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The Statement of Cash Flows

Chapter 12
 Chapter Outline

• Applications to people within and outside the firm

• The importance of cash flows
• Preparing the statement of cash flows
• Making decisions based on the statement of cash
flows
• Appendix: Direct method for preparing the
statement of cash flows
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 APPLICATIONS TO PEOPLE
WITHIN & OUTSIDE FIRM
 The statement of cash flows shows the company’s
cash receipts and cash payments, that is, the inflows
and outflows of cash.
 Internal users: Managers use it to determine how
cash is generated and paid out.
 Management can then plan for future cash
needs and monitor current cash use.
 External users: Analysis of the statement of cash
flows can help assess whether a company is
drowning in debt or not utilizing its cash effectively.
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 THE IMPORTANCE OF
CASH FLOWS
While the balance sheet shows balances of certain
accounts from one year to the next, it does not
offer detail of what caused the changes in account
balances.
This is the function of the statement of cash flows.

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Effective use of cash requires a
cross-functional effort

 All departments must safeguard and wisely use

the company’s cash .
 Examples: The marketing department should
make efforts to ensure that sales are made only to
customers who will pay off their account balances.
The purchasing department should help ensure that
cash is paid accurately and only after purchased
items have been inspected.
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The importance of cash flows

Activities of a business can be classified

into three major categories:
1. Operating activities
2. Investing activities
3. Financing activities

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 Operating activities
 Operating activities represent the day-to-day
transactions of the company.
 Examples of cash outflows:
 Pay wages, taxes, and expenses.
 Purchase inventory.
 Purchase trading securities.
 Examples of cash inflows:
 Sales to customers.
 Receipt of interest on investments.
 Sale of trading securities. Exhibit 12.1
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 Investing activities
 Investing activities affect long-term assets and
investments.
 Examples of cash outflows:
 Purchase long-term assets such as land and
equipment.
 Purchase long-term securities.
 Examples of cash inflows:
 Sale of long-term assets.
 Sale of long-term securities.
Exhibit 12.1
 Collection of loans. 8
 Financing activities
 Financing activities are transactions concerning
debt and stockholders’ equity.
 Examples of cash outflows:
 Reacquire company stock.
 Repay debt.
 Pay dividends.
 Examples of cash inflows:
 Sale of company stock.
 Issuance of debt.
Exhibit 12.1
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PREPARING THE STATEMENT
OF CASH FLOWS

 The statement of cash flows can be prepared using:

 the indirect method or
 the direct method.
 Both methods are according to GAAP and show
cash flows from operating activities, investing
activities, and financing activities.

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 Preparing the Statement of
Cash Flows
The difference in the two methods is the way cash
flows from operating activities are reported.
 The indirect method makes adjustments to only
selected income statement items - those necessary to
convert net income into net cash flows.
 The direct method makes adjustments to all items
on the income statement.
 The indirect method is the more widely used due
to its simpler format.
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 Comparing the Indirect method
to the Direct method (Exhibit 12.2)

Indirect Method Direct Method

Net Income $ XXX Cash receipts from customers $ XXX

Adjustments: Deductions:
Depreciation, etc. XXX Cash payments XXX
Net cash flows from Net cash flows from
operating activities $ XXX operating activites $ XXX

Under the indirect method, depreciation is an adjustment to

net income. However, depreciation does not cause an
outflow of cash; thus, depreciation expense must be added
back to net income to calculate net cash flows.
Under the direct method, there is no adjustment for
depreciation since it is neither a cash receipt or payment. 12
Indirect method for preparing the
Statement of Cash Flows
 The indirect method begins with net income and
then adjusts the income items that do not impact
cash.
 Items that reduce net income but do not reduce
cash are positive adjustments.
 Items that increase net income but do not increase
cash are negative adjustments.
 In effect, the accrual-based income statement is
converted into a cash-based income statement.
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 Operating activities

Adjustments to reconcile net income to net cash

flows provided by operating activities: (Exh. 12.3)
Net Income
+ Depreciation expense
+ Loss on sale of plant assets
- Gain on sale of plant assets
- Increases in current assets other than cash
+ Decreases in current assets other than cash
+ Increases in current liabilities
- Decreases in current liabilities
Net cash flows from operating activities 14
 Operating activities

Adjustments from the previous slide are discussed:

 Depreciation - Since depreciation affects net
income but does not affect cash flows, depreciation
expense must be added back to net income for
determining net cash flows.
 Gains and Losses – Since gains and losses affect
net income but not cash flows, they are adjustments
to net income to determine net cash flows.

