Chapter 7--Learning Objectives <ul><li>1. Understand how the statement of cash flows assists users in evaluation of firm p...
Current operating cash flows a major user need <ul><li>Current operating cash flows </li></ul><ul><li>(COCF) </li></ul><ul...
Current operating cash flows must be adequate for: <ul><li>1. Permanent working capital </li></ul><ul><li>2. Seasonal work...
Permanent working capital <ul><li>a firm’s permanent investment in net operating asset </li></ul><ul><li>receivables and i...
Seasonal working capital <ul><li>increases in inventory levels required by seasonally increased demands for the firm’s pro...
Adequacy ratios <ul><li>The following ratios help assess the adequacy of COCF to meet firm needs: </li></ul><ul><li>Capita...
Adequacy ratios (cont.) <ul><li>Capital Financing </li></ul><ul><li>Reinvestment </li></ul><ul><li>Cash-Interest Coverage ...
Performance and quality ratios <ul><li>Cash flow return on assets </li></ul><ul><li>Cash flow return on common equity </li...
Cash flow return on assets <ul><li>COCF before interest and taxes * </li></ul><ul><li>Average total assets </li></ul><ul><...
Cash flow return on common equity <ul><li>COCF - preferred dividends </li></ul><ul><li>Average common equity </li></ul>
Quality of sales ratio <ul><li>Cash from sales </li></ul><ul><li>Sales </li></ul>
Quality of income ratio # 1 <ul><li>Current operating cash flows </li></ul><ul><li>Operating income </li></ul>
Quality of income ratio # 2 <ul><li>C O C F  before  interest  and  taxes </li></ul><ul><li>Income before interest, taxes ...
Cash flow per share * <ul><li>C O C F  -  preferred  dividends </li></ul><ul><li>Average number of common shares </li></ul...
Chapter 7--Learning Objectives <ul><li>2. Interpret the format and content of the statement of cash flows </li></ul>
Statement of cash flows <ul><li>The purpose of the cash flow statement is to show the sources and uses of cash </li></ul><...
Statement of cash flows <ul><li>The statement has three principal sections: </li></ul><ul><li>1. Operating activities </li...
Statement of cash flows <ul><li>The statement can be prepared two ways </li></ul><ul><li>1. The indirect method </li></ul>...
Operating activities <ul><li>Routine inflows and outflows from regular operations </li></ul><ul><li>Net income used as a s...
Adjustments to net income in the operating section <ul><li>Items which affect income but not cash </li></ul><ul><li>--  De...
Relationships to remember <ul><li>An  increase  in another asset account </li></ul><ul><li>results in a  decrease  in cash...
Relationships to remember <ul><li>Similarly, a  decrease  in a  liability account results in a  decrease  in cash </li></u...
Investing activities <ul><li>Investments in our own business </li></ul><ul><li>Purchase of operational assets </li></ul><u...
Financing activities <ul><li>Transactions involving owners </li></ul><ul><li>Sale of stock </li></ul><ul><li>Payment of di...
Some special cases <ul><li>Purchase and sale of investments, whether short-term or long-term are  INVESTING  activities </...
More special cases <ul><li>Interest paid to creditors is considered to be an  OPERATING   activity </li></ul><ul><li>Divid...
Noncash investing and financing activities <ul><li>Transactions in which no cash is involved </li></ul><ul><li>Example:  P...
The direct method <ul><li>Starts with cash received from customers </li></ul><ul><li>Subtracts cash paid to </li></ul><ul>...
A separate reconciliation <ul><li>from net income </li></ul><ul><li>to </li></ul><ul><li>net cash flow from operating acti...
The indirect method <ul><li>Begins with net income </li></ul><ul><li>Adjusts for items which affect income but not cash an...
Chapter 7--Learning Objectives <ul><li>3. Derive cash flow information analytically from accrual information </li></ul>
Accrual based financial statements do not reveal cash received from customers or cash paid to suppliers <ul><li>We have to...
What do we know ? <ul><li>From the income statement, we know sales revenue </li></ul><ul><li>From the balance sheet, we kn...
<ul><li>Sales revenue </li></ul><ul><li>Plus: Beginning accts. receivable </li></ul><ul><li>Less: Ending accts. receivable...
Account receivable write-offs <ul><li>Beginning Allow. for Bad Debts </li></ul><ul><li>Plus: Bad Debt Expense </li></ul><u...
What about cash paid to suppliers ? <ul><li>Purchases </li></ul><ul><li>Plus: Beginning Accts. Payable </li></ul><ul><li>L...
