Statement of Cash Flows • Third required financial statement. • Does not affect the way transactions are recorded (i.e., information for statement is derived from data reported in other financial statements).
Income Statement vs. Statement of Cash Flows • Income statement. • Accrual basis results of entity’s operating activities during a period. • Revenue recognition, matching of expenses. • Statement of Cash Flows. • Cash flows associated with an entity’s operating, investing, and financing activities during a period. • Reconciles changes in cash account on balance sheet (i.e., beginning balance to ending balance).
Benefits of theStatement of Cash Flows • Numbers on cash flow statement are objective (i.e., cash is cash). • Eliminates judgments and estimates involved with accrual accounting as on income statement and balance sheet. • Useful information for users dependent upon a healthy cash flow from entity (e.g., employees, suppliers, lenders). • But in some instances, balance sheet and income statement may provide better information about financial status and operating performance.
Statement of Cash Flows:Categories of Activities • Sources. • Activities that generate cash. • Uses. • Activities that involve spending cash.
Cash Sources • Operations. • New borrowings. • New stock issues. • Sale of property, plant, and equipment. • Sale of other non-current assets.
Cash Uses • Cash dividends. • Repayment of borrowings. • Repurchase of stock. • Purchase of property, plant, and equipment. • Purchase of non-current assets.
Definition of Cash • Cash. • Cash equivalents. • Short-term investments. • Highly liquid. • Convertible to known amounts of cash. • Mature in no more than 90 days (GAAP). • Subject to insignificant risk of changes in value (IASB).
Organization of theStatement of Cash Flows • Operating activities • Investing activities. • Financing activities.
Operating Activities • All transactions that are not investing or financing activity. • Cash inflows associated with sales revenues. • Cash outflows associated with operating activities (e.g., payments to suppliers, employees, taxes, interest on loans).
Investing Activities • Outflows: • Acquiring long-lived assets (e.g., property, plant, equipment). • Making investments in securities (i.e., other than cash equivalents). • Lending money.
Investing Activities • Inflows: • Disposing of long-lived assets (e.g., property, plant, equipment). • Disposing of investments in securities (i.e., other than cash equivalents). • Collecting loans.
Financing Activities • Inflows: • Borrowing of cash. • Issuance of equity securities. • Outflows: • Repaying loans. • Retiring equity securities. • Payment of dividends. 11-13
Interest and Dividends • FASB. • Interest received or paid: operating activity. • Dividends received: operating activity. • Dividends paid: financing activity. • IASB. • Can be classified in any activity category as long as done in a consistent manner.
Significant Noncash Transactions • Significant investing and financing activities that did not involve cash. • E.g., conversion of a convertible bond into stock, purchase of a building with a notes payable. • Not reported in body of statement of cash flows; narrative statement or supplemental disclosure.
Operating Activities:Approaches to Presentation • Direct method. • Inflows (i.e. cash provided by operating activities). • Outflows (i.e. cash disbursed for operating activities). • Net cash flow (i.e. inflows - outflows). • Encouraged by FASB. • Indirect method. • Reconciliation of period’s net income and the period’s net cash flow from operations. • More difficult to understand. • Note: Cash flow from operating activities will be the same under either method.
Supplemental Disclosure • If direct method is used, FASB requires supplemental disclosure of reconciliation between net income and operating cash flows. • In effect, if direct method is used, indirect method is also required.
Operating Activities Cash Flow • Collections from customers. • Sales – (End AR – Beg AR). • Payments to suppliers. • Cost of goods sold + (End Inventory – Beg Inventory) – (End AP – Beg AP). • Interest paid. • Interest expense – (End Int. Pay – Beg Int. Pay).
Indirect Method ofPresenting Operating Activities • Start with net income. • Adjust for noncash items included in net income (i.e., adjustment of accrual based earnings). • Depreciation and amortization (add back). • Difference between sales and cash collected (i.e., the change in accounts receivable). • Differences between expenses and cash payments (i.e., Changes in accounts payable, inventory, prepaid expenses).
Indirect Method ofPresenting Operating Activities • Additions to net income. • Depreciation expense. • Decreases in: • Accounts receivable. • Inventories. • Prepaid Expenses. • Increases in: • Accounts payable. • Wages payable. • Interest payable. • Taxes payable. • Deferred taxes. • Loss on disposal.
Indirect Method ofPresenting Operating Activities • Subtractions from net income. • Increases in: • Accounts receivable. • Inventories. • Prepaid Expenses. • Decreases in: • Accounts payable. • Wages payable. • Interest payable. • Taxes payable. • Deferred taxes. • Gain on disposal.
Indirect Method ofPresenting Operating Activities • Depreciation. • Cash paid for property, plant, or equipment is a cash outflow. • Allocation of this amount to expense (via depreciation) is not a cash flow. • Therefore, must be subtracted out (added back) in operating activities section. • Gains and losses. • Cash proceeds from the sale of property, plant, or equipment is a cash inflow. • Recorded gain (loss) is not the cash flow. • Therefore, must be subtracted out (added back) in operating activities section.
Summary ofCash Flow Statement Cash flow from operating activities + Cash flow from investing activities + Cash flow from financing activities = Increase (decrease) in cash and cash equivalents + Cash and cash equivalents at beginning of year = Cash and cash equivalents at end of year
Cash Flow Ratios • Cash realization ratio (i.e., quality of earnings). • Cash generated by operations ÷ Net income. • Coverage ratios. • Use cash flow as numerator in Chapter 8 coverage ratios (i.e., times interest earned, fixed charges coverage). • Source and use percentages. • Reorganize data into sources and uses format; then show each item as percent of total sources. • Ratio of cash generated by operations to total debt.
Cash Flow Projections • “Free” Cash Flow. • Cash from operations less: • Fixed asset replacements necessary to maintain existing capacity. • Scheduled debt repayments. • Normal dividend payments.
Cash Flow Projections • Projected cash flow statement. • Useful to project amount, timing, and character of new financing. • For management: anticipate future cash needs. • For potential lenders: indicate ability to repay debt. • Cash budget. • Useful for shorter-term financial planning (e.g., seasonal needs, when excess cash is available to invest in short-term securities).