets ;epreciation 2ross ;epreciation w/o 0ssets ;epreciation 9nd ;epreciation ;epreciation 9xpense Sale of Fixed 0sset Cash from Sale Bess* Taxes 3aid on Sale Det from Fixed 0sset Sale ?>>> ('>>) &&>>

@>>> ((>>) <?>> <A>> @>>

(?)>>) @>> (?<>>) (?C>>) ?>>

'>> (&>>) (>>