The Statement of Cash Flows

Learning Objectives
By the end of this chapter, you should be able
to:
• Describe the kinds of information disclosed
by the statement of cash flows.
• List the three key areas of cash flows dis-
closed in a statement of cash flows.
• Identify and describe the two accepted state-
ment of cash flows formats.
• Explain the free cash flow concept

INTRODUCTION
A balance sheet (or statement of financial position, as it is often called) is a snap-
shot of the amounts of assets, liabilities, and owners’ equity at a specific mo-
ment in time. Balance sheets are prepared at least annually, often quarterly,
and even perhaps as often as monthly. An income statement is a summary of
revenues and expenses that covers a period of time, such as a year, a quarter,
or a month.
Although the balance sheet and income statement are prepared period-
ically and do disclose much about the condition of a company and its recent
earnings history, they do not tell the statement user much about how the com-
pany manages cash. Since cash flow is what companies use to pay bills and re-
ward the owners with dividends, cash activity is very important and is
summarized in the statement of cash flows, a statement that is required to be
issued along with the balance sheet and income statement.
This chapter explains the format and objectives of the statement of cash
flows, as required by FASB 95. FASB 95 was issued in 1987 by the Financial
Accounting Standards Board and superseded APB 19, which had been in place
83
 THE STATEMENT OF CASH FLOWS 84

for many years and stipulated how to prepare cash flows statements (previ-
ously called statement of sources and uses of cash). Please note that FASB 95 was
subsequently amended by SFAS No. 102 and 104.
In the sections that follow, we examine the two ways of preparing the
statement of cash flows.

THE USEFULNESS OF THE STATEMENT OF

CASH FLOWS
An investor, creditor, or other interested person needs to know how an or-
ganization got where it is and to predict what its prospects are for the reason-
ably near future. There are two reasons why an income statement does not
represent an adequate source of data for this purpose. First, an income state- ment
contains estimates and assumptions that are of a noncash nature. Such estimates
tend to be mixed in with the actual cash-generating and cash-dis- bursing
activities of the business; this mixture is not readily apparent when simply
examining the income statement.
Second, an income statement is most often prepared on an accrual basis.
As such, many of the figures (perhaps significant percentages of various ac-
counts) are far removed from actual cash flow.
The statement of cash flows provides the statement user with an insight into
the planning, decision making, and success of management in handling many
of the actions relating to cash. It also helps answer these important questions:
1. What amount of cash was generated and used by operations?
2. What was the source of cash invested in new plant and equipment?
3. How was the cash raised? From issuing stock or floating a bond?
4. Why, despite a healthy net income, was the cash balance lower than the
previous period?
5. How was the company able to pay dividends?
The purpose of the statement of cash flows is to summarize the results
of the other interrelated financial statements for the current period and to
present reasons for the inflows and outflows of cash.

THE NATURE OF THE STATEMENT OF

CASH FLOWS
The statement of cash flows summarizes the firm’s many sources and major
uses of cash in three key areas during a period of time:
1. Cash flows from operating activities. These are cash flows from day-to-day,
income-producing activities. They include the activities that are not in the
categories of investing and financing, described in the following section.
2. Cash flows from financing activities. These include issuance of capital stock,
debt securities, dividend payments, repayment of debt, and purchase of
treasury stock.
 THE STATEMENT OF CASH FLOWS 85

