Financial Accounting and Analysis

MSc in Finance
Overview of The Statement of Cash Flows

Fall 2021
 Financial
Accounting
and
Analysis

COURSE OVERVIEW
 Course Material
1. The Statement of Cash Flows
a) Purpose of The Statement of Cash Flows
b) Structure of The Statement of Cash Flows
c) Preparation of The Statement of Cash Flows

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 Purpose of The Statement of Cash Flows
• The statement of cash flows provides information about a company’s cash receipts and cash
payments during an accounting period
 Among other things, the statement of cash flows provides:
1) Reconciliation between reported income (accrual-basis) and cash flows from all of
the company’s activities (cash-basis);
2) Reconciliation of the beginning and ending cash on the balance sheet

• In addition to information about cash generated or used in operating activities, the statement of
cash flows provides information about:
 Cash provided (or used) in a firm’s investing and financing activities;
 This information (sources of cash) is crucial to analysts because, in theory:
 generating cash from operations can continue indefinitely; but
 generating cash from selling assets (investing area) is possible only as long as there
are assets to sell; and, similarly
 generating cash from debt financing (financing area) is possible only as long as
lenders are willing to lend*

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 Purpose of The Statement of Cash Flows
• In summary, information about the sources and uses of cash helps creditors, investors, and other
statement users evaluate the company’s:

 Liquidity: company’s ability to meet short-term obligations;

 Solvency: company’s ability to meet long-term obligations;
 Financial flexibility: company’s ability to react and adapt to financial adversities and
opportunities

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 Structure of The Statement of Cash Flows
• Classification of companies’ activities: Company’s day-to-day
activities strictly related to
the core-business.
Additionally, operating
activities may include cash
inflows/outflows related to
OPERATING* dealing/trading securities

Include purchase and

disposal of long-term assets
and other investments (e.g.,
PP&E, intangibles, etc.).
INVESTING* Cash inflows include cash
receipts from the sale of
nontrading securities.

Include obtaining or
FINANCING repaying capital. Indirect
borrowing using accounts
payables is not considered a
financing activity; such
borrowing is classified as an
operating activity

ACTIVITIES
*Under IFRS, (i) interests and dividends received may be classified either as an operating or as an investing activity, whereas (ii)
interests and dividends paid may be classified either as an operating or as a financing activity

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 Structure of The Statement of Cash Flows
Collections from customers
Receipts of interests & dividends
Sale of short-term investments
Other operating receipts
Sale of PP&E
Sale of long-term investments
Collections of loans from others
Issuance of shares
Sale of treasury shares
Proceeds from loans & borrowings
Payment to suppliers
Payments to employees
Operating
Payments of interest & income tax
Activities
Purchase of short-term investments
Other operating payments
Acquisition of PP&E
Investing
Purchase of long-term investments
Activities
Making loans to others
Payment of dividends
Financing Repurchase of shares
Activities Purchase of treasury shares
Payment of debt principal
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 Structure of The Statement of Cash Flows
• There are two accepted formats for reporting cash flows from operating activities (also known as
operating cash flows):
1) The direct method shows the specific cash inflows and outflows that result in reported
cash flows from operating activities. The main arguments in favor of the direct approach are
that:
a) it provides information on the specific sources of operating cash receipts and
payments;
b) it is useful in understanding historical performance and in predicting future operating
cash flows
2) The indirect method begins with net income. To reconcile it with operating cash flows,
adjustments are made for:
• non-cash items;
• non-operating items; and
• net changes in working capital
• The main arguments in favor of the indirect approach are that:
a) it shows the reasons for differences between net income and operating CF;
b) it mirrors a forecasting approach by forecasting future income and then derives cash
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flows by adjusting for changes in balance sheet accounts
 Structure of The Statement of Cash Flows
• Let’s consider Danone’s statement of cash flows:

Indirect
method

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 Structure of The Statement of Cash Flows
• Let’s consider Danone’s statement of cash flows:

