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©2006 Prentice Hall, Inc.
PREPARING & ANALYZING THE
STMT OF CASH FLOWS (1 of 2)
 Learning
objectives
 Categories of cash flows
 Accrual-basis accounting vs. cash-basis
accounting
 Overview of statement of cash flows
 Statement of cash flows—indirect
method
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©2006 Prentice Hall, Inc.
PREPARING & ANALYZING THE
STMT OF CASH FLOWS (2 of 2)
 Cash
flows from operating activities—
direct method
 Cash flows from investing and financing
activities
 Preparing the statement of cash flows
 Financial statement analysis
 Business risk, control, and ethics
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©2006 Prentice Hall, Inc.
Learning Objectives
(1 of 4)
 Categorize
cash flows as operating,
investing, or financing cash flows
 Explain the difference between
accrual-basis and cash-basis accounting
 Explain the difference between the
two methods of preparing and
presenting the statement of cash flows
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©2006 Prentice Hall, Inc.
Learning Objectives
(2 of 4)
 Compute
cash from operating activities
using the indirect method
 Compute cash from operating activities
using the direct method
 Compute cash from investing activities
and cash from financing activities
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©2006 Prentice Hall, Inc.
Learning Objectives
(3 of 4)
 Prepare
a complete statement of cash
flows and know the required
supplemental disclosures
 Use the statement of cash flows to
help evaluate a firm’s past and future
performance
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©2006 Prentice Hall, Inc.
Learning Objectives
(4 of 4)
 Identify
the risk of investing in a
given firm by using the statement of
cash flows and the related controls
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Categories of Cash Flows
(1 of 3)
 Cash
flow
Inflows
and outflows that result from
transactions
Cash account must increase or decrease
 Operating
activities
Cash
receipts and cash disbursements
from revenues and expenses
Involve
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current assets and current liabilities 11-8
Categories of Cash Flows
(2 of 3)
 Investing
activities
Cash
receipts and disbursements that
result from purchasing or selling longterm assets or investments in other firms
 Financing
activities
Cash
receipts and disbursements from
long-term debt and equity transactions
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©2006 Prentice Hall, Inc.
Categories of Cash Flows
(3 of 3)
 Financing
Debt
activities (continued)
 Issuing
debt
 Repaying debt
 Interest expense results from financing activities
because it arises from debt financing. Why is it
reported in the operating section?
Equity
 Receiving
contributions from owners
 Paying dividends to owners
©2006 Prentice Hall, Inc.
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Accrual-basis Accounting vs.
Cash-basis Accounting (1 of 2)
 Must
convert from accrual-basis
accounting (GAAP) to cash-basis
accounting to prepare statement of
cash flows
 Accrual-basis accounting
Revenues
recorded when earned and
expenses recorded when incurred
Timing
©2006 Prentice Hall, Inc.
of cash receipt is irrelevant
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Accrual-basis Accounting vs.
Cash-basis Accounting (2 of 2)
 Cash-basis
Revenues
accounting
recorded when cash received
and expenses recorded cash paid
Timing
of revenue and expense recognition is
irrelevant
 Convert
from accrual basis to cash basis
Accounts
payable (assume for inventory)
Beg bal $1,200; End
Compute cash paid
©2006 Prentice Hall, Inc.
bal $400; purch $36,300
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Overview of the
Statement of Cash Flows (1 of 3)
 Operating
Direct
activities
method
Cash
inflows and outflows explicitly
identified
Analyzes every item on income statement
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©2006 Prentice Hall, Inc.
Overview of the
Statement of Cash Flows (2 of 3)
 Operating
Indirect
activities (continued)
method
Reconciles
net income and cash flow
Starts with net income
Makes adjustments for income statement
items that do not affect cash
Adjust for changes in current assets and
current liabilities
Ends with net cash flow
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©2006 Prentice Hall, Inc.
Overview of the
Statement of Cash Flows (3 of 3)
 Investing
and financing activities
Same
presentation for both direct and
indirect methods
Cash flows for each activity directly
identified
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©2006 Prentice Hall, Inc.