3. Cash flows from investing activities. These include purchases and sales of pro-
ductive assets and other companies’ debts (bonds and notes) and equity
(common and preferred stocks issued by other companies).
Each of these three key areas is presented in a different section of the
statement of cash flows. The following outline details the major items in each
of the three sections. Please note that the outline contains examples of items
to be found in each section (operating, financing, and investing) but is not in-
tended to be all-inclusive.
A. Cash Flows from Operating Activities (covers all transactions not detailed in
the specifics of investing or financing activities)
1. Cash Inflows
(a) Sales of goods and services for cash and the collection of accounts
receivable
(b) Interest and dividends received on investments
2. Cash Outflows
(a) Purchases of materials and supplies
(b) Employee compensation
(c) Taxes
(d) Interest on borrowed money
B. Cash Flows from Financing Activities
1. Cash Inflows
(a) Issuing (selling) more common or preferred stock
(b) Issuing bonds, notes, and mortgages
2. Cash Outflows
(a) Dividends of common or preferred stock paid to owners
(b) Principal payments on bonds, notes, and mortgages
(c) Buying of stock for treasury purposes
C. Cash Flows from Investing Activities
1. Cash Inflows
(a) Sale of property, plant, and equipment
(b) Sale of a portion of the business, such as a division
(c) Sale of securities (investments)
2. Cash Outflows
(a) Acquisition of property, plant, and equipment
(b) Making loans to another organization
(c) Purchase of securities (investments)

Significant Noncash Financing and Investing Activities

In addition to the financing and investing activities, noncash financing
and investing activities, if significant, must be disclosed in a supplemental
schedule or reported in the footnotes to the statement of cash flows. For ex-
ample, the exchange of shares of $100,000 of stock for land valued at
$100,000, although not a cash transaction, could have a significant effect on
future cash flows and thus is a noncash financing and investing activity that
 THE STATEMENT OF CASH FLOWS 86

should be disclosed in the statement of cash flows. Other examples of signif-

icant noncash financing and investing activities include:
• Conversions of debt to equity
• Exchanges of assets for other assets
• Receipt of donated property

Answers appear at the end of this chapter.

1. Classify each of the following as either:

O. Operating Activity
F. Financing Activity
I. Investing Activity
N. Noncash Financing or Investing Activity
A. A company sold $100,000 of common stock to investors.
B. A company used $150,000 to acquire 10,000 shares of its own stock.
C. A company collected cash from its customers for goods sold and services provided.
D. A company purchased a factory for $1.5 million in cash.
E. A company purchased a factory for $1.5 million worth of its preferred stock.
F. A publishing company paid $50,000 cash for a copyright.

STATEMENT OF CASH FLOWS: FORMAT

ALTERNATIVES
FASB allows two alternative formats for the statement of cash flows. One
method is called the direct method; the other is called indirect. Although FASB
allows either method, it recommends the direct method.

The Direct Method

The direct method reports the major classes of net cash flows from operating
activities by listing all major operating cash receipts and payments. The direct
format must disclose at least the following categories of cash flows:
• Cash collected from customers
• Interest and dividends received
• Other operating receipts
• Cash paid to employees and suppliers
• Interest payments
• Income tax payments
 THE STATEMENT OF CASH FLOWS 87

6–1
Example Statement of Cash Flows (Direct Method)

Cash Flows from Operating Activities

Cash Received from Customers $8,150,583

Other Income 6,429 $8,157,012

Deduct:
Cash Paid to Suppliers and Employees $ 7,887,687
Interest Paid 13,026
Income Taxes Paid 68,821 7,969,534
Net Cash Flow from Operating Activities $187,478

Cash Flows from Financing Activities

Cash from Notes Payable—Bank $ 16,033
Deduct:
Payment of Notes Payable—Bank $ 33,703
Payment of Notes Payable—Other 10,000
Purchase of Treasury Stock 22,500 66,203
Net Cash Flow from Financing Activities ($ 50,170)

Cash Flows from Investing Activities

Purchase of Marketable Securities $ 66,006
Purchase of Property, Plant, and Equipment 59,290
Net Cash Flow from Investing Activities ($125,296)

Net Cash Increase $ 12,012

Beginning Cash Balance 37,988
Ending Cash Balance $ 50,000

The advantage of the direct method is that it gives the details of operating
cash flows. The main disadvantage is that it can be costly to collect the de-
tailed cashflow data. An example statement of cash flows is shown in Exhibit
6–1.