If necessary, Purchases is calculated <ul><li>Cost of Goods Sold </li></ul><ul><li>Plus: Ending Inventory </li></ul><ul><l...
Chapter 7--Learning Objectives <ul><li>4. Differentiate between the direct and indirect method of presentation </li></ul>
East-West Industries Statement of Cash Flows - Direct Method For the year ended June 30, 1995 <ul><li>Cash flows from oper...
East-West Industries Statement of Cash Flows - Direct Method (continued) <ul><li>Cash flows from investing activities </li...
East-West Industries Statement of Cash Flows - Direct Method (continued) <ul><li>Cash flows from financing activities </li...
Operating Section - Indirect Method <ul><li>Cash flows from operating activities </li></ul><ul><li>Net income $97,000 </li...
Operating Section - Indirect Method--continued <ul><li>Cash flows from operating activities </li></ul><ul><li>Gain on debt...
Chapter 7--Learning Objectives <ul><li>5. Prepare a statement of cash flows </li></ul>
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Chapter Seven

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  • Chapter Seven

    1. 1. Chapter 7--Learning Objectives <ul><li>1. Understand how the statement of cash flows assists users in evaluation of firm performance </li></ul>
    2. 2. Current operating cash flows a major user need <ul><li>Current operating cash flows </li></ul><ul><li>(COCF) </li></ul><ul><li>is cash available from </li></ul><ul><li>normal operations </li></ul>
    3. 3. Current operating cash flows must be adequate for: <ul><li>1. Permanent working capital </li></ul><ul><li>2. Seasonal working capital </li></ul><ul><li>3. Net fixed (and other long-term) assets </li></ul><ul><li>4. Repayment of debt principal & interest </li></ul><ul><li>5. Payment of dividends </li></ul>
    4. 4. Permanent working capital <ul><li>a firm’s permanent investment in net operating asset </li></ul><ul><li>receivables and inventory less the amount of this investment financed by trade creditors through accounts payable </li></ul>
    5. 5. Seasonal working capital <ul><li>increases in inventory levels required by seasonally increased demands for the firm’s product or service </li></ul>
    6. 6. Adequacy ratios <ul><li>The following ratios help assess the adequacy of COCF to meet firm needs: </li></ul><ul><li>Capital acquisition ratio </li></ul><ul><li>Debt coverage ratio </li></ul><ul><li>Dividend coverage ratio </li></ul><ul><li>Cash flow adequacy ratio </li></ul>
    7. 7. Adequacy ratios (cont.) <ul><li>Capital Financing </li></ul><ul><li>Reinvestment </li></ul><ul><li>Cash-Interest Coverage </li></ul><ul><li>Dividend Payout </li></ul>
    8. 8. Performance and quality ratios <ul><li>Cash flow return on assets </li></ul><ul><li>Cash flow return on common equity </li></ul><ul><li>Quality of sales ratio </li></ul><ul><li>Quality of income ratio (2) </li></ul><ul><li>Cash flow per share </li></ul>
    9. 9. Cash flow return on assets <ul><li>COCF before interest and taxes * </li></ul><ul><li>Average total assets </li></ul><ul><li>* inclusion of taxes varies in practice </li></ul>
    10. 10. Cash flow return on common equity <ul><li>COCF - preferred dividends </li></ul><ul><li>Average common equity </li></ul>
    11. 11. Quality of sales ratio <ul><li>Cash from sales </li></ul><ul><li>Sales </li></ul>
    12. 12. Quality of income ratio # 1 <ul><li>Current operating cash flows </li></ul><ul><li>Operating income </li></ul>
    13. 13. Quality of income ratio # 2 <ul><li>C O C F before interest and taxes </li></ul><ul><li>Income before interest, taxes & deprec. </li></ul>
    14. 14. Cash flow per share * <ul><li>C O C F - preferred dividends </li></ul><ul><li>Average number of common shares </li></ul><ul><li>*explicitly prohibited from disclosure in annual report </li></ul>
    15. 15. Chapter 7--Learning Objectives <ul><li>2. Interpret the format and content of the statement of cash flows </li></ul>
    16. 16. Statement of cash flows <ul><li>The purpose of the cash flow statement is to show the sources and uses of cash </li></ul><ul><li>Where did the cash come from ? </li></ul><ul><li>Where did it go ? </li></ul>
