STATEMENT OF CASH FLOWS (also called the cash flow statement)

Value: The statement’s value is that it helps users evaluate liquidity (nearness to cash of assets & liabilities.), solvency (ability of a company to pay its debts as they mature.), and financial flexibility (a. company’s ability to respond & adapt to financial adversity & unexpected needs & opportunities. b. Measures the “ability of an enterprise to take effective actions to alter the amounts & timing of cash flows so it can respond to unexpected needs & opportunities.”)

Purpose: The primary purpose is to provide relevant info about the cash receipts & cash payments of an enterprise during a period. Provides a basis for (1) computing rates of return, (2) evaluating the capital structure of the enterprise, & (3) assessing the liquidity, solvency, & financial flexibility of the enterprise.

Limitations: (1) The balance sheet does not reflect fair value because accountants use a historical cost basis in valuing & reporting most assets & liabilities. (2) Companies must use judgments & estimates to determine certain amounts, such as the collectibility of receivables & the useful life of long-term tangible & intangible assets. (3) The balance sheet omits many items that are of financial value to the business but cannot be recorded objectively, such as human resources, customer base, and reputation.

Reports: (1) the cash effects of operations during a period, (2) investing transactions, (3) financing transactions, & (4) the net increase or decrease in cash during the period. Reporting these helps investors/creditors/others know what’s happening to company’s most liquid resource.

Answers: 1. Where did the cash come from? 2. What was the cash used for? 3. What was the change in the cash balance? During the period.Content and Format of the Statement of Cash Flows classify cash receipts & cash payments during a period into 3 different activities1. Operating activities involve the cash effects of transactions that enter into the determination of net income.2. Investing include making & collecting loans & acquiring & disposing of investments (both debt & equity) & property, plant, & equipment.3. Financing activities involve liability & owners’ equity items. They include (a) obtaining resources from owners & providing them with a return on their investment, & (b) borrowing money from creditors & repaying the amounts borrowed.

Statement of Cash FlowsCash flows from operating activities $XXXCash flows from investing activities XXXCash flows from financing activities XXXNet increase (decrease) in cash XXXCash at the beginning of the year XXXCash at the end of year XXX

Basic Format of the Statement of Cash FlowsInflows and Outflows of Cash classified by activity

Operating Activity Investing Activities Financing ActivitiesInflow of Cash into Cash Pool

•When cash receipts (revenues) exceed cash expenditures (expenses).

•Sale of property, plant, & equip.•Sale of debt or equity securities of other entities.•Collection of loans to other entities.

•Issuance of equity securities.•Issuance of debt (bonds and notes).

Outflows of Cash out of Cash Pool

•When cash expenditures (expenses) exceedcash receipts (revenues).

•Purchase of property, plant & equipment.•Purchase of debt and equity securities of other entities.•Loans to other entities.

•Payment of dividends.•Redemption of debt.•Reacquisition of capital stock.

Companies obtain the information to prepare the statement of cash flows from several sources: (1) comparative balance sheets, (2) the current income statement, and (3) selected transaction data.Preparing the Statement of Cash Flows1.Determine the cash provided by (or used in) operating activities. 2.Determine the cash provided by or used in investing & financing activities. 3.Determine change (increase/decrease) in cash during the period. 4.Reconcile change in cash w/beginning & ending cash balances.Cash provided by operating activities is the excess of cash receipts over cash payments from operating activities. Companies determine this amount by converting net income on an accrual basis to a cash basis by adding to or deducting from net income those items in the income statement that do not affect cash. This procedure requires that a company analyze the current year’s income statement & the comparative balance sheets & selected transaction data. Analysis of ABC’s comparative balance sheets reveals 2 items that will affect the computation of net cash provided by operating activities: 1. The increase in accounts receivable reflects a noncash increase of $41,000 in revenues. 2. The increase in accounts payable reflects a noncash increase of $12,000 in expenses. To arrive at cash provided by operations, ABC Inc. deducts from net income the increase in accounts receivable ($41,000), & it adds back to net income the increase in accounts payable ($12,000).