The Indirect Method

The indirect method requires that net income and net cash flow from oper-
ating activities be reconciled through a series of adjustments. These adjust-
ments include reducing net income for noncash revenues, increasing net
income for noncash expenses (such as depreciation), and adjusting net in-
come for changes in working capital accounts. These adjustments (reconciling
net income to net cash flow) may appear in the body of the statement, as
shown in Exhibit 6–2, or they may appear in a supplemental schedule. The
adjustments should at least include:
 THE STATEMENT OF CASH FLOWS 88

xhibit 6–2
Example Statement of Cash Flows (Indirect Method)

Cash Flows from Operating Activities

Net Income $ 78,186

Add:
Depreciation $ 67,933
Increase in Accounts Payable 106,627
Reduction in Other Assets 2,000 176,560
$254,746

Deduct:
Increase in Accounts Receivable $ 23,197
Increase in Inventory 35,570
Increase in Prepaid Expenses 2,247
Reduction in Accrued Expenses 933
Reduction in Accrued Taxes 5,321 67,268
Net Cash Flow from Operating Activities $ 187,478

Cash Flows from Financing Activities

Cash from Notes Payable—Bank $ 16,033

Deduct:
Payment of Notes Payable—Bank $ 33,703
Payment of Notes Payable—Other 10,000
Purchase of Treasury Stock 22,500 66,203
Net Cash Flow from Financing Activities ($ 50,170)

Cash Flows from Investing Activities

Purchase of Marketable Securities $ 66,006
Purchase of Property, Plant, and Equipment 59,290
Net Cash Flows from Investing Activities ($125,296)

Net Cash Increase $ 12,012

Beginning Cash Balance 37,988

Ending Cash Balance $ 50,000

• Deferrals of past operating receipts and payments

• Accruals of expected future operating receipts and payments
• Changes in receivables, inventories, payables, and other operating current
assets and liabilities
• Other classes of reconciling items
• Noncash gains and losses
The indirect method, in contrast to the direct method, does not provide
a list of operating cash flows.
 THE STATEMENT OF CASH FLOWS 89

FREE CASH FLOW

There is a growing body of analytical techniques that utilize information from
the statement of cash flows. One such technique is the free cash flow (FCF)
calculation. The following is the formula for calculating one version of FCF:
Cash Flow from Operations – Capital Expenditures Required to Maintain
Productive Capacity Used in the Production of Income – Dividends
= Free Cash Flow (FCF) (version 1)

One major difficulty in calculating FCF (version 1) is determining the

capital expenditures required to maintain productive capacity used in the pro-
duction of income. Very few companies disclose the amount of capital expen-
ditures needed to maintain productive capacity. However, there are situations
in which the amount of capital expenditures needed to maintain productive
capacity is known. Version 2 of the FCF calculation is:
EBIT (1 – Tax Rate) + Depreciation & Amortization – Change in Net Working
Capital – Capital Expenditure = Free Cash Flow (FCF) (version 2)

EBIT is earnings before interest and taxes and can be derived from the com-
pany’s income statement. This version (version 2) does not subtract dividends
and therefore produces a free cash flow amount that is available to pay divi-
dends and other costs of capital.
If a company has positive FCF, it had adequate cash flow during the pe-
riod to keep productive capacity at current levels. Positive FCF is crucial for
long-term growth. Think of it this way: adequate free cash flow allows a com-
pany to pay dividends (and therefore reward stockholders) and do the things
that help growth, such as make acquisitions, develop new products, and invest
in new property, plant, and equipment.

Answers appear at the end of this chapter.

2. Using the information from Exhibit 6–1 and the version 1 formula of FCF, calculate:
A. the free cash flow, assuming that the capital expenditures required to maintain productive
capacity used in the production of income are exactly equal to the amount of cash flow spent
on property, plant, and equipment.
B. the FCF if the company paid $20,000 in dividends.

