Financial Accounting: Tools for Business Decision Making, 3rd Ed.

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Financial AccountingTools for Business Decision
Making, 3rd Ed.
Kimmel, Weygandt, Kieso
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Chapter 12
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Chapter 12 Statement of Cash Flows

• After studying Chapter 12, you should be able
  to
• Indicate the primary purpose of the statement of
  cash flows.
• Distinguish among operating, investing, and
  financing activities.
• Explain the impact of the product life cycle on a
  company's cash flows.
• Prepare a statement of cash flows using one of
  two approaches
• (a) the indirect method, or
• (b) the direct method.
• Use the statement of cash flows to evaluate a
  company.

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The Primary Purpose of the Statement of Cash
Flows Is...

• To provide information about
• cash receipts,
• cash payments, and
• the net change in cash resulting from
• operating,
• investing, and
• financing activities of a company during a period.

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Questions the Statement of Cash Flow Answers
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Operating Activities...

• Include
• The cash effects of transactions that create
  revenues and expenses and
• Enter into determination of net income.

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Investing Activities...

• Include
• Purchasing and disposing of investments and
  productive long-lived assets using cash and
• Lending money and collecting the loans.

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Financing Activities...

• Include
• Obtaining cash from issuing debt and repaying the
  amounts borrowed and
• Obtaining cash from stockholders and paying
  dividends.

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Types of Cash Flows -Operating Activities

• Cash inflows
• From sale of goods or services
• From return on loans (interest received) and on
  equity securities (dividends received)
• Cash outflows
• To suppliers for inventory
• To employees for services
• To government for taxes
• To lenders for interest
• To others for expenses

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Types of Cash Flows -Investing Activities

• Cash inflows
• From sale of property, plant, and equipment
• From sale of debt or equity securities of other
  entities
• From collection of principal on loans to other
  entities
• Cash outflows
• To purchase property, plant, and equipment
• To purchase debt or equity securities of other
  entities
• To make loans to other entities

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Types of Cash Flows -Financing Activities

• Cash inflows
• From sale of equity securities (company's own
  stock)
• From issuance of debt (bonds and notes)
• Cash outflows
• To stockholders as dividends
• To redeem long-term debt or reacquire capital
  stock

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Operating Activities - ALERT

• Some cash flows relating to investing or
  financing activities are classified as operating
  activities. For example...
• Receipts of investment revenue (interest and
  dividends) and
• Payments of interest to lenders are classified as
  operating activities because these items are
  reported in the income statement.

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Significant Noncash Activities...

• That do NOT affect cash are NOT reported in the
  body of the statement of cash flows.
• Are reported
• In a separate schedule at the bottom of the
  statement of cash flows or
• In a separate note or supplementary schedule to
  the financial statements.

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Significant Noncash Activities...

• 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 plant assets.

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Format of the Statement of Cash Flows

• Three parts
• operating
• investing
• financing

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Format of the Statement of Cash Flows

• Three activities
• operating
• investing
• financing
• PLUS
• noncash investing and financing activities

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The Product Life Cycle

• A series of phases all products go through
• The phases are often referred to as the
• introductory phase
• growth phase
• maturity phase
• decline phase.
• The phase a company is in affects its cash flows.

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Introductory Phase

• To support asset purchases the company may issue
  stock or debt. Expect
• cash from operations to be negative.
• cash from investing to to be
  negative.
• cash from financing to be
  positive.

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Growth Phase

• The company is striving to expand its production
  and sales.
• Expect
• small amounts of cash to be generated from
  operations.
• cash from investing to be negative.
• cash from financing to be positive.

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Maturity Phase

• Sales and production level-off
• Expect
• cash from operations to exceed investing needs.
• cash from investing to be
  neutral.
• cash from financing to be
  negative.

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Decline Phase

• Sales and production decline
• Expect
• cash from operations to decline
• cash from investing to possibly become
  positive.
• cash from financing to possibly become negative

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Why Report the Causes of Changes in Cash?
Because investors, creditors, and other
interested parties want to now what is happening
to a companys most liquid asset, CASH
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Statement of Cash Flows Helps Users Evaluate

• 1. The entity's ability to generate future cash
  flows
• 2. The entity's ability to pay dividends and meet
  obligations
• 3. The reasons for the difference between net
  income and net cash provided (used) by operating
  activities
• 4. The investing and financing transactions
  during the period

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Statement of Cash Flows Helps Answer the
Following Questions

• How did cash increase when there was a net loss
  for the period?
• How were the proceeds of the bond issue used?
• How was the expansion in the plant and equipment
  financed?
• Why were dividends not increased?
• How was the retirement of debt accomplished?
• How much money was borrowed during the year?
• Is cash flow greater or less than net income?

