Chapter 5

Statement of Cash Flows and Articulation

1. Important companion of the income statement 2. Three main categories of the cash flow statement: operating, investing, and financing 3. Cash flows from operations using either the direct or the indirect method 4. Prepare a complete statement of cash flows 5. Analysis of a firm’s financial strength from perspective of cash flows 6. Articulation of the three primary financial statements 7. Forecasted statement of cash flows

5-1

1.

Describe the circumstances in which the cash flow statement is a particularly important companion of the income statement. What Good is a Cash Flow Statement? We need the cash flow statement because:

• • •

Sometimes earnings fail. Everything is on one page. It is used as a forecasting tool.

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Sometimes Earnings Fail

The Big Loss Scenario When a company reports large noncash expenses such as:

- write-offs - depreciation

- provisions for future obligations … earnings may give a gloomier picture of current operations than warranted. (continued) 5-3

The Rapid Growth Scenario

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Rapidly growing firms use large amounts of cash to expand inventory.

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Cash collections on the growing accounts receivable often lag behind the need to pay creditors.

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Reported earnings may be positive, but operations are actually consuming rather than generating cash.

5-4

The Reality Check Scenario Companies entering phases in which it is critical that reported earnings look good, accounting assumptions can be stretched

• • •

Just before making a large loan application

•

Cash flow from operations, which is not impacted by accrual assumptions, provides an excellent reality check for earnings.

Just before the initial public offering of stock Just before being bought out by another company

5-5

Everything is on One Page

•

The cash flow statement includes information on operating, investing, and financing activities.

•

Everything you ever wanted to know about a company’s performance for the year is summarized in this one statement.

(continued) 5-6

It is Used as a Forecasting Tool

A pro forma cash flow statement is a prediction of what the actual cash flow statement will look like in future years if the operating, investing, and financing plans are implemented.

5-7

2.

Outline the structure of and information reported in the three main categories of the cash flow statement: operating, investing, and financing

Statement of Cash Flows A statement of cash flows explains the change during the period in cash and cash equivalents.

What is this? 5-8

Cash Equivalent

•

A cash equivalent is a short-term, highly liquid investment that can be converted easily into cash.

•

To qualify as a cash equivalent, an item must be:

1. Readily convertible into cash 2. So near to its maturity that there is insignificant risk of changes in value due to changes in interest rates 5-9

Three Categories of Cash Flows

•

Operating activities include those transactions and events that enter into the determination of net income.  Cash receipts from selling goods or from providing services.

 Receipts from Interest, dividends, and similar items.  Payments to purchase inventory and to pay wages, taxes, and similar expenses. 5-10

(continued)

5-11

Three Categories of Cash Flows

•

•

The primary investing activities are the purchase and sale of land, buildings, equipment, and other assets not generally held for resale. In addition, investing activities include those transactions and events that involve the purchase and sale of financial instruments not intended for trading purposes, as well as making and collecting loans. (continued) 5-12

(continued)

5-13

Three Categories of Cash Flows Financing activities include those transactions and events whereby resources are obtained from, or repaid to, owners (equity financing) and creditors (debt financing): • Cash proceeds from issuing stocks or bonds. • Payments to reacquire stock (treasury stock) or to retire bonds. • Payment of dividends.

(continued)

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(concluded)

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Cash Flow Patterns

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•

•

Most companies (73% in the United States in 2006) generate positive cash flow from operations. In normal times, most companies use cash to expand or enhance long-term assets, so cash from investing activities is usually negative (83% of the time in the United States in 2006). No general statement can be made about cash flow from financing activities. (continued)

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Noncash Investing and Financing Activities

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• •

Noncash investing and financing activities affect an entity’s financial position but not the entity’s cash flow. Examples include:  Equipment purchased with a note payable  Land acquired by issuing stock Significant transactions should be disclosed separately. These transactions do NOT appear in the statement of cash flows. 5-18

Cash Flow Categories Under IAS 7 The provisions of IAS 7, Statement of Cash Flows, are more flexible than the U.S. rules contained in SFAS No. 95. Here is a summary of these differences:

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3.

Compute cash flow from operations using either the direct or the indirect method

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Operating Activities: Direct Method

•

The direct method is essentially a reexamination of each income statement item with the objective of reporting how much cash was received or disbursed in association with the item.

•

To prepare the operating section, each income statement item must be adjusted for the effects of accruals.

5-22

Operating Activities: Indirect Method

•

The indirect method begins with net income as reported on the income statement and adjusts the accrual amount for any items that do not affect cash flow.

•

Both the direct and indirect methods produce identical results—that is, the same amount of net cash provided by (or used in) operations.