3. Assume that a company has EBIT of $1,000,000 and the following facts also exist:
Tax rate: 35%
Depreciation for the year: $100,000
Change in WC: +$50,000
Capital expenditures for the year: $150,000
“Think About It” continues on next page.
 THE STATEMENT OF CASH FLOWS 90

Think About It continued from previous page.

A. Calculate the Free Cash Flow (FCF) using the version 2 method.
FCF = $

B. If a similar cash flow projection is made for next year and management is contemplating another
$600,000 of capital spending above current year levels, what do you think would have to happen
to carry out management’s plans?

Under generally accepted accounting principles (GAAP), a

full set of financial statements includes the balance sheet, in-
come statement, and statement of cash flows, as required by
FASB. The statement of cash flows must cover the same period
as the income statement. The statement of cash flows provides
insight into how cash has been generated and how it has been
used by a company. In addition, the statement of cash flows
allows interested parties to understand how cash inflows might
be generated and used in the future.
There are two acceptable formats for the statement of cash flows: direct
and indirect. Both the direct and indirect methods classify cash flows accord- ing
to operating, investing, and financing activities. The different presentations
affect the operating section only. The investing and financing sections do not
differ between the two presentations. Some experts believe that the direct
method is more revealing of a company’s ability to generate sufficient cash
from operations to pay debts, reinvest in operations, and make distributions
to owners. The indirect method focuses on the difference between net income
and net cash flow from operations and provides useful links among the state-
ment of cash flows, the income statement, and the balance sheet.
One metric that can be calculated using the statement of cash flows is
free cash flow (FCF). This chapter shows how FCF is calculated using the
statement of cash flows and how it is a useful measurement to be considered
by management and external parties such as investors and creditors.
 THE STATEMENT OF CASH FLOWS 91

Questions

1. FASB 95 established standards for: 1. (b)

(a) how to prepare the balance sheet on a cash basis.
(b) cash flow reporting.
(c) the sources and uses of funds statement.
(d) preparing the income statement on a cash basis.

2. Which of the following cannot be determined from the statement 2. (d)

of cash flows?
(a) The amount of cash generated and used by operations
(b) The source of cash invested in new plant and equipment
(c) The amount of cash raised from issuing stock or floating a bond
(d) The amount of stock awarded in a stock split during the period

3. Which of the following entries would be found in the operating 3. (c)

activities section of the statement of cash flows?
(a) Cash received from selling the firm’s common stock
(b) Cash received from dividends on marketable securities
(c) Cash received from the sale of goods and services
(d) Cash paid to acquire property, plant, and equipment

4. Which of the following statements describes the direct method of the 4. (a)
statement of cash flows?
(a) It reports the major classes of net cash flows from operating activities
by listing all major operating cash receipts and payments.
(b) It requires that net income and net cash flow from operating activities
be reconciled through a series of adjustments.
(c) It shows all cash and noncash activities that impact the ability to pay
interest and dividends on corporate capital.
(d) It only shows cash flows from operating activities and excludes cash
flows from financing and investing activities.

5. Which of the following statements describes the indirect method of the 5. (b)
statement of cash flows?
(a) It reports the major classes of net cash flows from operating activities
by listing all major operating cash receipts and payments.
(b) It requires that net income and net cash flow from operating activities
be reconciled through a series of adjustments.
(c) It shows all cash and noncash activities that impact the ability to pay
interest and dividends on corporate capital.
(d) It only shows cash flows from operating activities and excludes cash
flows from financing and investing activities.
 THE STATEMENT OF CASH FLOWS 92

ANSWERS TO “THINK ABOUT

IT…” QUESTIONS FROM
THIS CHAPTER
1. A
. F
B.

F
C.

O
D. I
E. N
F. I
2. A.
$128,18
8
B. $108,1
88
3. A. $450,000
B. Another $600,000 of capital spending will not
be possible without additional financing from
outside the company.