CHAPTER 8 THE CASH FLOW STATEMENT: ITS CONTENT AND USE

1. CHAPTER 8 THE CASH FLOW STATEMENT: ITS CONTENT AND USE

2. Chapter Overview • Why is a company’s cash flow statement important? • What are the types of transactions that may cause cash inflows and cash outflows for a company? • What do users need to know about a company’s cash flow statement? • How does a company report the cash flows from its operating activities on its cash flow statement under the direct method?

3. Chapter Overview • How do users combine the changes in a company’s current assets and current liabilities with its revenues and expenses for the accounting period to determine the company’s operating cash flows? • Why do internal and external users study a company’s cash flow statement in conjunction with its income statement and balance sheet? • What cash flow ratios are used to evaluate a company’s performance?

4. Why the Cash Flow Statementis Important • A company’s cash flow statement shows the changes in a company’s cash during an accounting period from operating, investing, and financing activities. • It primarily provides information about a company’s ability to remain solvent (meet its obligations) and to grow.

5. Why the Cash Flow Statementis Important • A cash flow statement can help users answer questions such as , “How much cash was provided or used by the company’s operating activities?”, or “What are the reasons that cash increased or decreased during an accounting period?” • A company cannot survive without cash to operate day-to-day; and thus, studying the cash flow statement provides important information on a company’s financial stability.

6. Cash Inflows and Outflows • A company’s cash flow statement shows the inflows (receipts) and outflows (payments) during an accounting period. • The cash flow statement reconciles the beginning balance of cash from the balance sheet to the ending balance of cash on the balance sheet.

7. Cash Account and Cash Flows

8. Balance Sheet Accounts and Cash Flows

9. When cash is collected, the asset accounts receivable decreases Inflows (Receipts) of Cash • A decrease in an asset (other than cash) causes an inflow (increase) of cash when cash is received in exchange for the asset. • This occurs when a company collects $200 on an accounts receivable from a customer.

10. When a company borrows money in exchange for a note payable, the liability notes payable increases. Inflows (Receipts) of Cash • An increase in a liability may also cause an inflow (increase) of cash when a company receives cash in exchange for the liability. • This occurs when a company borrows $4,000 from a bank and signs a note payable.

11. When an owner invests additional cash into the business, owners’ capital increases. Inflows (Receipts) of Cash • An increase in owners’ equity may also cause an inflow (increase) of cash when additional investments are made in the business. • This occurs when a company’s owner invests an additional $1,000 into the business.

12. When cash is paid, the asset store supplies increases. Outflows (Payments) of Cash • An increase in an asset (other than cash) causes an outflow (decrease) of cash when a company pays cash for the asset. • This occurs when a company pays $50 for purchased supplies.

13. When a company pay a portion of its outstanding notes payable, the liability notes payable decreases. Outflows (Payments) of Cash • A decrease in a liability causes an outflow (decrease) of cash when a company pays cash for outstanding debts. • This occurs when a company pays $500 to reduce its notes payable.

14. When an owner withdraws cash from the business, owners’ capital decreases. Outflows (Payments) of Cash • An decrease in owners’ equity may also cause an outflow (decrease) of cash for owners’ withdrawals from the business. • This occurs when an owner withdraws $300 from the company.

15. Organization of the Cash Flow Statement • The cash flow statement shows a company’s cash flows in three sections according to the type of activity that caused the increase or decrease in cash. Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities

16. The Nature of Operating Cash Flows • Operating cash flows include cash inflows and outflows related to the profit-making activities of a company. • Collections from customers, payments for merchandise purchases, payments to employees and for other operating expenses are included in this category. Cash flow from operating activities

17. The Nature of Investing Cash Flows • Investing cash flows include cash inflows and outflows related to lending activities, investing in other companies and long-term operating assets. • Purchases and sales of property and equipment are included in this category. Cash flow from investing activities

18. The Nature of Financing Cash Flows • Financing cash flows include cash inflows and outflows related to acquiring owner’s capital, rewarding owners by returning profits, and non-operating debt activities. • Investments and withdrawals by owners and acquiring or repaying loans are included in this category. Cash flow from financing activities

19. Examples of Cash FlowsExhibit 8-4

20. Under the direct method, a company identifies the underlying reasons for cash inflows and outflows, which provides a detailed picture of cash flow activity. Examples include collections from customers (cash inflows) or payments of interest (cash outflows). Net Cash Flows from Operating Activities: Direct Method

21. Under the indirect method, a company starts with net income, adjusting this for non cash items (such as depreciation) and net changes in non-cash current assets and liabilities during the period.This provides less detail but an important reconciliation between net income on the income statement and cash flows from operations. Net Cash Flows from Operating Activities: Indirect Method

22. Detailed cash transactions occurring during January 2004 • By carefully analyzing all of the changes in the cash account, we can summarize the detail transactions that cause Sweet Temptations’ cash to increase from $7,300 to $11,030 during January 2004 Net Cash Flows from Operating Activities: Direct Method Sweet Temptations Cash Account: January 2004

23. Net Cash Flows from Operating Activities: Direct Method Sweet Temptations Cash Account: January 2004 • After identifying the cash transactions, operating cash flows can be segregated.