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Sources of Information for the Statement of Cash
Flows

• Comparative balance sheet
• Current income statement
• Additional information

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Comparative Balance Sheet

• Indicates the amount of changes in assets,
  liabilities, and stockholders' equities from the
  beginning to the end of the period.

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COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31, 2003
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Current Income Statement

• Information in this statement helps the reader
  determine the amount of cash provided or used by
  operations during the period.

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Income Statement and Additional Information

• COMPUTER SERVICES COMPANY
• Income Statement
• For the Year Ended December 31, 2003
• Revenues 85,000
• Operating expenses 40,000
• Income before income taxes 45,000
• Income tax expense 10,000
• Net income 35,000
• Additional Information
• (a) Examination of selected data indicates that a
  dividend of 15,000 was declared and paid during
  the year.
• (b) The equipment was purchased at the end of
  2003. No depreciation was taken in 2003.

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Indirect and Direct Methods

• Convert net income from an accrual basis to a
  cash basis.
• This conversion may be done by two
  methods
• indirect
• direct

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Indirect and Direct Methods

• Both methods arrive at the same total amount for
  Net cash provided by operating activities.
• The methods differ in disclosing the items that
  make up the total amount.
• The choice of methods affects only the operating
  activities section the investing and financing
  activities sections are the same.

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Indirect Method

• The indirect method is used extensively in
  practice.
• Most companies favor the indirect method for the
  following reasons
• it is easier to prepare
• it focuses on the differences between net income
  and net cash flow from operating activities
• it tends to reveal less company information to
  competitors.

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Direct Method

• The FASB prefers the direct method but allows the
  use of either method.
• When the direct method is used, the net cash flow
  from operating activities as computed using the
  indirect method must also be reported in a
  separate schedule.

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Statement Of Cash Flows - Indirect Method

• The transactions of Computer Services Company for
  the year ended 2003 are used to illustrate the
  preparation of a statement of cash flows .
• Computer services Company started in January 1,
  2003, when it issued 50,000 shares of 1 par
  value common stock for 50,000 cash.
• The company rented its office space and furniture
  and performed consulting services throughout the
  first year.

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Determine Net Cash Provided/Used By Operating
Activities

• Adjust net income for items that did not affect
  cash.
• Net income must be converted because earned
  revenues may include credit sales that have not
  been collected in cash and expenses incurred that
  may not have been paid in cash.

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Determine Net Cash Provided/Used By Operating
Activities

• Receivables, payables, prepayments, and
  inventories must be analyzed for their effects on
  cash.

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Determine Net Cash Provided/Used By Operating
Activities

• Computer Services Company had revenues of 85,000
  in its first year of operations.
• However, CSC collected only 55,000 in cash.
  Accrual basis revenue was 85,000, cash basis
  revenue would be 55,000.
• The increase in accounts receivable of 30,000
  must be deducted from net income.
• If accounts receivable decrease, the decrease
  must be added to net income.

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• COMPUTER SERVICES COMPANY
• Statement of Cash Flows--Indirect Method
  (Partial)
• For the Year Ended December 31, 2003
• Cash flows from operating activities
• Net income 35,000
• Adjustments to reconcile net income to
• net cash provided by operating activities
• Increase in accounts receivable (30,000)
  

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Determine Net Cash Provided/Used By Operating
Activities

• Accounts payable - When accounts payable increase
  during a year, operating expenses on an accrual
  basis are higher than they are on a cash basis.
• For CSC, operating expenses reported in the
  income statement were 40,000.
• Since Accounts Payable increased 4,000, 36,000
  (40,000 4,000) of the expenses were paid in
  cash.
• To convert net income to net cash provided by
  operating activities, an increase in accounts
  payable must be added to net income, a decrease
  subtracted.

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• COMPUTER SERVICES COMPANY
• Statement of Cash Flows--Indirect Method
  (Partial)
• For the Year Ended December 31, 2003
• Cash flows from operating activities
• Net income 35,000
• Adjustments to reconcile net income to
• net cash provided by operating activities
• Increase in accounts receivable (30,000)
• Increase in accounts payable
  4,000 (26,000)
• Net cash provided by operating activities
  9,000

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Determine Net Cash Provided/Used By Investing
and Financing Activities

• No data are given for the increases in Equipment
  of 10,000 and Common Stock of 50,000. Assume
  any differences involve cash.
• The increase in equipment is from a purchase of
  equipment for 10,000 cash. This purchase is
  reported as a cash outflow in the investing
  activities section.
• The increase of common stock results from the
  issuance of common stock for 50,000 cash. It is
  reported as an inflow of cash in the financing
  activities section of the statement of cash flows.

