1

chapter 5
The Statement of
Cash Flows
An electronic presentation
by Douglas Cloud
Pepperdine University

Learning Objectives
1. Describe the circumstances in which the
cash flow statement is a particularly
important companion to the income
statement.
2. Outline the structure of and information
reported in the three main categories of
the cash flow statement: operating,
investing, and financing.
Continued

Learning Objectives
3. Compute cash flow from operations
using either the direct or indirect method.
4. Prepare a complete statement of cash
flows and provide the required
supplemental disclosures.
5. Understand the differences among cash
flow statements prepared according to
U.S. GAAP, U.K. GAAP, and
international accounting
Continued standards.

Learning Objectives
6. Assess a firms financial strength by
analyzing the relationships among cash
flows from operating, investing, and
financing activities and by computing
financial ratios based on cash flow data.
7. Use knowledge of how the three
primary financial statements tie together
in order to prepare a forecasted statement
of cash flows.

What Good Is a Cash Flow

Statement?
Does a statement of cash
flows tell us anything we
dont already know from
other statements?

What Good Is a Cash Flow

Statement?
Yes, because there are
situations where net
income does not give us an
accurate picture.

What Good Is a Cash Flow

Statement?
Also, everything you want
Finally, a statement of cash
to know about a company
flows is an excellent
is summarized in this one
forecasting tool.
statement.

Structure of the Cash Flow

Statement
It must be readily convertible to cash
It is a short-term,
and it must be so near to maturity
that
liquid
there
risks ofhighly
changes
in
Whatisisinsignificant
a cash
investment.
value
due to changes in interest
rate.
equivalent?

Structure of the Cash Flow

Statement
Cash Inflows

CASH
INFLOWS

Operating
Activities

Investing
Activities

Financing
Activities

10

Cash Flow Patterns

Operating ActivitiesTransactions and

events that enter into the determination of net

income.
Investing ActivitiesTransactions and
events that involve the purchase and sale of
securities, property, plant, equipment, and
other assets not generally held for resale, and
the making and collecting of loans.
Financing ActivitiesTransactions and
events whereby resources are obtained from
or repaid to owners and creditors.

11

Cash Flow Patterns

Over the Life of a Company

Start-up, High-Growth Company

Investing

Financing

Operating

12

Cash Flow Patterns

Over the Life of a Company

Steady-State Company
Investing
Dividends

Operating

Financing

13

Cash Flow Patterns

Over the Life of a Company

Cash Cow
Investing
Loan Repayment
Share Repurchases
Dividends

Operating

Financing

14

Noncash Transactions

Investing and financing activities that

do not affect cash.
Significant transactions should be
disclosed separately.
These transactions do not affect the
statement of cash flows.

Reporting Cash Flows from

Operations
Direct MethodA method of reporting net
cash flows from operations that shows cash
receipts and payments for a period of time.
This method is more straight forward.
Indirect MethodA method of reporting net
cash flow from operations that involves
reconciling net income to a cash basis. It
shows how noncash flows affect net income.

15

16

The Direct Method

This method reports directly the major
classes of operating cash receipts and
payments of an entity during a period.
Accrual-basis revenues and expenses
must be converted to equivalent cash
receipts and payments.
The amount of cash actually collected
or paid is determined.

17

Indirect Method
The indirect method makes the
following adjustments:
Adjustments for receivables and other
current operating assets.
Adjustments for payables and other
current liabilities.
Adjustments for depreciation and other
noncash items.
Adjustments for gains and losses.

18

Operating Activities
Cash Inflow

Cash Outflow

Cash receipt of
sales
Inventory payments
Collection of Interest payments
receivables
Wages
Interest revenue
Utilities
Dividend revenue
Rent

19
Relationship Between Net
Income and Operating Cash Flow

Business engages in
operating activities
Cash is received and
disbursed
Operating cash flow

Undo accrual
accounting to get
back to cash flow

Apply accrual
accounting rules
Net income

Example of Operating Activities

Section for the Direct Method
Sales and Cash Collected from Customers:
Beginning accounts receivable
$ 40
+ Sales
150
= Cash available for collection
$190
Ending accounts receivable
60
= Cash Collected from Customers
$130

20

Example of Operating Activities

Section for the Direct Method
Cost of Goods Sold and Cash Paid for Inventory:
Ending inventory
$ 75
+ Cost of goods sold
80
= Required inventory
$155
Beginning inventory
100
= Cash paid for inventory this year
$ 55

21

Example of Operating Activities

Section for the Direct Method
Wages Expense and Cash Paid for Wages:
Beginning wages payable
$ 7
+ Wages expense
25
= Total obligation to employee
$32
Ending wages payable
10
= Cash paid for wages
$22

22

Adjustments for Gains

and Losses
Gains or losses do not represent the cash
effect of the transaction.
Account

Adjustment to
Net Income

Losses
Gains

These adjustments are made to net income

since the sale of an investment is an investing
activity, not an operating activity.