    17. 17. Statement of cash flows <ul><li>The statement has three principal sections: </li></ul><ul><li>1. Operating activities </li></ul><ul><li>2. Investing activities </li></ul><ul><li>3. Financing activities </li></ul><ul><li>And two ancillary sections </li></ul><ul><li>1. Noncash investing / financing </li></ul><ul><li>2. Reconciliation </li></ul>
    18. 18. Statement of cash flows <ul><li>The statement can be prepared two ways </li></ul><ul><li>1. The indirect method </li></ul><ul><li>2. The direct method </li></ul>
    19. 19. Operating activities <ul><li>Routine inflows and outflows from regular operations </li></ul><ul><li>Net income used as a starting point in indirect method </li></ul><ul><li>Net income must be adjusted for items which affect income but not cash and for noncash items </li></ul>
    20. 20. Adjustments to net income in the operating section <ul><li>Items which affect income but not cash </li></ul><ul><li>-- Depreciation and amortization </li></ul><ul><li>Noncash items </li></ul><ul><li>-- Changes in current asset accounts </li></ul><ul><li> (except certain investments) </li></ul><ul><li>-- Changes in current liability accounts </li></ul>
    21. 21. Relationships to remember <ul><li>An increase in another asset account </li></ul><ul><li>results in a decrease in cash </li></ul><ul><li>ANOTHER ASSET UP -- CASH DOWN </li></ul><ul><li>ANOTHER ASSET DOWN -- CASH UP </li></ul>
    22. 22. Relationships to remember <ul><li>Similarly, a decrease in a liability account results in a decrease in cash </li></ul><ul><li>LIABILITY DOWN -- CASH DOWN </li></ul><ul><li>LIABILITY UP -- CASH UP </li></ul>
    23. 23. Investing activities <ul><li>Investments in our own business </li></ul><ul><li>Purchase of operational assets </li></ul><ul><li>Sale of operational assets </li></ul><ul><li>Investments in other businesses </li></ul><ul><li>Purchase of securities </li></ul><ul><li>Sale of securities </li></ul><ul><li>Making loans to other entities </li></ul><ul><li>Collecting such loans </li></ul>
    24. 24. Financing activities <ul><li>Transactions involving owners </li></ul><ul><li>Sale of stock </li></ul><ul><li>Payment of dividends </li></ul><ul><li>Treasury stock transactions </li></ul><ul><li>Transactions involving creditors </li></ul><ul><li>Borrowing long-term </li></ul><ul><li>Repaying long-term debt </li></ul>
    25. 25. Some special cases <ul><li>Purchase and sale of investments, whether short-term or long-term are INVESTING activities </li></ul><ul><li>Dividends and interest received from investments are considered to be OPERATING activities </li></ul>
    26. 26. More special cases <ul><li>Interest paid to creditors is considered to be an OPERATING activity </li></ul><ul><li>Dividends paid to stockholders are considered to be a FINANCING activity </li></ul>
    27. 27. Noncash investing and financing activities <ul><li>Transactions in which no cash is involved </li></ul><ul><li>Example: Purchase of equipment with no down payment by issuing a long-term note payable </li></ul>
    28. 28. The direct method <ul><li>Starts with cash received from customers </li></ul><ul><li>Subtracts cash paid to </li></ul><ul><li>Suppliers </li></ul><ul><li>Employees </li></ul><ul><li>Creditors (interest payments) </li></ul><ul><li>Governments (taxes) </li></ul><ul><li>Others (for operations) </li></ul>
    29. 29. A separate reconciliation <ul><li>from net income </li></ul><ul><li>to </li></ul><ul><li>net cash flow from operating activities </li></ul><ul><li>is required </li></ul><ul><li>when the direct method </li></ul><ul><li>is used </li></ul>
    30. 30. The indirect method <ul><li>Begins with net income </li></ul><ul><li>Adjusts for items which affect income but not cash and for noncash items </li></ul><ul><li>Only the operating section is different between the indirect and direct methods </li></ul><ul><li>The investing and financing sections are identical </li></ul>
    31. 31. Chapter 7--Learning Objectives <ul><li>3. Derive cash flow information analytically from accrual information </li></ul>
    32. 32. Accrual based financial statements do not reveal cash received from customers or cash paid to suppliers <ul><li>We have to dig this information out for ourselves </li></ul>