Next, company determines its investing & financing activities. Investing activity was land purchase. It had 2 financing activities: (1) Common stock increased $50,000 from the issuance of 50,000 shares for cash. (2) The company paid $14,000 cash in dividends. Knowing the amounts provided/used by operating, investing, & financing activities,

the company determines the net increase in cash. The increase in cash of $31,000 reported in the statement of CF agrees w/increase of $31,000 in cash calculated from comparative balance sheets.

Net Income $ 39,000Adjustments to reconcile net income to net cash

provided by operating activities: Increase in accounts receivable $(41,000) Increase in accounts payable 12,000 (29,000)Net cash provided by operating activities $10,000

ABC INC.Statement of Cash Flows

For The Year Ended December 31, 2012Cash flows from operating activities Net income $39,000 Adjustments to reconcile net income to net

cash provided by operating activities: Increase in accounts receivable $(41,000) Increase in accounts payable 12,000 (29,000) Net cash provided by operating activities 10,000Cash flows from investing activities Purchase of land (15,000) Net cash used by investing activities (15,000)Cash flows from financing activities Issuance of common stock 50,000 Payment of cash dividends (14,000) Net cash provided by financing activities 36,000Net increase in cash 31,000Cash at beginning of year -0-Cash at end of year $31,000

Comprehensive Statement of Cash FlowsABC INC.

Statement of Cash FlowsFor The Year Ended December 31, 2012

Cash flows from operating activities Net income $320,750 Adjustments to reconcile net income to net

cash provided by operating activities: Depreciation expense $ 88,400 Amortization of intangibles 16,300 Gain on sale of plant assets (8,700) Increase in accounts receivable (net) (11,000) Decrease in inventory 15,500 Decrease in accounts payable 9,500 91,000 Net cash provided by operating activities 411,750Cash flows from investing activities Sale of plant assets 90,000 Purchase of equipment (182,500) Purchase of land (70,000) Net cash used by investing activities (162,000)Cash flows from financing activities Payment of cash dividend (19,800) Issuance of common stock 100,000 Redemption of bonds (50,000) Net cash provided by financing activities 30,200Net increase in cash 279,950Cash at beginning of year 135,000Cash at end of year $414,950Noncash investing and financing activities Purchase of equipment through issuance of $50,000 of bonds

Note that the company purchased equipment through the issuance of $50,000 of bonds, which is a significant noncash transaction.

Significant Noncash ActivitiesNot all of a company’s significant activities involve cash. Examples of significant noncash activities are: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 long-lived assets.Significant financing and investing activities that do not affect cash are not reported in the body of the statement of cash flows. Rather, theyare reported in either a separate schedule at the bottom of the statement of cash flows or in separate notes to the financial statements. Such reporting of these noncash activities satisfies the full disclosure principle.Net cash provided by operating activities - A high amount indicates that a company is able to generate sufficient cash from operations to pay its bills w/out further borrowing. A low or negative amount indicates that a company may have to borrow or issue equity securities to acquire sufficient cash to pay its bills.1. How successful is the company in generating net cash provided by operating activities?2. What are the trends in net cash flow provided by operating activities over time?3. What are the major reasons for the positive or negative net cash provided by operating activities?A company could easily experience a “cash crunch” because it has its cash tied up in receivables and inventory. If it encounters problems in collecting receivables, or if inventory moves slowly or becomes obsolete, its creditors may have difficulty collecting on their loans.Current cash debt coverage ratio

Assess liquidity. Indicates whether the company can pay off its current liabilities from its operations in a given year.

Current CashDebt Coverage Ratio=Net Cash Providedby Operating ActivitiesAverageCurrent Liabilities

The higher the current cash debt coverage ratio, the less likely a company will have liquidity problems. For example, a ratio near 1:1 is good: It indicates that the company can meet all of its current obligations from internally generated cash flow.

Cash debt coverage ratio

Provides information on financial flexibility. Indicates a company’s ability to repay its liabilities from net cash provided by operating activities, without having to liquidate the assets employed in its operations.

Cash DebtCoverage Ratio=Net Cash Provided byOperating ActivitiesAverage Total Liabilities

The higher this ratio, the less likely the company will experience difficulty in meeting its obligations as they come due. It signals whether the company can pay its debts and survive if external sources of funds become limited or too expensive.

Free Cash Flow

A more sophisticated way to examine a company’s financial flexibility is to develop a free cash flow analysis. It is the amount of discretionary cash flow a company has. It can use this cash flow to purchase additional investments, retire its debt, purchase treasury stock, or simply add to its liquidity.