23

24

Adjustments for Receivables

Changes in accounts directly affect
revenues recorded on an accrual basis.
Account
Accounts Receivable
Accounts Receivable
Inventory

Account
Change

Adjustment to
Net Income

25

Adjustments for Payables

Changes in liabilities mean the reverse of
changes in current operating asset accounts.
Account
Accounts Payable
Wages Payable

Account
Change

Adjustment to
Net Income

26

Noncash Adjustments
Depreciation and similar noncash items do
not affect cash and are not reported on the
statement of cash flows.
Any noncash item that reduces net income
should be added back to net income in the
indirect method.
Any noncash item that increases net income
should be subtracted from net income in the
indirect method.

27

Investing Activities
Cash Inflow

Cash Outflow

Sale of plant assets

Purchase of plant assets
Sale of securities,
Purchase of securities,
other than trading
other than trading
securities
securities
Collection of
Making of loans with
principal on loans
other entities

28

Financing Activities
Cash Inflow
Cash Outflow
Issuance of own
Dividend payments
stock
Repaying principal
Borrowings
on borrowing
Treasury Stock
purchase

Differences between Income and

Cash from Operations
Company Name
General Motors
Lehman Brothers
Ford Motors
Citigroup

Cash from
Net
Operations Income
$19,750 $ 4,452
(14,733 )
1,775
33,764
3,467
2,673
13,519

SOURCE: Standard and Poor COMPUTSTAT

Year 2000
(All amounts are in
millions)

29

Difference
$(15,298 )
16,508
(30,297 )
10,846

General Format of a
Statement of Cash Flows

30

Cash Provided by (Used for):

Operating Activities
$XXX
Investing Activities
XXX
Financing Activities
XXX
Net Increase (Decrease) in Cash
$XXX
CashBeginning of Year
XXX
CashEnd of Year
$XXX

Preparing a
Cash Flow Statement
1. Compute how much the cash balance changed
during the year.
2. Convert the income statement from an
accrual-basis to a cash-basis summary of
operations.
a. Eliminate expenses that do not involve the
outflow of cash, such as depreciation.
b. Eliminate gains and losses associated with
investing or financing activities.
c. Adjust for changes in the balances of
current assets and current liabilities.

31

Preparing a
Cash Flow Statement
3. Analyze the long-term assets to identify the
cash flow effects of investing activities.
4. Analyze the long-term debt and stockholders
equity account to determine the cash flow
effects of any financing transactions.
5. Make sure that the total new cash flow from
operating, investing, and financing activities
is equal to the net increase or decrease in cash
as computed in Step 1, then prepare a formal
statement.
6. Prepare supplement disclosure of significant
noncash transactions.

32

Example: Comparative
Balance Sheet
Assets
Cash and Cash Equivalents
Accounts Receivable
Inventory
Equipment
Accumulated Depreciation
Total Assets
Liabilities and Equity
Accounts Payable
Long-term Notes Payable
Common Stock
Retained Earnings
Total Liabilities and Equity

33

2005
$ 82
180
170
200
(72)
$560

2004
$ 40
150
200
140
(60)
$470

$100
100
250
110
$560

$ 80
50
250
90
$470

34

Income Statement, 2005

Sales
Expenses:
Cost of goods sold
Selling and general expense
Depreciation
Interest expense
Operating income
Gain from sale of equipment
Income before income taxes
Income tax expense
Net income

$345
$120
58
20
2

(200 )
$145
5
$140
30
$110

35

Step 1
Determine change in cash and cash
equivalents:
Cash 2004........................... $ 40
Cash 2005...........................
82
Change in Cash................... $ 42

36

Step 2
Convert from an accrual-basis to a cashbasis summary of operations:
EXAMPLE: Eliminate depreciation
expense, $44, because it does
not require the use of cash.

Cash provided by operations

Accumulated Depreciation

44

(t-account or work sheet entry)

44

37

Step 2
Convert from an accrual-basis to a cashbasis summary of operations:
EXAMPLE: Eliminate the $5 gain from
selling equipment.

Cash
33
Add back $5 to cash
provided
by operations.
Accumulated
Depreciation
32
Equipment
Gain on Sale of Equipment

60
5

38

Step 3
Analyze the long-term assets to identify the
ash flow effects of investing activities.
Expenditures for Property, Plant, and Equipment:
Beginning equipment
$140
Equipment sold during the year
60
=
80
Ending equipment
200
= Expenditures for equipment during
year
$ 120

39

Step 4
Analyze the long-term debt and
stockholders equity accounts to determine
the cash flow effects of any financing
transactions:
Expenditures for Long-Term Debt:
Beginning L-T Notes Payable balance
Notes reacquired during the year
=
Ending L-T Notes Payable balance
= L-T Notes Payable issued during year

$ 50
0
50
100
50

40

Step 4
Analyze the long-term debt and
stockholders equity accounts to determine
the cash flow effects of any financing
transactions:
Payment of Dividends:
Beginning Retained Earnings balance
+ Net income
=
Ending Retained Earnings balance
= Dividends paid

$ 90
110
200
110
90

41

Steps 5 and 6
Steps 5 and 6 relate
to actually preparing
the formal and
supplementary
statements.

