Detailed analysis of the statement of cash flows

1. Chapter 4
Statement of Cash Flows
4-1

2. 4-2
Why Cash Flow is
Important: An Example

3. 4-3
Why Cash Flow is
Important: An Example
• The company reported rising
amounts of net income.
• The company failed to generate
any cash from its operations.
• These deficits were offset by
borrowings.
• The company went bankrupt in
2008.

4. 4-4
Why Cash Flow is
Important: An Example
• It is possible for a company to post a
healthy net income but not have
cash needed to pay its employees,
suppliers, and bankers.
• Positive net income on the income
statement is ultimately insignificant
unless a company can translate its
earnings into cash.

5. 4-5
Why Cash Flow is
Important: An Example
• The statement of cash flows
provides information about cash
inflows and outflows during an
accounting period and over time.
• It is extremely important as an
analytical tool.

6. 4-6
Why Cash Flow is
Important: An Example
Cash flows are segregated by:
• operating activities,
• investing activities, and
• financing activities.

7. 4-7
Statement of Cash Flows:
Basic Principle
• The statement of cash flows is
another way of presenting the
balance sheet of the company.
• The balance sheet shows amounts at
the end of the accounting period.
• The statement of cash flows shows
changes in the balance sheet
accounts between periods.

8. 4-8
Statement of Cash Flows:
Basic Principle
• Change in cash between periods is
explained by changes in all other balance
sheet accounts.
• Each balance sheet account is related
either to an operating activity, an investing
activity, or a financing activity.
• Change in cash between periods is equal to
cash flow from operating activities,
investing activities, or financing activities.

9. 4-9
Statement of Cash Flows:
Basic Principle

10. 4-10
Statement of Cash Flows:
Basic Principle
• Cash account increased by $1,299 million
between November 30, 2006 and 2007.
 Operations used cash (net outflow) of
$45,945 million.
 Investing activities used cash (net outflow) of
$1,698 million.
 The company borrowed (net inflow) $48,592
million.
• The company borrowed to cover the cash
deficit in operations and capital
expenditures.

11. 4-11
Preparing a Statement of
Cash Flows
• Begins with a return to the balance
sheet
• Requires reordering of the
information presented on a balance
sheet
• Shows changes over time rather than
the absolute dollar amount of the
accounts at a point in time

12. 4-12
Preparing a Statement of
Cash Flows

13. 4-13
Preparing a Statement of
Cash Flows

14. 4-14
Preparing a Statement of
Cash Flows
Four parts of a statement of cash
flows
• Cash
• Operating activities
• Investing activities
• Financing activities

15. 4-15
Preparing a Statement of
Cash Flows
Cash
• Cash
• Highly liquid short-term marketable
securities (cash equivalents)

16. 4-16
Preparing a Statement of
Cash Flows
Operating activities
• Delivering or producing goods for sale
• Providing services
• Cash effects of transactions and other events
that enter into the determination of income

17. 4-17
Preparing a Statement of
Cash Flows
Investing activities
• Acquiring and selling (or otherwise disposing
of) securities that are not cash equivalents or
productive assets that are expected to benefit
the firm for long periods
• Lending money and collecting on loans

18. 4-18
Preparing a Statement of
Cash Flows
Financing activities
• Borrowing from creditors and repaying principal
• Obtaining resources from owners and providing
them with a return on the investment

19. 4-19
Preparing a Statement of
Cash Flows
Preparing a Statement of Cash Flows
• Calculate the changes in all of the balance sheet
accounts, including cash.
• List the changes in all of the accounts except cash as
inflows or outflows.
• Categorize the flows by operating, financing, or
investing activities.
• The inflows less the outflows balance to and explain
the change in cash.

20. 4-20
Preparing a Statement of
Cash Flows

21. 4-21
Preparing a Statement of
Cash Flows
• Next, transfer the account changes to the
appropriate area of a statement of cash
flows.
• In doing so, a determination must be made
of what constitutes an inflow and what
constitutes an outflow.

