Chapter 3

Income Flows
versus Cash Flows:
Understanding the
Statement of Cash
Flows

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Statement of Cash Flow
Provides Key Insights into
The three sections logically corresponding to
the primary pursuits to generate profits.
The cash flows to and from the entities with
which the business conducts business.
Can be combined with other financial
statements to assess the overall quality of
overall financial statements.

Chapter: 03 2
Statement of Cash Flow

Required presentation since 1987

Cash and cash equivalents

• Cash on hand
• Cash on deposit
• Investments in short-term, highly
liquid securities
Statement of Cash Flows (Contd.)
SFAS 95, FASB Codification Topic 230
Cash equivalents include highly liquid
investments, very short-term treasury bills,
commercial paper, and money market funds.
Reporting:
 Interest paid and dividends paid - Operating or
Financing activities.
 Interest received and dividends received - Operating

or Investing activities.

Chapter: 03 4
Statement of Cash Flows (Contd.)
IAS 7
Cash equivalents include those under
U.S.GAAP and bank overdrafts
Reporting
 Interestpaid/received and dividends received -
Operating activities.
 Dividends paid - Financing activity.

Chapter: 03 5
Income Flows vs. Cash Flows
Why cash flows do not equal income
flows?
Accrual accounting used for net income
Noncash expenses

Chapter: 03 6
Statement Use
o Internal (management) users
o Determine dividend policy
o Evaluate cash generated by operations
o Review investing and financing policy

o External users
o Assess firm’s ability to increase dividends
o Assess firm’s ability to pay debt from operations
o Assess firm’s relationship of cash from operations to
in relation to the cash from financing
Cash Flows from Operations
Direct Method
Indirect Method
2 types of adjustments:
Non-working capital accounts
Adjustments for changes in working capital accounts
 Working Capital = Current Assets minus Current Liabilities

Chapter: 03 8
Non-Working Capital Accounts
Examples
Depreciation and amortization
Deferred income taxes
Employee stock option expense
Gain/loss on disposition of asset
Pension cost
Impairment charges

Chapter: 03 9
Working Capital Accounts
Examples
Accounts receivable
Inventories
Prepaid expenses
Accounts payable
Income taxes payable

Chapter: 03 10
Net Income relative to Cash Flows from
Operations
Type 1 adjustments
Usually increase cash flows over net income
Type 2 adjustments’ effects depend on:
Firm’s stage in life cycle
Length of firm’s operating cycle

Chapter: 03 11
 Simplified Schematic of the computation of Accruals from the
Operating Section of the Statement of Cash Flows

Chapter: 03 12
Net Income relative to Cash Flows
Relation among PepsiCo's Net Income, Cash Flows from Operations, Cash Flows from
Investing Activities, and Cash Flows from Financing Activities

Chapter: 03 13
Product Life Cycle
Introduction
Revenues are low
Net income may be negative
Negative CF from operating activities
Negative CF from investing activities
External financing (Positive CF from financing)

Chapter: 03 14
Product Life Cycle (Contd.)
Growth
Increasing revenues.
Net income becomes positive.
Increasing cash flows from operations.
Continuing negative cash flows from investing
activities.
Decreasing positive cash flows from financing
activities.

Chapter: 03 15
Product Life Cycle (Contd.)
Maturity
Peak revenues.
Peak net income.
Positive cash flows from operations.
Cash flows from investing activities may begin
to increase.
Cash flows from financing activities may
become negative (repayment of debt, stock
repurchases, etc.).
Chapter: 03 16
Product Life Cycle (Contd.)
Decline
Revenues decrease.
Net income decreases (may become
negative).
Cash flows from operations decreases.
Cash flows from investing activities positive
(as firm divests).
Cash flows from financing activities negative.

Chapter: 03 17
The Relation between Cash Balances and
Net Cash Flows
Net cash flows equal the (net) sum of
cash flows provided by or used for
operating, investing, and financing
activities.
Ending Cash Balance = Beginning Cash +
Cash Receipts – Cash Expenditures

Chapter: 03 18
Preparing a Statement of Cash Flows
May be necessary for firms outside U.S.
Estimates made should approximate
actual values.

Change in
Non-cash assets
Liabilities Cash flow
Shareholders’ equity

Chapter: 03 19
Preparing a Statement of Cash Flows
(Contd.)
Accounting equation
Δ Cash = Δ Liabilities + Δ Shareholders’ Equity
- Δ Non-Cash Assets
In general:
 Changes in current assets and current liabilities
affect Operating Activities.
 Changes in Fixed Assets and other noncurrent
assets affect Investing Activities.
 Changes in Long-term liabilities and Stockholders’
Equity accounts (except net income) affect
Financing Activities.
Chapter: 03 20
Preparing a Statement of Cash Flows
(Contd.)
Notable Exceptions
Marketable securities
 These are considered to be Investing Activities,

regardless of short-term nature.

Notes payable
 If payable to banks, are considered financing
activities, even if very short-term.
Current portion of long-term debt
 Financing

Chapter: 03 21
Statement of Cash Flows Assess Earnings
Quality
Gauge whether reported net income
reflects the underlying economics of the
business.
Highlights accounting accruals, which can
provide insight into the overall
sustainability and quality of a firm’s
reported earnings.

Chapter: 03 22
Operating Cash Flow/Current Maturities of Long-
Term Debt and Current Notes Payable

Operating Cash Flow

Current Maturities of Long-Term Debt
and Current Notes Payable

o Indicates a firm’s abilities to meet its

current maturities of debt
o Higher ratio indicates better liquidity
Operating Cash Flow to Total Debt
Operating Cash Flow
Total Debt

o Indicates a firm’s ability to cover total

debt with the yearly operating cash flow

o Conservative approach is to include all

possible balance sheet debt
Operating Cash Flow per Share
Operating Cash Flow - Preferred Dividends
Diluted Weighted Average
Common Shares Outstanding

o A better indication of a firm’s ability to

make capital expenditure decisions and
pay dividends than is earnings per share
o Does not reflect firm’s profitability
o Firms are prohibited from reporting this statistic
in financial statements or in the notes thereto
Operating Cash Flow to Cash Dividends
Operating Cash Flow
Cash Dividends

o Indicates a firm’s ability to cover cash

dividends with the yearly operating cash
flow