1 chapter 12 `. 2 chapter 12 statement of cash flows after studying chapter 12, you should be able...
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Chapter 12`
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Chapter 12 Statement of Cash Flows
After studying Chapter 12, you should be able to:
Indicate the primary purpose of the statement of cash flows.
Distinguish among operating, investing, and financing activities.
Explain the impact of the product life cycle on a company's cash flows.
Prepare a statement of cash flows using one of two approaches: (a) the indirect method, or (b) the direct method.
Use the statement of cash flows to evaluate a company.
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The Primary Purpose of the Statement of Cash Flows
Is...
To provide information about: cash receipts, cash payments, and the net change in cash resulting
from:operating,investing, andfinancing activities of a company during a period.
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Questions the Statement of Cash Flow Answers
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Operating Activities...
Include: The cash effects of transactions that
create revenues and expenses and Enter into determination of net
income.
Involve Income Statement Items
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Investing Activities...
Include: Purchasing and disposing of
investments and productive long-lived assets using cash and
Lending money and collecting the loans.
Involve Investments and Noncurrrent Asset Items
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Financing Activities...
Include: Obtaining cash from issuing debt and
repaying the amounts borrowed and Obtaining cash from stockholders
and paying dividends.
Involve Noncurrent Liability and Stockholders’ Equity Items
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Types of Cash Flows -Operating Activities
Cash inflows: From sale of goods or services From return on loans (interest
received) and on equity securities (dividends received)
Cash outflows: To suppliers for inventory To employees for services To government for taxes To lenders for interest To others for expenses
Illustration 12-1
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Types of Cash Flows -Investing Activities
Cash inflows: From sale of property, plant, and equipment From sale of debt or equity securities of other
entities From collection of principal on loans to other
entitiesCash outflows:
To purchase property, plant, and equipment To purchase debt or equity securities of other
entities To make loans to other entities
Illustration 12-1
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Types of Cash Flows -Financing Activities
Cash inflows: From sale of equity securities
(company's own stock) From issuance of debt (bonds and notes)
Cash outflows: To stockholders as dividends To redeem long-term debt or reacquire
capital stock
Illustration 12-1
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Operating Activities - ALERT
Some cash flows relating to investing or financing activities are classified as operating activities. For example... Receipts of investment revenue (interest
and dividends) and Payments of interest to lenders are
classified as operating activities because these items are reported in the income statement.
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Significant Noncash Activities...
That do NOT affect cash are NOT reported in the body of the statement of cash flows.
Are reported: In a separate schedule at the bottom of the
statement of cash flows or In a separate note or supplementary
schedule to the financial statements.
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Significant Noncash Activities...
1. Issuance of common stock to purchase assets.
2. Conversion of bonds into common stock.3. Issuance of debt to purchase assets.4. Exchanges of plant assets.
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Format of the Statement of Cash Flows
Three parts: operating investing financing
Plus significant noncash investing and financing activities in separate schedule or at bottom of the statement of cash flows.
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Format of the Statement of Cash Flows
Three activities:
operating
investing
financing
PLUS
noncash investing and
financing activities
Body of Statement
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The Product Life CycleA series of phases all products go
throughThe phases are often referred to as the:
introductory phase growth phase maturity phase decline phase.
The phase a company is in affects its cash flows.
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Introductory Phase
To support asset purchases the company may issue stock or debt. Expect:
cash from operations to be negative.
cash from investing to to be negative.
cash from financing to be positive.
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The company is striving to expand its production and sales.
Expect:small amounts of cash to be
generated from operations.cash from investing to be negative.cash from financing to be positive.
Growth Phase
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Sales and production level-offExpect:cash from operations to exceed
investing needs.cash from investing to
be neutral.cash from financing to
be negative.
Maturity Phase
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Sales and production declineExpect:cash from operations to declinecash from investing to
possibly become positive.
cash from financing to possibly become negative
Decline Phase
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Impact of Product Life Cycle on Cash Flows
0
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Why Report the Causes of Changes in Cash?
Because investors, creditors, and other interested parties want to now what is happening to a company’s most liquid asset,
CASH
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Statement of Cash Flows Helps Users Evaluate
1. The entity's ability to generate future cash flows
2. The entity's ability to pay dividends and meet obligations
3. The reasons for the difference between net income and net cash provided (used) by operating activities
4. The investing and financing transactions during the period
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Statement of Cash Flows Helps Answer the Following Questions
How did cash increase when there was a net loss for the period?
How were the proceeds of the bond issue used?How was the expansion in the plant and
equipment financed?Why were dividends not increased?How was the retirement of debt accomplished?How much money was borrowed during the
year?Is cash flow greater or less than net income?