Net CashbyOperating Activities−Capital Expenditures−Dividends=FreeCash FlowIn a free cash flow analysis, we 1st deduct capital spending, to indicate it is the least discretionary expenditure a company generally makes. (W/out continued efforts to maintain & expand facilities; it is unlikely that a company can continue to maintain its competitive position.) We then deduct dividends. Although a company can cut its dividend, it usually will do so only in a financial emergency. The amount resulting after these deductions is the company’s free cash flow. The greater the amount of free cash flow, the greater the company’s financial flexibility.Questions that a free cash flow analysis answers are:1. Is the company able to pay its dividends without resorting to external financing?2. If business operations decline, will the company be able to maintain its needed capital investment?3. What is the amount of discretionary cash flow that can be used for additional investment, retirement of debt, purchase of treasury stock, or addition to liquidity?

ABC CompanyFree Cash Flow Analysis

Net cash provided by operating activities $411,750

Less: Capital expenditures (252,500)

Dividends (19,800)

Free cash flow $139,450

This computation shows that ABC has a positive, & substantial, net cash provided by operating activities of $411,750. Nestor’s statement of cash flows reports that the company purchased equipment of $182,500 and land of $70,000 for total capital spending of $252,500. Nestor has more than sufficient cash flow to meet its dividend payment and therefore has satisfactory financial flexibility.

As you can see from looking back at Comprehensive Income Statement ABC used its free cash flow to redeem bonds & add to its liquidity. If it finds additional investments that are profitable, it can increase its spending w/out putting its dividend or basic capital spending in jeopardy. Companies that have strong financial flexibility can take advantage of profitable investments even in tough times. In addition, strong financial flexibility frees companies from worry about survival in poor economic times. In fact, those with strong financial flexibility often fare better in a poor economy because they can take advantage of opportunities that other companies cannot.Supplemental Disclosures - Company still needs to provide important supplemental info that may not be presented elsewhere in the statement. There are normally 4 types of info that are supplemental to account titles and amounts presented in the balance sheet.1. CONTINGENCIES. Material events that have an uncertain outcome.An existing situation involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) that will ultimately be resolved when 1 or more future events occur or fail to occur. In short, contingencies are material events w/an uncertain future. IE: Gain contingencies are tax operating- loss carry forwards or company litigation against another party. IE: Loss contingencies relate to litigation, environmental

issues, possible tax assessments, or government investigations.2. ACCOUNTING POLICIES. Explanations of the valuation methods used or the basic assumptions made concerning inventory valuations, depreciation methods, investments in subsidiaries, etc.GAAP recommends disclosure for all significant accounting principles & methods that involve selection from among alternatives or those that are peculiar to a given industry. IE: Companies can compute inventories under several cost flow assumptions (e.g., LIFO & FIFO), depreciate plant & equipment under several accepted methods (e.g., double-declining balance & straight-line), & carry investments at different valuations (e.g., cost, equity, & fair value). Sophisticated users know of these possibilities & examine statements closely to determine the methods used.Companies must also disclose info about the nature of their operations, the use of estimates in preparing financial statements, certain significant estimates, & vulnerabilities due to certain concentrations. Disclosure of significant accounting principles & methods & of risks & uncertainties is particularly useful if given in a separate Summary of Significant Accounting Policies preceding the notes to the financial statements or as theinitial note.3. CONTRACTUAL SITUATIONS. Explanations of certain restrictions or covenants attached to specific assets or, more likely, to liabilities.Companies should disclose contractual situations, if significant, in the notes to the financial statements. IE: they must clearly state the essential provisions of lease contracts, pension obligations, & stock option plans in the notes. Analysts want to know not only the amount of the liabilities, but also how the different contractual provisions affect the company at present & in the future. Companies must disclose the following commitments if the amounts are material: commitments related to obligations to maintain working capital, to limit the payment of dividends, to restrict the use of assets, & to require the maintenance of certain financial ratios. The rule is, “When in doubt, disclose.”4. FAIR VALUES. Disclosures of fair values, particularly for financial instruments.Fair value info may be more useful than historical cost for certain types of assets & liabilities. This is particularly so in the case of financial instruments. Financial instruments - Cash, an ownership interest, or a contractual right to receive or obligation to deliver cash or another financial instrument. Such contractual rights to receive cash or other financial instruments are assets. Contractual obligations to pay are liabilities. Cash, investments, accounts receivable, & payables are examples of financial instruments.Given the expanded use of fair value measurements, GAAP also has expanded disclosures about fair value measurements. To increase consistency & comparability in the use of fair value measures, companies follow a fair value hierarchy that provides insight into how to determine fair value. The hierarchy has 3 levels. Level 1 measures (the most reliable) are based on observable inputs, ie: market prices for identical assets or liabilities. Level 2 measures (less reliable) are based on market-based inputs other than those included in Level 1, ie: those based on market prices for similar assets or liabilities. Level 3 measures (least reliable) are based on unobservable inputs, ie: a company’s own data or assumptions. In addition, companies must provide significant additional disclosure related to Level 3 measurements. The disclosures related to Level 3 are substantial & must identify what assumptions the company used to generate the fair value numbers & any related income effects. Companies will want to use Level 1 and 2 measurements as much as possible. In most cases, these valuations should be very reliable, as the fair value measurements are based on market info. In contrast, a company that uses Level 3 measurements extensively must be carefully evaluated to understand the impact these valuations have on the financial statements.For major groups of assets & liabilities, companies must make the following fair value disclosures: (1) the fair value measurement & (2) the fair value hierarchy level of the measurements as a whole, classified by Level 1, 2, or 3.Techniques of DisclosureParenthetical Explanations - Companies often provide additional info by parenthetical explanations following the item. IE:Stockholders’ Equity (in millions)Common stock, par value $0.01 per share (1,837 million shares issued) $18

