Chapter 5

Statement of Cash Flows

Overview of Statement

of Cash Flows

The statement of cash flows provides a thorough

explanation of the changes that occurred in a

firms cash balance during the entire accounting period.

The statement of cash flows reports cash receipts

and payments of a company during a given period

for operating, financing, and investing activities.

Cash includes cash and cash equivalents.

Purposes of Cash Flow

Statement

It shows the relationship of net income to changes

in cash balances.

It reports past cash flows as an aid to: Predicting future cash flows

Evaluating the way management generates and uses cash

Determining a companys ability to pay interest and dividends and to pay debts when they are due

Purposes of Cash Flow

Statement

The relationship among the balance sheet, income

statement, and statement of cash flows:

Balance Sheet

December 31,

20X3

Balance Sheet

December 31,

20X2

Income Statement

Statement of Cash Flows

Typical Activities Affecting

Cash

Cash is affected by two primary areas of a

firm.

Operating management - largely concerned

with the major day-to-day activities that

generate revenues and expenses

Financial management - largely concerned

with where to get cash and how to use cash

for the benefit of the entity

Typical Activities Affecting

Cash

1. Operating activities - transactions that affect the

income statement

2. Financing activities - activities that include

obtaining resources as a borrower or issuer of

securities and repaying creditors and owners

3. Investing activities - activities that involve

(1) providing and collecting cash as a lender or as an

owner of securities and

(2) acquiring and disposing of plant, property,

equipment, and other long-term productive assets

Typical Activities Affecting

Cash

Cash inflows Collections from

customers

Interest and dividends collected

Other operating receipts

Cash outflows Cash payments to suppliers

Cash payments to employees

Interest and tax payments

Other operating cash payments

Typical operating activities

Typical Activities Affecting

Cash

Cash inflows Borrowing cash from

creditors

Issuing equity securities

Issuing debt securities

Cash outflows Repayment of amounts

borrowed

Repurchase of equity shares

Payment of dividends

Typical financing activities

Typical Activities Affecting

Cash

Cash inflows Sale of property, plant, and

equipment

Sale of securities that are not cash equivalents

Receipt of loan repayments

Cash outflows

Purchase of property, plant,

and equipment

Purchase of securities that

are not cash equivalents

Making loans

Typical investing activities

How to treat Interest payments

and Dividends payments?

Preparing a Statement of Cash

Flows

Financing Activities

2 general rules for financing activities:

a. Increases in cash (cash inflows) stem from

increase in liabilities or paid In capital

b. Decreases in cash (cash outflows ) stem

from decreases in liabilities or paid in capital

Preparing a Statement of Cash

Flows

Investing activities

2 general rules for investing activities

a. Increases in Cash stem from decreases in

long lived assets, loans and investments

b. Decreases in cash stem from increases in

long lived assets, loans and investments

Approaches to Calculating the

Cash Flow from Operating Activities

2 approaches may be used to compute cash

flow from operating activities.

1. Direct method - the method that calculates net cash

provided by operating activities as collections minus

operating distributions

2. Indirect method - the method that adjusts the accrual

net income to reflect only cash receipts and outlays

Under either method, the final cash flow from operating

activities will be the same.

Transactions Affecting Cash

Flows from All Sources

Effects of operating transactions on cash:

Sales of goods and services for cash +

Sales of goods and services on credit 0

Receive dividends or interest +

Collection of accounts receivable +

Recognize cost of goods sold 0

Purchase inventory for cash -

Purchase inventory on credit 0

Pay trade accounts payable -

0 denotes that the transaction has no effect on cash.

Transactions Affecting Cash

Flows from All Sources

Effects of operating transactions on cash: Accrue operating expenses 0

Pay operating expenses -

Accrue taxes 0

Pay taxes -

Accrue interest 0

Pay interest -

Prepay expenses for cash -

Write off prepaid expenses 0

Charge depreciation or amortization 0

0 denotes that the transaction has no effect on cash.

Transactions Affecting Cash

Flows from All Sources

Effects of investing activities on cash:

Purchase fixed assets for cash -

Purchase fixed assets by issuing debt 0

Sell fixed assets +

Purchase securities that are not cash equivalents -

Make a loan -

0 denotes that the transaction has no effect on cash.

Transactions Affecting Cash

Flows from All Sources

Effects of financing transactions on cash:

Increase long-term or short-term debt +

Reduce long-term or short-term debt -

Sell common or preferred shares +

Repurchase or retire common or preferred shares -

Pay dividends -

Convert debt to common stock 0

0 denotes that the transaction has no effect on cash.

Schedule of non cash investing

and financing activities

Common stock issued to acquire store

equipment

Loan taken to acquire furniture

Changes in the

Balance Sheet Equation

The balance sheet equation can be rearranged as follows:

Cash = Liabilities + Equity - Noncash Assets

or

DCash = DL + DSE - DNCA

Any change (D) in a noncash item (liability, equity, or

asset) must be accompanied by a change in cash to

keep the equation balanced.

Changes in the

Balance Sheet Equation

The statement of cash flows focuses on the change

in the noncash accounts as a way of explaining how

and why the amount of cash changes during a given

period.

Change in cash = Change in all noncash accounts

or

What happened to cash = Why it happened

Preparing a Statement of Cash

Flows - The Indirect Method

In calculating cash flows from operating

activities, the alternative to the direct method

is the indirect method.

The indirect method is generally more

convenient.

The indirect method reconciles

accrual net income to cash flows

from operating activities.

Reconciliation of Net Income to Net Cash

Provided by Operations

Items included in the reconciliation:

Depreciation is added back to net income because it

was deducted in arriving at net income, but it does not represent a use of cash.

Increases in noncash current assets result in less cash flow from operations, so such increases are deducted from net income.

Decreases in noncash current assets result in more cash flow from operations, so such decreases are added back to net income.

Reconciliation of Net Income to Net

Cash Provided by Operations

Items included in the reconciliation (continued):

Increases in current liabilities result in more cash flow from operations, so such increases are added back to net income.

Decreases in current liabilities result in less cash flow from operations, so such decreases are deducted from net income.

The Crisis of Negative Cash

Flow

Although investors make many decisions

based on net income, earnings numbers do

not tell the whole story of what is happening

inside a company.

Sometimes companies can show

lots of net income, but that net

income comes from selling off

assets to meet its obligations.