22. 4-22
Preparing a Statement of
Cash Flows

23. 4-23
Preparing a Statement of
Cash Flows

24. 4-24
Preparing a Statement of
Cash Flows
Exhibit 4.2 – inflows
• Decrease in other assets
• Increase in long-term debt
• Increase in common stock and additional
paid-in capital

25. 4-25
Preparing a Statement of
Cash Flows

26. 4-26
Preparing a Statement of
Cash Flows
Exhibit 4.2 – outflows
• Increase in inventories
• Decrease in notes payable

27. 4-27
Preparing a Statement of
Cash Flows
Accumulated depreciation
• Appears in the asset section
• Is actually a contra-asset
• Reduces the amount of total assets
• Shown in parentheses on the balance sheet
• Has the same effect as a liability account

28. 4-28
Preparing a Statement of
Cash Flows
Other complications
• Two transactions in one account
• Multiple transactions affecting other accounts

29. 4-29
Calculating Cash Flow
from Operating Activities
• Operating activities represent cash
generated internally.
• Investing and financing activities
provide cash from external sources.

30. 4-30
Calculating Cash Flow
from Operating Activities
• Firms may use one of two methods to
calculate cash flow from operating
activities:
 Direct Method
 Indirect Method
• Direct and indirect methods yield
identical figures for net cash flow from
operating activities.

31. 4-31
Calculating Cash Flow
from Operating Activities
Direct Method shows
• Cash collection from customers
• Interest and dividends collected
• Other operating cash receipts
• Cash paid to suppliers
• Interest paid
• Taxes paid
• Other operating cash payments

32. 4-32
Calculating Cash Flow
from Operating Activities
The indirect method starts with net
income and adjusts for
• deferrals
• accruals
• noncash items
• nonoperating items

33. 4-33
Calculating Cash Flow
from Operating Activities

34. 4-34
Calculating Cash Flow
from Operating Activities

35. 4-35
Calculating Cash Flow
from Operating Activities

36. 4-36
Calculating Cash Flow
from Operating Activities
Indirect method – Sage Inc.
• Depreciation and amortization are
added to net income.
• Increase in deferred tax liability
account is added to net income.
• Increase in accounts receivable is
deducted.
• Increase in inventory is deducted.

37. 4-37
Calculating Cash Flow
from Operating Activities
Indirect method – Sage Inc.
• Decrease in prepaid expenses is added.
• Increase in accounts payable is added.
• Decrease in accrued liabilities is
subtracted.
• Increase in income taxes payable is
added.

38. 4-38
Cash Flow from Investing
Activities

39. 4-39
Cash Flow from Investing
Activities
• Additions to property, plant,
and equipment represent a
cash outflow of $14.1 million.
• Decrease in other assets
represents a cash inflow of
$295 thousand.

40. 4-40
Cash Flow from Financing
Activities

41. 4-41
Cash Flow from Financing
Activities
• Sage Inc. issued new shares of stock
during 2016.
• The total cash generated from stock
sales amounted to $256 thousand.

42. 4-42
Cash Flow from Financing
Activities
Short-term debt and current
maturities of long-term debt jointly
explain Sage Inc.’s net reduction in
short-term borrowings:

43. 4-43
Cash Flow from Financing
Activities
• Long-term borrowings should be
segregated into two components:
 Additions to long-term borrowings
 Reduction of long-term borrowings

44. 4-44
Cash Flow from Financing
Activities
Additions to long-term borrowings and
reductions of long-term borrowings on the
Sage Inc. statement of cash flows reconcile
the change in the long-term debt account
on the balance sheet.

45. 4-45
Cash Flow from Financing
Activities
• Change in retained earnings results
from net income recognition and the
payment of cash dividends.
 Payment of cash dividends is financing
outflow.
 Declaration of a cash dividend would
not affect cash.

46. 4-46
Cash Flow from Financing
Activities
This information is provided in the Sage
Inc. Statement of Stockholders’ Equity.