(continued) 5-23

Operating Activities: Indirect Method The adjustments for the indirect method are of three basic types: • Revenues and expenses that do not involve cash inflow or outflow. • Gains and losses associated with investing or financing activities. • Adjustments for changes in current operating assets and liabilities that indicate noncash sources of revenues and expenses. 5-24

Operating Activities

5-25

Operating Activities: Direct Method Sales and Cash Collected from Customers

+ =  =

Beginning accounts receivable Sales Cash available for collection Ending accounts receivable Cash collected from customers

$ 40 150 $190 60 $130

(continued) 5-26

Operating Activities: Direct Method Cost of Goods Sold and Cash Paid for Inventory

+ =  =

Ending inventory Cost of goods sold Required inventory Beginning inventory Inventory purchased this year

$ 75 80 $155 100 $ 55

(continued) 5-27

Operating Activities: Direct Method Wages Expense and Cash Paid for Wages

+ = – =

Beginning wages payable Wages expense Total obligation to employees Ending wages payable Cash paid for wages

$ 7 25 $32 10 $22

(continued) 5-28

Operating Activities: Direct Method Depreciation Expense

5-29

Operating Activities: Indirect Method Sales

The $20 increase in accounts receivable means that cash collected is $20 less than the $150 the sales number indicates. So, the necessary adjustment is to subtract the $20 to show that $130 was collected on account. (continued) 5-30

Operating Activities: Indirect Method Cost of Goods Sold

The $25 decrease in inventory means that although cost of good sold of $80 is included in the income statement, less cash was used to purchase inventory than suggested—add $25 to net income.

(continued) 5-31

Operating Activities: Indirect Method Wages Expense

The $3 increase in wages payable indicates that only $22 of the $25 expense was paid in cash. The $3 increase in wages payable is added to net income.

(continued) 5-32

Operating Activities: Indirect Method Depreciation Expense

The $30 depreciation expense is a noncash expense. Because it was subtracted in computing net income, it must be added back to net income because it was deducted from net income to determine the accrual net income. (continued)

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Operating Activities: Indirect Method

Note the same net cash from operating activities as calculated using the direct method.

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Important •

Depreciation is not a source of cash. Because you added depreciation back to net income as an adjustment using the indirect method does not mean that there is an inflow of cash. However, depreciation does lower the amount of income taxes paid.

•

One advantage of the indirect method is that it highlights how cash flow can be improved in the short run by adjusting operating procedures. 5-35

Comparison of Direct and Indirect Methods Direct Method

The shaded area is reported in the Operating Activities section of the statement of cash flows. (continued)

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Comparison of Direct and Indirect Methods Indirect Method

With the indirect method, only net income and the adjustments are reported. The Operating Activities section of the statement of cash flows includes the shaded information above. (continued)

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4.

Prepare a complete statement of cash flows and provide the required supplemental disclosures

Preparing a Complete Statement of Cash Flows Basic information to prepare the three sections of the cash flow statement comes from the balance sheet and income statement, as follows:

• • •

Operating—income statement adjusted for changes in current operating assets and liabilities. Investing—changes in long-term assets. Financing—changes in long-term liabilities and owners’ equity.

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Preparing a Complete Statement of Cash Flows Step 1: Compute How Much the Cash Balance Changed During the Year

The statement of cash flow is not complete until the sum of cash from operating, investing, and financing activities exactly matches the total change in the cash balance during the year.

(continued) 5-41

Cash increased $10 during the year.

(continued)

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Preparing a Complete Statement of Cash Flows Step 2: Convert the Income Statement from an Accrual-Basis to a Cash-Basis Summary of Operations

This is done in three steps: (a) Eliminate expenses that do not involve the outflow of cash, such as depreciation expense.

(continued) 5-43

(continued)

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Preparing a Complete Statement of Cash Flows Step 2: Continued

(b) Eliminate gains and losses associated with investing or financing activities to avoid counting these items twice.

(continued) 5-45

Replace with new 5-7

(continued)

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Preparing a Complete Statement of Cash Flows Step 2: Continued

(c) Adjust for changes in the balances of current operating assets and operating liabilities.

(continued) 5-47

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(continued)

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Because an interest payable account does not exist, we can safely assume that all interest expense was paid for in cash. Therefore, there is no need for an adjustment.

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Preparing a Complete Statement of Cash Flows Step 3: Analyze the Long-Term Assets to Identify the Cash Flow Effects of Investing Activities.

• Orchard Blossom reports two long-term asset accounts: Land and Buildings.

