Chapter%204,%20Statement%20of%20Cash%20Flows

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Statement of Cash Flows- First Approach
Appendix 6- Introduction to preparation of the
Statement of Cash Flows
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Cash Flow Statement

• Flow statement
• Periodic
• Provides information regarding the liquidity of a
  firm
• explains the reasons for increase or decrease in
  cash balance from one balance sheet date to the
  next
• classifies the reasons for the change as an
  operating, investing or financing activity.
• amount of net income in a period is usually
  different than the amount of increase in cash in
  the same period
• reconciles net income with cash flow from
  operations.

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Classification of Cash Flows

• Operations -- cash flows related to selling
  goods and services that is, the principle
  business of the firm.
• Investing -- cash flows related to the
  acquisition or sale of noncurrent assets.
• Financing -- long term and short term cash flows
  related to liabilities and owners equity
  dividends are a financing cash outflow.

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What is Cash?

• Cash includes cash and cash equivalents
• Cash equivalents
• treasury bills maturing in 90 days or less
• investment funds
• foreign currency on hand
• checking account and free savings account

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External Uses of CFS

• To assess the ability of a firm to manage cash
  flows
• To assess the ability of a firm to generate cash
  through its operations
• To assess the companys ability to meet its
  obligations and its dividend policy
• To provide information about the effectiveness of
  the firm to convert its revenues to cash
• To provide information to estimate or anticipate
  the companys need for additional financing

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Internal Uses of CFS

• Along side with cash budget CFS is used
• To assess liquidity
• Determine if short-term financing is necessary
• To determine dividend policy
• Decide to distribute or increase or decrease
• To evaluate the investment and financing
  decisions

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Cash flow from operating activities

• Examples (IAS No.7)
• cash received from customers through sale of
  goods or services performed
• cash received from non-operating activities such
  as dividends from investments, interest revenue,
  commissions, and fees
• cash payments to suppliers or employees
• cash payments for taxes and other expenses

In effect, the income statement is changed from
accrual basis to cash basis
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Investing Activities

• Examples of investing activities include
• cash payments to acquire property, plant, and
  equipment (PPE), other tangible or intangible
  assets, and other long-term assets and sale of
  such assets
• loans extended to other companies and collection
  of such loans

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Financing Activities

• Examples of financing activities are
• cash received from issuing share capital
• cash proceeds from issuing bonds, loans, notes,
  mortgages and other short or long-term
  borrowings
• cash repayment of loans and other borrowings and
• cash payments to shareholders as dividends.

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Classification of Cash in-flows and outflows
To wages salary payments To suppliers for
purchases of inventories To other operating
expenses To interest payments To tax payments To
advance payments to suppliers
From sales of goods and services to
customers From receipt of customer advances From
receipt of interest revenue or dividends or rent
revenue or similar revenue items
Operating Activities
From sale of PPE and other long-term assets From
collection of loans
To purchase PPE and other long-term assets To
make loans and to collect such loans
Investing Activities
From sale of common or preferred stock From
issuance of short or long term debt
Financing Activities
To repay debt To pay dividends
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Format of the Cash Flow Statement
Name of the Company Cash Flow Statement For the
period Cash from operating activities
A Cash from investing activities B Cash from
financing activities C Net Change in
Cash D (ABC) increase or (decrease)
Beginning Cash balance CB, from the beginning
balance sheet Ending Cash balance CB D
should equal to ending cash
balance in
the ending balance sheet Non-cash Investing and
Financing Activities
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Determination of Cash Flows From Operating
Activities

• Direct Method
• Income Statement items are converted to cash
  flows individually
• Indirect Method
• Net income or loss is adjusted for accruals such
  as accounts receivable and payable, and for
  non-cash expenses such as depreciation
• reconciliation of the accrual based and cash
  based accounting

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Comparison of Methods

• Direct method of presentation calculates cash
  flow from operations by subtracting cash
  disbursements to supplies, employees, and others
  from cash receipts from customers.
• The indirect method calculates cash flow from
  operations by adjusting net income for non-cash
  revenues and expenses.
• Most firms present their cash flows using the
  indirect method.

Only operating activities section is different
between the methods, investing and financing
sections are the same.
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How to prepare cash flow statement

• Firms could prepare their own cash flow statement
  directly from the cash account.
• however, we need two consecutive balance sheets
  and the income statement that covers the period
  between the two balance sheets

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Algebraic Formulation

• Assets Liabilities Shareholders Equity
• or A L SHE
• Assets are either cash (C) or not (Non-Cash)
• Thus reorganizing
• C Non Cash Assets (NCA) L
  SE
• ? C ? NCA ? L ? SE
• Where ? means the change in the balance of the
  item from the previous period.
• Solving for change in cash
• ? C ? L ? SE - ? NCA

Based on Stickney and Weil, 10th ed. Financial
Accounting Slides http//www.swlearning.com/accoun
ting/stickney/tenth_edition/stickney.html
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Algebraic Formulation (Cont.)

• ? C ? L ? SE - ? NCA
• The change in cash, ? C, is the increase or
  decrease in the cash account.
• This amount must equal changes in liabilities
  plus changes in shareholders equity minus
  changes in assets other than cash.
• Thus, we can identify the causes in the change in
  the cash account by studying the changes in
  non-cash accounts.

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Indirect Method cash flow from operations
Adjusting Net Income of the period (accrual) to
cash basis income
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Indirect Method- operating activities-
Adjustments to net income

• Net income
• noncash expenses depreciation, amortization,
  uncollectible account expense,etc
• loss on sale of asset
• increases in current liabilities
• decreases in current assets
• - gain on sale of asset
• - decrease in current liabilities
• increase in current assets
• Cashflow from operating activities

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Noncash Expenses

• Noncash expenses, such as depreciation expense,
  are added back because they were deducted to
  measure net income but did not require any cash
  payment in the current period
• They are not truly sources of cash, even though
  they are associated with cash inflows but
  reversal of an accrued expense

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Effects of a Sale of a Long-Term Assets on Cash
Flows

• A few transactions complicate the derivation of a
  cash flow statement from a comparative balance
  sheet, for example, the sale of a long-term (or
  fixed) asset.
• Recall the journal entry for the sale of an asset

Cash
nnnn Accumulated Depreciation
nnnn Asset
nnnn
Gain (or loss) on sale
nnnn
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Sale of an Asset

• Each of the four parts of the above journal entry
  require an adjustment in the cash flow statement.
• The first line, cash, adds a line to the
  investing section.
• The second line, a debit to accumulated
  depreciation, increases the depreciation expense
  above the change in the change in the accumulated
  depreciation account.
• The third line, a credit to the asset, increases
  the amount of cash invested in long-lived assets
  above the change in the fixed asset accounts.
• The fourth line, a gain or loss, is reversed out
  in the operating sections since this is not a
  cash flow.

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Comparison of Cash Flow to Net Income

• Net income is an accrual based concept and
  purports to show the long-term.
• Cash flows purport to show the short term.
• Consider the outlook for both short-term and
  long-term and consider that each is either good
  or poor.
• A strong growing firm would show both good
  long-term and good short-term outlooks.
• A failing firm would show both poor long-term and
  poor short term outlooks.
• What about a firm with good cash flows
  (short-term) but poor net income (long-term)?
• What about a firm with poor cash flows
  (short-term) but good net income (long-term)?