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 Operating activities
 Increase in current assets – Increases other than
cash have a negative effect on cash flows.
 Decrease in current assets – Decreases other than
cash have a positive effect on cash flows.
 Increase in current liabilities – An increase results
in a positive adjustment to net cash flows.
 Decrease in current liabilities – A decrease results
in a negative adjustment.
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Example using the indirect method
(Exhibit 12.6)

Cash Flows from Operating Activities

Net Income 13,200
Adjustments to Reconcile Net Income to
Net Cash Flows from Operating Activities
Depreciation 45,800
Loss on Sale of Investments 14,000
Gain on Sale of Plant Assets (7,000)
Changes in Current Assets and Current Liabilities
Decrease in Accounts Receivable 500
Decrease in Inventory 27,400
Increase in Prepaid Expenses (3,500)
Increase in Accounts Payable 30,000
Increase in Accrued Liabilities 20,000
Decrease in Income Tax Payable (6,000) 121,200
Net Cash Flows from Operating Activities 134,400 17
 Investing activities
Adjustments to reconcile net income to net cash flows
provided by investing activities: (Exh. 12.3)

Net Income
+ Sale of plant assets
(e.g., investments, land, building, equipment)
- Purchases of plant assets
+ Collections of long-term receivables
- Long-term loans to others
Net cash flows from investing activities

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 Financing activities
Adjustments to reconcile net income to net cash flows
provided by financing activities: (Exh. 12.3)

Net Income
+ Issuance of stock
+ Sale of treasure stock
- Purchase of treasury stock
+ Borrowing (issuing notes or bonds payable)
- Payment of notes or bonds payable
- Payment of dividends
Net cash flows from financing activities
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 Net increase (decrease)
in cash
The final lines of the Statement of Cash Flows are:
Net increase (decrease) in cash
+ Cash at beginning of year
Cash at end of year

At the bottom of the statement, the Schedule of

Noncash Investing and Financing Transactions is
shown. Example:
Schedule of Noncash Investing and Financing Transactions
Issue of notes for plant assets
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 Preparing the
statement of cash flows

Note: The textbook contains a step-by-step example of

preparing the Statement of Cash Flows using the indirect
method. The example uses the comparative balance sheets
and income statement for a company, along with a record of
transactions affecting non-current accounts. This material is
too cumbersome for inclusion in these slides.

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 Direct method for preparing
the Statement of Cash Flows
The main difference between the indirect and direct
methods is how the section on cash flows from
operating activities is prepared.
Using the direct method, the section on cash flows
from operating activities shows the actual cash
receipts and actual cash payments associated with
operating activities.
They are not derived indirectly using
adjustments to net income, as under the indirect
method. 22
 MAKING DECISIONS BASED ON
THE STATEMENT OF CASH FLOWS

Investors and lenders need to know if a company

will have sufficient cash to meet its obligations and
how efficiently a company generates cash.
The statement of cash flows is very helpful for
evaluating a company’s free cash flow and cash-
generating capacity.

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 Free cash flow

Free cash flow is how much cash is left over after

subtracting the funds necessary to maintain a
company’s planned operations.
Calculation:
Free Cash Flow = Net cash flows from - Dividends - Purchase of + Sale of
Operating Activities Plant Assets Plant Assets

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 Cash flow yield

A good measure of a company’s cash-generating

capacity is cash flow yield.
Cash flow yield is the ratio of a company’s net cash
flows from operating activities to its net income.
Calculation:
Net Cash Flows from Operating Activities
Cash Flow Yield =
Net Income

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APPENDIX

Direct Method for Preparing the

Statement of Cash Flows
 Direct Method for Preparing
the Statement of Cash Flows
 The direct method takes each income statement
item and converts it to its cash equivalent.
 Using the information from Exhibits 12.4 and
12.5, we will look at each line item on BLT’s
income statement and convert it to its cash
equivalent.

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 Cash receipts from sales
 Cash is collected immediately from cash sales, but
cash is not collected until a future time from credit
sales.
– A credit sale results in an account receivable, not
cash. Later, customers send in cash to pay off
their accounts receivable.
Cash receipts from sales = $380,000 + $500 (decrease in A/R)
+ decrease in Accounts Receivable
Cash Receipts = Sales + OR
from Sales - increase in Accounts Receivable
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 Interest income

BLT’s income statement shows interest income of

$8,000. For simplicity, it is assumed that BLT
received cash for all its interest income. Thus,
this amount is a cash inflow.

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 Cash paid for purchases
+ increase in Inventory + decrease in Accounts Payable
Cash Payments = Cost of Goods Sold + OR + OR
for Purchases - decrease in Inventory - increase in Accounts Payable

BLT’s cash payments for purchases is:

= $270,000 - $27,400 - $30,000
= $212,600

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 Cash paid for wages, supplies,
and other
 Operating expenses are calculated based on
accruals as well as actual amounts paid.
+ increase in + decrease in
Prepaid Expenses Accrued Liabilities
Cash Payments for = Operating + OR + OR - Depreciation and
Operating Expenses Expenses - decrease in - increase in other Noncash Expenses
Prepaid Expenses Accrued Liabilities

BLT’s cash payments for operating expenses is:

= $89,000 + $3,500 - $20,000 - $45,800
= $26,700
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 Paid cash for income tax

Convert income tax expense to its cash equivalent.

BTL’s cash payments for income tax is:
= $8,800 + $6,000
= $14,800

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 Direct method
 Whether the indirect method or direct method is
used, the resulting amount for net cash flows
from operating activities is the same.
 When the direct method is used, the statement of
cash flows must include a section at the bottom
showing the reconciliation of net income to net
cash flows from operating activities.

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