    33. 33. What do we know ? <ul><li>From the income statement, we know sales revenue </li></ul><ul><li>From the balance sheet, we know beginning and ending accounts receivable </li></ul><ul><li>These numbers can be used to work toward cash received from customers </li></ul>
    34. 34. <ul><li>Sales revenue </li></ul><ul><li>Plus: Beginning accts. receivable </li></ul><ul><li>Less: Ending accts. receivable </li></ul><ul><li>Less: Accts. receivable written off </li></ul><ul><li>Equals: Cash recd. from customers </li></ul><ul><li>(Now how do we get accounts written off?) </li></ul>Cash received from customers
    35. 35. Account receivable write-offs <ul><li>Beginning Allow. for Bad Debts </li></ul><ul><li>Plus: Bad Debt Expense </li></ul><ul><li>Less: Ending Allow. for Bad Debts </li></ul><ul><li>Equals: Accounts written off </li></ul>
    36. 36. What about cash paid to suppliers ? <ul><li>Purchases </li></ul><ul><li>Plus: Beginning Accts. Payable </li></ul><ul><li>Less: Ending Accts. Payable </li></ul><ul><li>Equals Cash paid to suppliers </li></ul>
    37. 37. If necessary, Purchases is calculated <ul><li>Cost of Goods Sold </li></ul><ul><li>Plus: Ending Inventory </li></ul><ul><li>Less: Beginning Inventory </li></ul><ul><li>Equals: Purchases </li></ul>
    38. 38. Chapter 7--Learning Objectives <ul><li>4. Differentiate between the direct and indirect method of presentation </li></ul>
    39. 39. East-West Industries Statement of Cash Flows - Direct Method For the year ended June 30, 1995 <ul><li>Cash flows from operating activities </li></ul><ul><li>Collections from customers $200,000 </li></ul><ul><li>Payments to vendors (60,000) </li></ul><ul><li>Payments to employees (40,000) </li></ul><ul><li>Payments to creditors (20,000) </li></ul><ul><li>Payments to utilities (20,000) </li></ul><ul><li>Payments to governments (30,000) </li></ul><ul><li>Cash flow from operations $30,000 </li></ul>
    40. 40. East-West Industries Statement of Cash Flows - Direct Method (continued) <ul><li>Cash flows from investing activities </li></ul><ul><li>Proceeds from sale of PP&E 100,000 </li></ul><ul><li>Proceeds from sale of land 110,000 </li></ul><ul><li>Proceeds from sale of patents 70,000 </li></ul><ul><li>Purchase of PP&E (200,000) </li></ul><ul><li>Purchase of land ( 50,000) </li></ul><ul><li>Purchase of intangibles ( 20,000) </li></ul><ul><li>Cash flow from investing 10,000 </li></ul>
    41. 41. East-West Industries Statement of Cash Flows - Direct Method (continued) <ul><li>Cash flows from financing activities </li></ul><ul><li>Sale of stock 30,000 </li></ul><ul><li>Issuance of bonds 100,000 </li></ul><ul><li>Repurchase of stock (90,000) </li></ul><ul><li>Retirement of debt (10,000) </li></ul><ul><li>Payment of dividends (20,000) </li></ul><ul><li>Cash flow from financing 10,000 </li></ul><ul><li>Net increase in cash 50,000 </li></ul><ul><li>Balance, June 30, 1994 120,000 </li></ul><ul><li>Balance, June 30, 1995 170,000 </li></ul>
    42. 42. Operating Section - Indirect Method <ul><li>Cash flows from operating activities </li></ul><ul><li>Net income $97,000 </li></ul><ul><li>Depreciation expense 48,000 </li></ul><ul><li>Amortization of patents 4,000 </li></ul><ul><li>Depletion of natural res. 6,000 </li></ul><ul><li>Deferred income taxes 17,000 </li></ul><ul><li>Noncash interest expense 19,000 </li></ul><ul><li>Gain on sale of land (47,000) </li></ul><ul><li>Loss on sale of PP&E 12,000 </li></ul><ul><li>Gain on debt retirement (40,000) 19,000 </li></ul>
    43. 43. Operating Section - Indirect Method--continued <ul><li>Cash flows from operating activities </li></ul><ul><li>Gain on debt retirement (40,000) 19,000 </li></ul><ul><li>Decrease in accts. receivable 9,000 </li></ul><ul><li>Increase in AFBD 3,000 </li></ul><ul><li>Increase in inventory (60,000) </li></ul><ul><li>Decrease in accts. payable (30,000) </li></ul><ul><li>Decrease in wages payable (12,000) </li></ul><ul><li>Increase in utilities payable 4,000 </li></ul><ul><li>Net cash flow from operations $30,000 </li></ul>
    44. 44. Chapter 7--Learning Objectives <ul><li>5. Prepare a statement of cash flows </li></ul>

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