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 Preparation of The Statement of Cash Flows
• The statement of cash flows is prepared from the company’s income statement and comparative
balance sheets

Revenue(s)

Expenses IS

Net income
Operating BS
cash flows
Operating
Current assets Current liabilities cash flows

Long-term liabilities
Financing
Investing Long-term assets cash flows
cash flows
Owners’equity
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 Preparation of The Statement of Cash Flows
• Recall the accounting equation that is central to the balance sheet:
Assets = Liabilities + Equity
 Cash (& cash equivalents) is an asset
• The statement of cash flows ultimately shows the change in cash during an accounting period
(whatever the format):
 The beginning and ending balances of cash are shown on the company’s BS for the
previous and current years;
 The bottom of the statement of cash flows reconciles beginning with ending cash

Beginning BS Statement of Cash Flows Ending BS

Beginning cash Plus: cash receipts Less: cash payments Ending cash

• Because a company’s operating activities are reported on an accrual basis in the income
statement:
 Any differences between the accrual basis and the cash basis of accounting for operating
transactions result in an increase/decrease in some (usually) short-term asset or liability on
the BS

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 Preparation of The Statement of Cash Flows
• Using the indirect method to report CF from operating activities requires to:
 Reconcile a company’s net income to its operating cash flow. To perform this reconciliation,
net income is adjusted for the following:
a) any non-operating activities (e.g., gain or loss on disposal of PP&E);
b) any non-cash expenses (e.g., D&A); and
c) changes in operating WC items
• Changes in WC accounts include increases and decreases in the current operating asset and
liability accounts
 The changes in these accounts arise from applying accrual accounting*;
 To make the WC adjustments under the indirect method:
a) any increase/decrease in a current operating asset account is subtracted/added from
net income;
b) any increase/decrease in a current operating liability account is added/subtracted
from net income

*That is, recognition of revenues when they are earned and expenses when they are incurred, instead of when the cash is
received or paid 13
 Preparation of The Statement of Cash Flows

Net Income

Depreciation, Depletion & Amortization

Gains on sales of Losses on sales of

long-term assets long-term assets

Increases Decreases Decreases Increases

in current in current in current in current
assets liabilities assets liabilities
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 Preparation of The Statement of Cash Flows
• The second step in preparing the statement of cash flows is to determine the total cash flows from
investing activities
 The presentation of this information is identical, regardless of whether the direct or indirect
method is used for operating cash flow
 These cash flows (from investing operations) are typically represented by purchases and
sales of PP&E and other long-lived asset
• CASH RECEIVED FROM DISPOSAL OF PP&E*:
 To determine the cash inflow from the disposal of PP&E, it is necessary to consider three
pieces of information: (i) historical cost, (ii) accumulated depreciation, and (iii) gain/loss on
the sales (from the IS). The cash inflow is then determined as follows:
+ Historical cost of PP&E sold
- Accumulated depreciation on PP&E sold
= Book value of PP&E sold
+/- Gain/loss on disposal of PP&E (from the IS)
= Cash received from disposal of PP&E

*The cash outflow from the purchase of PP&E is the overall cost of PP&E acquired, less the increase in accounts payable due to
the purchase 15
 Preparation of The Statement of Cash Flows
• The third step in preparing the statement of cash flows is to determine the total cash flows from
financing activities
 The presentation of this information is identical, regardless of whether the direct or indirect
method is used for operating cash flows. These cash flows (from financing operations) are
typically represented by issue/reimbursement of short/long-term debt and equity capital, and
dividends
• DEBT AND EQUITY:
 For the purposes of the preparation of the statement of cash flows, issue/reimbursement of
new/existing debt/equity capital is a cash inflow/outflow relating to financing activities
• DIVIDENDS PAID:
 Recall that: Beginning RE + Net Income – Dividends = Ending RE
 Based on this relationship, the amount of cash dividends paid can be determined as follows:
+ Beginning balance of retained earnings
+ Net income
- Ending balance of retained earnings
= Dividends paid*

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*Note that dividends paid are also disclosed in the statement of changes in equity