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Sources of Information for the Statement of Cash Flows
Comparative balance sheetCurrent income statementAdditional information
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Comparative Balance Sheet
Indicates the amount of changes in assets, liabilities, and stockholders' equities from the beginning to the end of the period.
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COMPUTER SERVICES COMPANYComparative Balance Sheet
December 31, 2003
Assets
Dec. 31,
2003
Jan.1, 2003
Increase/ Decrease
Cash $34,000 $ 0 $34,000 increase Accounts receivable
30,000 0 30,000 increase
Equipment 10,000 0 10,000 increase Total $74,000 $ 0
Liabilities and stockholders’
equity
Accounts payable $4,000 $0 $4,000 increase Common stock 50,000 0 50,000 increase Retained earnings
20,000 0 20,000 increase
Total $74,000 $0
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Current Income Statement
Information in this statement helps the reader determine the amount of cash provided or used by operations during the period.
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Income Statement and Additional Information
COMPUTER SERVICES COMPANYIncome Statement
For the Year Ended December 31, 2003Revenues $85,000Operating expenses 40,000Income before income taxes
45,000Income tax expense 10,000Net income $35,000
Additional Information:(a) Examination of selected data indicates that a dividend
of $15,000 was declared and paid during the year.(b) The equipment was purchased at the end of 2003. No
depreciation was taken in 2003.
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Indirect and Direct Methods
Convert net income from an accrual basis to a cash basis.
This conversion may be done by two methods: indirect direct
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Indirect and Direct Methods
Both methods arrive at the same total amount for “Net cash” provided by operating activities.
The methods differ in disclosing the items that make up the total amount.
The choice of methods affects only the operating activities section; the investing and financing activities sections are the same.
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Indirect Method
The indirect method is used extensively in practice.
Most companies favor the indirect method for the following reasons: it is easier to prepare it focuses on the differences between net
income and net cash flow from operating activities
it tends to reveal less company information to competitors.
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Direct Method
The FASB prefers the direct method but allows the use of either method.
When the direct method is used, the net cash flow from operating activities as computed using the indirect method must also be reported in a separate schedule.
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Steps in Preparing Statement of Cash Flows
$34,000 - 0 = $34,000
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Statement Of Cash Flows - Indirect Method
The transactions of Computer Services Company for the year ended 2003 are used to illustrate the preparation of a statement of cash flows .
Computer services Company started in January 1, 2003, when it issued 50,000 shares of $1 par value common stock for $50,000 cash.
The company rented its office space and furniture and performed consulting services throughout the first year.
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Steps in Preparing Statement of Cash Flows
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Determine Net Cash Provided/Used By Operating Activities
Adjust net income for items that did not affect cash.
Net income must be converted because earned revenues may include credit sales that have not been collected in cash and expenses incurred that may not have been paid in cash.
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Net Income Versus Net Cash Provided by Operating
Activities
Add Cash advances
Deduct prepaid expenses
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Receivables, payables, prepayments, and inventories must be analyzed for their effects on cash.
Determine Net Cash Provided/Used By Operating Activities
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Computer Services Company had revenues of $85,000 in its first year of operations.
However, CSC collected only $55,000 in cash. Accrual basis revenue was $85,000, cash basis revenue would be $55,000.
The increase in accounts receivable of $30,000 must be deducted from net income.
If accounts receivable decrease, the decrease must be added to net income.
Determine Net Cash Provided/Used By Operating Activities
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COMPUTER SERVICES COMPANY Statement of Cash Flows--Indirect Method (Partial)
For the Year Ended December 31, 2003
Cash flows from operating activities Net income
$35,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(30,000)
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Accounts payable - When accounts payable increase during a year, operating expenses on an accrual basis are higher than they are on a cash basis.
For CSC, operating expenses reported in the income statement were $40,000.
Since Accounts Payable increased $4,000, $36,000 ($40,000 – $4,000) of the expenses were paid in cash.
To convert net income to net cash provided by operating activities, an increase in accounts payable must be added to net income, a decrease subtracted.
Determine Net Cash Provided/Used By Operating Activities
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COMPUTER SERVICES COMPANY Statement of Cash Flows--Indirect Method (Partial)
For the Year Ended December 31, 2003
Cash flows from operating activities Net income
$35,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(30,000) Increase in accounts payable 4,000
(26,000)Net cash provided by operating activities $
9,000
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Steps in Preparing Statement of Cash Flows
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Determine Net Cash Provided/Used By Investing and Financing Activities
No data are given for the increases in Equipment of $10,000 and Common Stock of $50,000. Assume any differences involve cash.
The increase in equipment is from a purchase of equipment for $10,000 cash. This purchase is reported as a cash outflow in the investing activities section.