47. 4-47
Change in Cash
Net cash provided by operating activities, less
the net cash used by investing activities,
plus the net cash provided by financing
activities produced a net decrease in cash
and cash equivalents for Sage Inc.:

48. 4-48
Change in Cash
• The cash flows provided (used) by operating,
investing, and financing activities vary
considerably depending on
 the company,
 its performance,
 its ability to generate cash,
 its financing and investing strategies, and
 its success in implementing financing and
investing strategies.

49. 4-49
Change in Cash

50. 4-50
Analyzing the Statement of
Cash Flows
The statement of cash flows helps the analyst
determine the following:
• Ability to generate cash flows in the future
• Capacity to meet cash obligations
• Future external financing needs
• Success in productively managing investing
activities
• Effectiveness in implementing financing and
investing strategies.

51. 4-51
Analyzing the Statement of
Cash Flows
Cash Flow from Operations
• It is possible for a firm to be highly
profitable and
 not be able to pay dividends
 not be able to invest in new
equipment
 not be able to service debt
 go bankrupt

52. 4-52
Analyzing the Statement of
Cash Flows
Cash Flow from Operations
• Ongoing operation depends on success in
generating cash from operations.
• Firms need cash to satisfy creditors and
investors.

53. 4-53
Analyzing the Statement of
Cash Flows
Cash Flow from Operations
• Temporary shortfalls of cash can be
satisfied by borrowing or other means, but
ultimately a firm must generate cash.
• Periods of high interest rates and inflation
contributed to the enhanced attention paid
to cash flow by investors and creditors.

54. 4-54
Analyzing the Statement of
Cash Flows
Nocash Corporation
• Nocash Corporation had sales of $50,000 in its
first year of operations.
• Nocash Corporation had sales of $100,000 in
its second year of operations.
• Nocash Corporation had expenses of $40,000
in its first year of operations.
• Nocash Corporation had expenses of $70,000
in its second year of operations.

55. 4-55
Analyzing the Statement of
Cash Flows

56. 4-56
Analyzing the Statement of
Cash Flows
Nocash Corporation
• The income statement does not show several relevant
facts.
 Nocash eased its credit policies and attracted lower
quality customers.
 Nocash purchased a new line of inventory near the end
of Year 1 and had to sell it below cost.
 Rumors regarding problems with accounts receivable
and inventory management prompted some suppliers
to refuse the sale of goods on credit to Nocash.

57. 4-57
Analyzing the Statement of
Cash Flows
Nocash Corporation
• The effects of these factors can be found on
the balance sheet:

58. 4-58
Analyzing the Statement of
Cash Flows
Nocash Corporation
• If Nocash’s net income is recalculated on a
cash basis, the following adjustments would
be made:

59. 4-59
Analyzing the Statement of
Cash Flows
Nocash Corporation
• More sales revenue was recognized in computing
net income than was collected in cash.
• The increase in accounts receivable is subtracted.

60. 4-60
Analyzing the Statement of
Cash Flows
Nocash Corporation
• The increase in inventory is deducted,
reflecting the cash outflow for inventory
purchases in excess of the expense
recognized through cost of goods sold.

61. 4-61
Analyzing the Statement of
Cash Flows
Nocash Corporation
• Cash payments to suppliers in Year 2 were greater
than the amount of expense recorded.
• The decrease in accounts payable is deducted.

62. 4-62
Analyzing the Statement of
Cash Flows
Nocash Corporation
• Appearance of $10,000 note payable
indicates that borrowing has enabled
Nocash to operate.
• Unless Nocash can generate cash, its
problems will compound.
• Bankers refer to this problem as a
company’s “selling itself out of
business.”

63. 4-63
Sage Inc.: Analysis of the
Statement of Cash Flows
• An analysis of the statement of cash
flows should cover the following
areas:
 Analysis of cash flow from operating activities
 Analysis of cash inflows
 Analysis of cash outflows

64. 4-64
Sage Inc.: Analysis of the
Statement of Cash Flows
• Cash Flow from Operating Activities
 The statement of cash flows provides the net
cash flow from operating activities.
 The analyst should be concerned with
• the success or failure of generating cash from
operations,
• the underlying causes of operating cash flow,
• the magnitude of operating cash flow, and
• fluctuations in cash flow from operations.