(continued) 5-54

Investing Activities

• • •

Cash Inflow Sale of plant assets Sale of securities, other than trading securities Collection of principal on loans

• • •

Cash Outflow Purchase of plant assets Purchase of securities, other than trading securities Making of loans with other entities

(continued)

5-55

Investing Activities

The land account increased by $15 during the year. Because there is no indication of a land sale, we conclude that the $15 represents the price of new land purchased during the year.

(continued)

5-56

Investing Activities

The building account increased $40 during the year. In the absence of any other information, this increase would suggest that Orchard Blossom purchased buildings with a cost of $40. However, additional… (continued) 5-57

Investing Activities

…information above is available that indicates that buildings were sold for $32. The $32 cash proceeds from the sale is a cash inflow from investing activities. (continued)

5-58

Investing Activities

Cash proceeds (given) Book value ($36  $14) Gain on sale of building

(continued)

$32 22 $10

5-59

Investing Activities

Known

(continued) 5-60

Investing Activities

Building(s) costing $76 must have been purchased during the year.

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Preparing a Complete Statement of Cash Flows Step 4: Analyze the Long-Term Debt and Stockholders’ Equity Accounts to Determine the Cash Flow Effects of Any Financing Transactions.

(continued) 5-62

Financing Activities

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Cash Inflow Issuance of own stock Borrowings

• • •

Cash Outflow Dividend payments Repaying principal on borrowing Treasury stock purchase

5-63

Financing Activities

We can infer that Orchard Blossom repaid $21 in long-term loans during the year.

(continued) 5-64

Financing Activities

Retained earnings increased by $9. We know there was a $15 net income, so we can use a Taccount to determine the amount of the dividend. The $40 ($100 – $60) increase in Orchard Blossom’s paid-in capital account during the year represents a cash inflow from the issuance of new shares of stock. This cash inflow is reported as part of cash from financing activities. 5-65

Financing Activities

The $6 debit, or “squeeze” figure, has to be the dividends declared (and we will assume paid) during the year. 5-66

Preparing a Complete Statement of Cash Flows Step 5: Prepare a Formal Statement of Cash Flows.

Based on our analyses of the income statement and balance sheet accounts, we have identified all inflows and outflow of cash for Orchard Blossom for the year, and we have categorized those cash flows based on the type of activity.

(continued) 5-67

5-68

Preparing a Complete Statement of Cash Flows Step 6: Prepare Supplemental Disclosure.

• FASB ASC Topic 230 requires separate disclosure of the cash paid for interest and for income taxes during the year.

o Cash paid for interest and income taxes o Noncash investing and financing activities

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5.

• •

Assess a firm’s financial strength by analyzing the relationships among cash flows from operating, investing, and financing activities and by computing financial ratios based on cash flow data Cash Flow Patterns It is possible to gain useful insights about a company by analyzing the relationships among the three cash flow categories.

Exhibit 5-9 on Slides 5-71 and 5-72 shows the eight different possible patterns.

5-70

(continued)

5-71

5-72

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Cash Flow Ratios Cash Flow to Net Income Ratio

Cash from operations Cash-flow-to-net= Net income income ratio • Measure of earnings quality • Tends to be greater than 1 • Should remain fairly stable for the years for a specific company

5-74

Cash Flow Ratios Cash Flow Adequacy Ratio

Cash flow = adequacy ratio

Cash from operations Capital expenditures and acquisitions

• A cash cow is a business that is generating

•

enough cash from operations to completely pay for all new plant and equipment purchases with cash left over to repay loans or distribute to owners. This ratio indicates whether a business is a cash cow. (continued)

5-75

Cash Flow Ratios Cash Flow Adequacy Ratio

5-76

Cash Flow Ratios Cash Times Interest Earned

Cash times interest earned ratio

• •

=

Cash from operations + Interest paid + Taxes paid Interest expense

Measures interest-paying ability Generally, a higher ratio indicates more solvency (continued) 5-77

Cash Flow Ratios Cash Times Interest Earned

5-78

6.

Demonstrates how the three primary financial statements tie together, or articulate, in a unified framework

Articulation: How the Financial Statements Tie Together In an accounting context, articulation means that the three primary financial statements are not isolated lists of numbers but are an integrated set of reports on a company’s financial health. (continued) 5-79

$6

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7.

Use knowledge of how the three primary financial statements tie together to prepare a forecasted statement of cash flows Forecasted Statement of Cash Flows

1. Compute the change in cash. 2. Convert the income statement from an accrual basis to a cash basis. 3. Analyze the long-term asset accounts. 4. Analyze the long-term debt and stockholders’ equity accounts. 5. Prepare the statement of cash flows. 6. Disclose any significant noncash activities.

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