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COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31, 2003
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Determine Net Cash Provided/Used By Investing
and Financing Activities

• Reasons for the increase of 20,000 in the
  Retained Earnings.
• Net income increased retained earnings by
  35,000. REPORTED IN THE OPERATING ACTIVITIES
  SECTION.
• The additional information indicates that a cash
  dividend of 15,000 was declared and paid.
  REPORTED IN THE FINANCING ACTIVITIES SECTION.

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• COMPUTER SERVICES COMPANY
• Statement of Cash Flows--Indirect Method
  (Partial)
• For the Year Ended December 31, 2003
• Cash flows from operating activities
• Net income 35,000
• Adjustments to reconcile net income to
• net cash provided by operating activities
• Increase in accounts receivable (30,000)
• Increase in accounts payable
  4,000 (26,000)
• Net cash provided by operating activities
  9,000
• Cash flows from investing activities
• Purchase of equipment (10,000)
• Cash flows from financing activities
• Issuance of Common Stock 50,000
• Payment of cash dividends (15,000)
• Net cash provided by financing activities
  35,000
• Net increase in cash 34,000

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• COMPUTER SERVICES COMPANY
• Statement of Cash Flows--Direct Method
  (Partial)
• For the Year Ended December 31, 2003
• Cash flows from operating activities
• Cash receipts from customers
  765,000
• Cash payments
• To supplier 550,000
• For operating expenses
  158,000
• For income taxes 48,000 756,000
• Net cash provided by operating activities
  9,000

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Free Cash Flow

• In the statement of cash flows, cash from
  operations is intended to indicate the
  cash-generating capability of the company.
• Statement of Cash flows fails to take into
  account that a company must invest in new fixed
  assets to maintain its current level of
  operations and it must maintain dividends at
  current levels to satisfy investors.

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Free Cash Flow

• Cash Provided By Operations
• Capital Expenditures
• Dividends Paid
  
• Free Cash Flow

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Using Cash Flows to Evaluate a Company

• The 2001 statement of cash flows of Microsoft
  Corporation provides information for the
  computations of these measures.
• MICROSOFT CORPORATION
• STATEMENT OF CASH FLOWS (PARTIAL)
• 2001
• Cash flows from operations 13,422
• Additions to property, plant,
• and equipment (1,103)
• Other assets and investments ( 66,346)
• Short-term investments 58,315
• Cash used by investing activities (9,134)
• Cash paid for dividends on preferred stock
  (0)

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• MICROSOFT CORPORATION
• STATEMENT OF CASH FLOWS (Partial)
• 2001
• Cash flows from operations 13,422
• Less Expenditures on property, plant,
• and equipment 1,103
• Dividends z 0
• Free Cash Flow 12,319

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Assessing Liquidity, Solvency, and Profitability
Using Cash Flows

• Rather than using numbers from the income
  statement for assessment purposes, we use numbers
  from the statement of cash flows.

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Cash-Based Measures

• Accrual-based measures allows too much management
  discretion.
• One disadvantage to the cash-based measures is no
  readily available published industry averages for
  comparison.

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Liquidity

• Liquidity is the ability of a business to meet
  its immediate obligations.
• One measure of liquidity is the current ratio.
• A disadvantage of the current ratio is that it
  uses year-end balances of current assets and
  current liabilities (may not be representative of
  a company's position during most of the year.)

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Current Cash Debt Coverage Ratio

• A ratio that partially corrects this is the
  current cash debt coverage ratio.
• Cash provided by operations
• Average current liabilities
• Since cash from operations involves the entire
  year rather than a balance at one point in time,
  it is often considered a better representation of
  liquidity on the average day.

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Solvency

• Solvency is the ability of a firm to survive over
  the long term.
• One measure of solvency is the debt to total
  assets ratio.
• A measure of solvency that uses cash figures is
  the cash debt coverage ratio.
• Cash Provided By Operations
• Average Total Liabilities
• This ratio measures a company's ability to repay
  its liabilities from cash generated from
  operations.

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Profitability

• Profitability refers to a company's ability to
  generate a reasonable return.
• Accrual-based ratios that measure profitability
  are gross profit rate, profit rate margin, and
  return on assets.
• A cash-based measure of performance is the cash
  return on sales ratio.

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