Statement of Cash Flows—
Indirect Method
 Used
by 90% of companies. Why?
 Financial statements needed
Current
year income statement
Beginning and ending balance sheet
 Steps
to calculate operating cash flows
 Cash flow indirect method example
11-16
©2006 Prentice Hall, Inc.
Steps to Calculate Operating
Cash Flows (1 of 2)
1.
2.
Start with net income
Add back non-cash expenses such as
depreciation

3.
Undo the effect of non-cash expenses
Adjust for changes in current assets

Increase (decrease) in account should
be subtracted from (added to) net
income to arrive at cash balance. Why?11-17
©2006 Prentice Hall, Inc.
Steps to Calculate Operating
Cash Flows (2 of 2)
4.
Adjust for changes in current liabilities

Increase (decrease) in account should be
added to (subtracted from) net income
to arrive at cash balance. Why?
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©2006 Prentice Hall, Inc.
Cash Flow Indirect Method
Example (1 of 4)
Sales Revenues
Cost of Goods Sold
Gross Margin
Depreciation Expense
Interest Expense
Salary Expense
Net Income
$ 500,000
284,000
216,000
$ 50,000
5,000
105,000
160,000
$ 56,000
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©2006 Prentice Hall, Inc.
Cash Flow Indirect Method
Example (2 of 4)
Cash
Accounts Receivable, net
Inventory
Prepaid Insurance
Prepaid Rent
Total Current Assets
Equip, net of $75K & $125K Accum Depr
Total Assets
Beginning
$ 37,500
17,000
27,000
28,000
109,500
175,000
$ 284,500
Ending
$ 75,000
13,000
20,000
12,000
4,000
124,000
193,000
$ 317,000
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©2006 Prentice Hall, Inc.
Cash Flow Indirect Method
Example (3 of 4)
Accounts Payable
Unearned Revenue
Interest Payable
Total Current Liabilities
Long-term Notes Payable
Beginning
9,000
$
4,375
1,500
14,875
40,000
Ending
4,250
$
3,125
4,000
11,375
15,000
Common Stock
Retained Earnings
Total Liabilities and Equity
40,000
189,625
$ 284,500
45,000
245,625
$ 317,000
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©2006 Prentice Hall, Inc.
Cash Flow Indirect Method
Example (4 of 4)
+/Net income
Depreciation expense
Decrease in accounts receivable
Decrease in inventory
Increase in prepaid insurance
Decrease in prepaid rent
Decrease in accounts payable
Decrease in unearned revenue
Increase in interest payable
Net cash from operating activities
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©2006 Prentice Hall, Inc.
Cash Flows from Operating
Activities—Direct Method (1 of 6)
 Changing
revenues from accrual basis
to cash basis
Accounts
receivable
Beginning balance (balance sheet)
+ Sales (income statement)
- Cash collected from customers (compute)
Ending balance (balance sheet)
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©2006 Prentice Hall, Inc.
Cash Flows from Operating
Activities—Direct Method (2 of 6)
 Changing
expenses from accrual basis
to cash basis
Cost
of goods sold
Inventory
account
Beginning inventory (balance sheet)
+ Purchases (compute)
- Cost of goods sold (income statement)
Ending balance (balance sheet)
©2006 Prentice Hall, Inc.
11-24
Cash Flows from Operating
Activities—Direct Method (3 of 6)
Cost
of goods sold (continued)
Accounts
payable
Beginning balance (balance sheet)
+ Purchases (from inventory computation)
- Cash paid to vendors (compute)
Ending balance (balance sheet)
11-25
©2006 Prentice Hall, Inc.
Cash Flows from Operating
Activities—Direct Method (4 of 6)
 Changing
expenses from accrual basis
to cash basis (continued)
Rent
expense
Prepaid
rent
Beginning balance (balance sheet)
+ Cash paid for rent (compute)
- Rent expense (income statement)
Ending balance (balance sheet)
©2006 Prentice Hall, Inc.