24. Net Cash Flows from Investing Activities Sweet Temptations Cash Account: January 2004 • After identifying the operating cash flows, investing cash flows can be segregated.

25. Net Cash Flows from Financing Activities Sweet Temptations Cash Account: January 2004 • After identifying operating and investing cash flows, financing cash flows can be segregated.

26. Sweet Temptations’ Cash Flow Statement

27. Expanding Calculations under the Direct Method • While a company can analyze every transaction in its cash account, this would be a time consuming process given the thousands of transactions recorded during an accounting period. • Instead, under accrual-basis accounting, changes in non-cash current assets and liabilities can be defined in terms of operating cash inflows and outflows.

28. Cash Collections from Customers • Sales revenues on the income statement arise from cash and credit sales to customers. • By understanding the changes in the current asset accounts receivable during the year, sales revenues can be converted to cash collections from customers. • When accounts receivable increases, a credit sale is made (but no cash is received). When it decreases, cash is collected (but no revenue is recorded).

29. Cash Collections from Customers • Assume a company reports $500,000 in sales revenues on its income statement, and the following activity is recorded in accounts receivable during the year: • How can this be analyzed to determine the cash collections from customers on the cash flow statement?

30. 1. Accounts receivable (A/R) shows a net decrease during the year – what does it mean when A/R decreases? Cash Collections from Customers 4. The net decrease of $2,500 must be added to net sales to obtain cash collections from customers 3. This is true; credit sales were $350,000 and cash collections were $352,500. From a cash flow perspective, sales on the income statement are understated when A/R decreases during the year. 2. It means the company collected more cash from customers than it recorded in credit sales.

31. Cash inflow from operating activities Cash Collections from Customers • After we complete the analysis of the net changes in accounts receivable, cash collections from customers (under the direct method) is computed as follows:

32. Cash Payments to Employees • Salary expense on the income statement arises when employees perform services and a company recognizes the expense in the period the services are performed. • By understanding the changes in the current liability salaries payable during the year, salary expense can be converted to cash payments to employees. • When salaries payable increases, expense is being recorded (but no cash is paid). When it decreases, cash is paid (but no expense is recorded).

33. Cash Paymentsto Employees • Assume a company reports $25,000 in salaries expense on its income statement, and the following activity is recorded in salaries payable during the year: • How can this be analyzed to determine the cash payments to employees on the cash flow statement?

34. 1. Salaries Payable (S/P) shows a net increase during the year – what does it mean when S/P increases? Cash Payments to Employees 3. This is true; salary expense was $25,000 and cash payments to employees were $15,000. From a cash flow perspective, salary expense on the income statement is overstated when S/P increases during the year. 2. It means the company recorded more salary expense than cash paid to employees. • The net increase of $10,000 must be subtracted from salary expense to obtain cash payments to employees

35. Cash outflow from operating activities Cash Paymentsto Employees • After we complete the analysis of the net changes in salaries payable, cash payments to employees (under the direct method) is computed as follows:

36. Calculation of Operating Cash Flows

37. A measure of a company’s liquidity - how much net cash is generated from each dollar of net sales generated by a company. A measure of how well a company uses its total resources to generate net cash from operating activities. A measure of how well a company uses its owners’ capital to generate net cash from operating activities. Cash Flow Statement Usefulness

38. Net Cash Flow Provided by Operating Activities Net Sales Operating CashFlow Margin • Operating cash flow margin describes how much net cash a company generates from each dollar of net sales, providing an additional measure of a company’s liquidity.

39. [Net cash flow provided by operating activities + Interest paid] Average Total Assets Cash Return on Total Assets • Cash return on total assets measures how well a company is using its resources to generate net cash from operating activities.

40. Net Cash Flow Provided by Operating Activities Average Owners’ Equity Cash Return on Owners’ Equity • A company’s cash return on owners’ equity measures how much net cash from operating activities the company generates with each dollar of owners’ capital.