Operating Activities Section:

Indirect Method
Cash Flows from Operating Activities:
Net income
Adjustments:
Depreciation expense
Gain on sale of equipment
Increase in accounts receivable
Decrease in inventory
Increase in accounts payable
Net Cash Provided by Operating
Activities
Continued

$110
44
(5 )
(30 )
30
20
$169

42

Operating Activities Section:

Direct Method
Cash Flows from Operating Activities:
Cash Collected from Customers
Cash Payments for:
Inventory
Selling & General Expenses
Interest
Income Taxes
Net Cash Provided by Operating
Activities
Continued

$414
(155 )
(58 )
(2 )
(30 )
(245 )
$169

43

Operating Activities Section:

Direct Method
The investing and
financing sections are the
same whether the direct or
indirect approach is used.

44

Investing and Financing

Activities Sections
Cash Flows from Investing Activities:
Proceeds from sale of equipment
Purchase of equipment
Net cash provided by investing
activities
Cash Flows from Financing Activities:
Issuance of long-term notes payable
Payment of cash dividends
Net cash used for financing activities
Net increase in cash
Cash, January 1, 2005
Cash, December 31, 2005

45

$ 33
(120 )
(87 )
50
(90 )
(40 )
42
40
82

Investing and Financing

Activities Sections
Cash Flows from Investing Activities:
Proceeds from sale of equipment
Purchase of equipment
Net cash provided by investing
activities
Cash Flows from Financing Activities:
Issuance of long-term notes payable
Payment of cash dividends
Net cash used for financing activities
Net increase in cash
Cash, January 1, 2005
Cash, December 31, 2005

46

$ 33
(120 )
(87 )
50
(90 )
(40 )
42
40
82

47

Quick Review
Which of the following items would be listed
under Cash Provided by Investing Activities?
Paid cash dividend
Issued preferred stock
Sold merchandise for
cash

Sold equipment at
book value
Click the bulls nose to skip Quick Review

48

Quick Review
Which of the following items would be shown
under Cash Provided by Operating Activities?
Issued bonds to finance
new construction
Purchased treasury stock
Paid the weekly payroll
Declared and paid a cash
dividend

49

Quick Review
Which of the following items would be shown
under Cash Provided by Financing Activities?
Payment of a cash dividend
Recorded depreciation for the
period
Received cash on account
from a customer

Payment of cash to acquire

land

50

Which of the following statement is true

concerning preparing the statement of cash
flows using the indirect method?
A loss from the sale of equipment is added
to net income under the cash provided by
operating activities category.
A gain on sale of land is an investing activity
because a noncurrent asset is involved.
Issuing common stock to purchase land is
both a financing activity and an investing
activity.
An increase in Accounts Payable results in a
decrease in the adjusted cash-basis net income.

International Cash
Flow Statements

In 1987, the United States

led the world concerning
the statement of cash flows
by issuing SFAS No. 95.

51

International Cash
Flow Statements
In 1992, the IASC issued IAS 7 which closely
matched the provisions of SAFS No. 7. The
international standard was more flexible in
classification of certain transactions.
Interest and dividends received can be classified as
either operating or investing.
Interest and dividends paid can be classified as
operating or investing.
Income taxes will be classified as operating unless
specifically related to financing or investing
transactions.

52

International Cash
Flow Statements

In 1991, the United

Kingdom issued
FRS 1. It specified
eight categories for
classifying cash
flows.

Operating activities
Returns on investments and
servicing of finance
Taxation
Capital expenditures and
financial investment
Acquisition and disposal
Equity dividend paid
Management of liquid
resources
Financing

53

54

Assessing Financial Strength

Financial strength is
a function of

Liquidity
Profitability
Growth potential
Risk

55

Assessing Financial Strength

Cash flow-to-net income
Cash from operations
Net income

o Measure of earnings quality

o Tends to be greater than 1
o Should remain fairly stable
for the years for a specific
company

56

Assessing Financial Strength

Cash flow adequacy
Cash from operations
Net income
o Measures relationship between investment spending
and cash generated by operations
o Indicate a companys attitude towards reinvestment
in long-lived production assets
o When ratio is small it indicates that cash flows from
operations fall short of funding growth

57

Assessing Financial Strength

Cash times interest earned
Cash from operations + Interest paid + Taxes paid
Interest expense

o Measures ability to service

debt
o Generally, a higher ratio
indicates more solvency

Forecasted Statement of
Cash Flows
Six Steps
1. Compute the change in cash.
2. Convert the income statement
from an accrual to cash basis.
3. Analyze the long-term asset
accounts.
4. Analyze the long-term debt and
stockholders equity.
5. Prepare the forecasted
statement of cash flows.
6. Disclose noncash activities.

58

59

chapter 5

The End

60

61

Correct! Click on my
glass to move on.

62

Correct! Click on my
glass to move on.

63

Correct! Click on my
glass to move on.

64

Correct! Click on my
glass to move on.

65

Incorrect!

Return to
Question

66

Incorrect!

Click button to return to question

67

Incorrect!

Click button to return to question

68

Incorrect!

Click button to return to question