11-26
Cash Flows from Operating
Activities—Direct Method (5 of 6)
 Changing
expenses from accrual basis
to cash basis (continued)
Interest
expense
Interest
payable
Beginning balance (balance sheet)
+ Interest expense (income statement)
- Cash paid for interest (compute)
Ending balance (balance sheet)
©2006 Prentice Hall, Inc.
11-27
Cash Flows from Operating
Activities—Direct Method (6 of 6)
Use the information provided earlier
Cash collected from customers
Cash paid to vendors
Cash paid to employees
Cash paid for insurance
Cash paid for rent
Cash paid for interest
Net cash from operating activities
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©2006 Prentice Hall, Inc.
Cash Flows from Investing and
Financing Activities (1 of 3)
 Investing
cash flows
Equipment
purchases/disposals require
the following accounts
Asset
account (beg & end)
Accumulated depreciation (beg & end)
Depreciation expense (current)
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©2006 Prentice Hall, Inc.
Cash Flows from Investing and
Financing Activities (2 of 3)
 Financing
Debt
cash flows
financing
Need
to analyze changes in long-term
liability accounts
Equity
financing
Additional
capital contributions
 Common
and preferred stock accounts
Dividends
 Retained
©2006 Prentice Hall, Inc.
earnings and current net income
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Cash Flows from Investing and
Financing Activities (3 of 3)
Use the information provided earlier
Investing Activities
Purchase of equipment
Net cash used by investing activities
Financing Activities
Repayment of note payable
Proceeds from issue of new stock
Net cash used by financing activities
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©2006 Prentice Hall, Inc.
Preparing the Statement of
Cash Flows (1 of 3)
 Prepare
operating, investing, and
financing sections
 Supplementary disclosures
Noncash
financing and investing
activities
Cash paid for interest expense and
income taxes
Broken
out in supplementary disclosures
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because usually part of subtotals
©2006 Prentice Hall, Inc.
Preparing the Statement of
Cash Flows (2 of 3)
 Add
beginning cash to sum of
operating, investing, and financing
activities to get ending cash balance
Reconciles
cash account on balance sheet
 Which
financial statement is easier to
manipulate, the statement of cash
flows or the income statement? Why?
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©2006 Prentice Hall, Inc.
Preparing the Statement of
Cash Flows (3 of 3)
Use the information provided earlier
Net cash provided by operations
Net cash used by investing activities
Net cash used by financing activities
Cash at beginning of year
Cash at end of year
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©2006 Prentice Hall, Inc.
Financial Statement Analysis
 Using
cash flows to evaluate
performance
Free
cash flow
Cash flow adequacy ratio
Cash needed to pay current liabilities
11-35
©2006 Prentice Hall, Inc.
Free Cash Flow
Net cash from operating activities
- Cash dividends
- Capital expenditures
_
Free cash flow
 Why does a company need positive
free-cash flow?
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©2006 Prentice Hall, Inc.
Cash Flow Adequacy Ratio
 Measures
the firm’s ability to generate
enough cash from operating activities
to pay for its capital expenditures
Net cash from operating activities _
Cash required for investing activities
Cash
required for investing activities
 Cash
paid for capital expenditures and
acquisitions minus cash proceeds from disposal of
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capital assets
©2006 Prentice Hall, Inc.
Cash Needed to Pay Current
Liabilities (1 of 2)
 Current
cash debt coverage ratio
Measures
a firm’s ability to generate the
cash it needs in the short-run
A liquidity measure
Net Cash Provided by Operations
Average Current Liabilities
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©2006 Prentice Hall, Inc.
Cash Needed to Pay Current
Liabilities (2 of 2)
 How
does current cash debt coverage
ratio differ from other liquidity
measures previously discussed?
Current
ratio
Quick ratio
Working capital
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©2006 Prentice Hall, Inc.
Business Risk, Control, and Ethics
 Investors’
risks associated with
statement of cash flows
Investors
look for positive cash flows
from operations
How could a company manipulate
operating cash flows?
11-40
©2006 Prentice Hall, Inc.
Comments or questions about PowerPoint Slides?
Contact Dr. Richard Newmark at
University of Northern Colorado’s
Kenneth W. Monfort College of Business
richard.newmark@PhDuh.com
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