Notes - Companies use notes if they cannot conveniently show additional explanations as parenthetical explanations. Companies commonly use notes to disclose the following: the existence & amount of any preferred stock dividends in arrears, the terms of or obligations imposed by purchase commitments, special financial arrangements & instruments, depreciation policies, any changes in the application of accounting principles, & the existence of contingencies. Notes therefore must present all essential facts as completely and succinctly as possible.

Cross Reference & Contra Items - Companies “cross-reference” a direct relationship between an asset and a liability on the balance sheet. IE: company might show the following entries—1 listed among the current assets, & the other listed among the current liabilities.

This cross-reference points out that the company will redeem $2,300,000 of bonds payable currently, for which it has only set aside $800,000. Therefore, it needs additional cash from unrestricted cash, from sales of investments, from profits, or from some other source. Alternatively, the company can show the same information parenthetically.A contra account on a balance sheet reduces either an asset, liability, or owners’ equity account. IE: Accumulated Depreciation & Discount on Bonds Payable. Contra accounts provide some flexibility in presenting the financial info. W/the use of the Accumulated Depreciation account, for example, a reader of the statement can see the original cost of the asset as well as the depreciation to date.An adjunct account, on the other hand, increases either an asset, liability, or owners’ equity account. IE: Premium on Bonds Payable, which, when added to the Bonds Payable account, describes the total bond liability of the company.

Supporting Schedules - Often a company needs a separate schedule to present more detailed information about certain assets or liabilitiesTerminologyReserve - Companies have used the term “reserve” in differing ways: to describe amounts deducted from assets (contra accounts such as accumulated depreciation & allowance for doubtful accounts); as a part of the title of contingent or estimated liabilities; & to describe an appropriation of retained earnings. Because of the different meanings attached to this term, misinterpretation often resulted from its use. Therefore, the profession has recommended that companies use the word reserve only to describe an appropriation of retained earnings. The use of the term in this narrower sense—to describe appropriated retained earnings—has resulted in a better understanding of its significance when it appears in a balance sheet. However, the term “appropriated” appears more logical, and we encourage its use.

Surplus - For years the profession has recommended that the use of the word surplus be discontinued in balance sheet presentations of

Current Assets (in part)Cash on deposit with sinking fund trustee for redemptionof bonds payable—see Current liabilities $800,000

Current Liabilities (in part)Bonds payable to be redeemed in 2013—see Current assets $2,300,000

owners’ equity. The use of the terms capital surplus, paid-in surplus, and earned surplus is confusing. Although condemned by the profession, these terms appear all too frequently in current financial statements.