The increase of common stock results from the issuance of common stock for $50,000 cash. It is reported as an inflow of cash in the financing activities section of the statement of cash flows.
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COMPUTER SERVICES COMPANYComparative Balance Sheet
December 31, 2003
Assets Dec. 31,2003
Jan. 1,2003
ChangeIncrease/ Decrease
Cash $34,000 $ 0 $34,000 increaseAccountsreceivable
30,000 0 30,000 increase
Equipment 10,000 0 10,000 increaseTotal $74,000 $ 0
Liabilities andstockholders’
equityAccounts payable $4,000 $0 $4,000 increaseCommon stock 50,000 0 50,000 increaseRetainedearnings
20,000 0 20,000 increase
Total $74,000 $0
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Determine Net Cash Provided/Used By Investing and Financing Activities
Reasons for the increase of $20,000 in the Retained Earnings. Net income increased retained earnings by
$35,000. REPORTED IN THE OPERATING ACTIVITIES SECTION.
The additional information indicates that a cash dividend of $15,000 was declared and paid. REPORTED IN THE FINANCING ACTIVITIES SECTION.
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COMPUTER SERVICES COMPANY Statement of Cash Flows--Indirect Method (Partial)
For the Year Ended December 31, 2003
Cash flows from operating activities Net income $35,000
Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(30,000) Increase in accounts payable 4,000 (26,000)Net cash provided by operating activities $ 9,000Cash flows from investing activities
Purchase of equipment (10,000)Cash flows from financing activities
Issuance of Common Stock $50,000Payment of cash dividends (15,000)
Net cash provided by financing activities 35,000Net increase in cash $34,000
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Major Classes of Cash Receipts and Payments -- Direct Method
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Formula to Compute Cash Receipts from Customers-Direct Method
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Formula to Compute Cash Payment to Suppliers-Direct Method
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Formula to Compute Cash Payments for Operating Expenses-Direct Method
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COMPUTER SERVICES COMPANY Statement of Cash Flows--Direct Method (Partial)
For the Year Ended December 31, 2003
Cash flows from operating activities Cash receipts from customers $
765,000 Cash payments To supplier $550,000
For operating expenses 158,000 For income taxes 48,000
756,000Net cash provided by operating activities $
9,000
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Free Cash FlowIn the statement of cash flows, cash from
operations is intended to indicate the cash-generating capability of the company.
Statement of Cash flows fails to take into account that a company must invest in new fixed assets to maintain its current level of operations and it must maintain dividends at current levels to satisfy investors.
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Cash Provided By Operations
– Capital Expenditures
– Dividends Paid
Free Cash Flow
Free Cash Flow
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The 2001 statement of cash flows of Microsoft Corporation
provides information for the computations of these measures.
MICROSOFT CORPORATIONSTATEMENT OF CASH FLOWS (PARTIAL)
2001Cash flows from operations $13,422Additions to property, plant,
and equipment $ (1,103)Other assets and investments ( 66,346)Short-term investments 58,315Cash used by investing activities (9,134)Cash paid for dividends on preferred stock (0)
Using Cash Flows to Evaluate a Company
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MICROSOFT CORPORATIONSTATEMENT OF CASH FLOWS (Partial)
2001Cash flows from operations 13,422Less: Expenditures on property, plant,
and equipment 1,103 Dividends z 0
Free Cash Flow 12,319
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Rather than using numbers from the income statement for assessment purposes, we use numbers from the statement of cash flows.
Assessing Liquidity, Solvency, and Profitability Using Cash Flows
The ratios are cash-based instead
of accural-based.
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Accrual-based measures allows too much management discretion.
One disadvantage to the cash-based measures is no readily available published industry averages for comparison.
Cash-Based Measures
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LiquidityLiquidity is the ability of a business to
meet its immediate obligations.One measure of liquidity is the current
ratio. A disadvantage of the current ratio is
that it uses year-end balances of current assets and current liabilities (may not be representative of a company's position during most of the year.)
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Current Cash Debt Coverage Ratio
A ratio that partially corrects this is the current cash debt coverage ratio.
Cash provided by operationsAverage current liabilities
Since cash from operations involves the entire year rather than a balance at one point in time, it is often considered a better representation of liquidity on the average day.
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Solvency
Solvency is the ability of a firm to survive over the long term. One measure of solvency is the debt to total assets
ratio.A measure of solvency that uses cash figures is
the cash debt coverage ratio.Cash Provided By Operations
Average Total LiabilitiesThis ratio measures a company's ability to repay its
liabilities from cash generated from operations.
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Profitability
Profitability refers to a company's ability to generate a reasonable return.
Accrual-based ratios that measure profitability are gross profit rate, profit rate margin, and return on assets.
A cash-based measure of performance is the cash return on sales ratio.