65. 4-65
Sage Inc.: Analysis of the
Statement of Cash Flows

66. 4-66
Sage Inc.: Analysis of the
Statement of Cash Flows
Cash Flow from Operating Activities – Sage Inc.
• Negative cash flow from operations in 2015
• Positive net income in 2015
• Apparent cause was substantial growth in
accounts receivable and inventories.
• Positive cash flow in 2016
• It will be necessary to monitor cash flow
operations and the management of
inventories.

67. 4-67
Sage Inc.: Analysis of the
Statement of Cash Flows
• Summary Analysis of the Statement of
Cash Flows
 Provides an approach to analyzing the statement
of cash flows
 Provides comparative cash flow data
 Underlines the importance of internal cash
generation from operations
 Highlights the implications for investing and
financing activities when cash is not generated
from operations

68. 4-68
Sage Inc.: Analysis of the
Statement of Cash Flows

69. 4-69
Sage Inc.: Analysis of the
Statement of Cash Flows

70. 4-70
Sage Inc.: Analysis of the
Statement of Cash Flows
Analysis of Cash Inflows – Sage Inc.
• Operations supplied 62% of needed cash in
2016 and 73% in 2014.
• The firm had to borrow heavily in 2015, with
debt accounting for 98% of cash inflows.
• Sage Inc. also borrowed in 2016 and 2014 to
obtain needed cash not supplied by
operations.

71. 4-71
Sage Inc.: Analysis of the
Statement of Cash Flows
Analysis of Cash Inflows
• Generating cash from operations is the preferred
method for obtaining cash.
• Using external sources to generate the majority
of cash year after year should be further
investigated.

72. 4-72
Sage Inc.: Analysis of the
Statement of Cash Flows
Analysis of Cash Outflows – Sage Inc.
• Purchases of property, plant, and equipment
decreased in 2015 compared to 2014.
• Capital expenditures increased in dollars from 2015 to
2014 but not in percentage due to negative cash flow
from operations.
• Dividends paid increased from 2014 to 2015 and
decreased from 2015 to 2016, but percentages
declined each year due to cash outflows.

73. 4-73
Sage Inc.: Analysis of the
Statement of Cash Flows
Analysis of Cash Outflows – Sage Inc.
• Capital expenditures in 2014 were covered by
cash from operations.
• Capital expenditures in 2015 were covered by
borrowing.
• Capital expenditures in 2016 were covered by
both cash from operations and borrowing.

74. 4-74
Sage Inc.: Analysis of the
Statement of Cash Flows
• Analysis of Cash Outflows
 When analyzing cash outflows, the
analyst should consider
• the necessity of the outflow and
• how the outflow was financed.

75. 4-75
Sage Inc.: Analysis of the
Statement of Cash Flows
Analysis of Cash Outflows
• Generally, it is best to finance
 short-term assets with short-term debt
and
 long-term assets with long-term debt or
issuance of stock.

76. 4-76
Sage Inc.: Analysis of the
Statement of Cash Flows
Analysis of Cash Outflows
• Repayment of debt is a necessary outflow.
• Notes to the financial statements are useful
in assessing how much cash will be needed
in upcoming years to repay outstanding
debt.

77. 4-77
Sage Inc.: Analysis of the
Statement of Cash Flows
• Firms should only pay dividends if
the company has excess cash not
needed for
 expansion,
 property, plant, or equipment, or
 repayment of debt.

78. 4-78
Qualitative Issues Relating to
the Statement of Cash Flows
• Recording operating expenses as capital
expenditures
• Management of current asset and liability
accounts
• Accounting for vendor financing
transactions
• Recording of purchases and sales of trading
securities for nonfinancial companies

79. 4-79
Appendix 4A: Statement of
Cash Flows – Direct Method

80. 4-80
Appendix 4A: Statement of
Cash Flows – Direct Method

81. 4-81
Appendix 4A: Statement of
Cash Flows – Direct Method