TAs: Darla Andoni and Anna Hennessey
Chapter 12 Summary
Learning Objectives 12.1-12.3
Cash flow statement describes how cash at the beginning of the period becomes cash at the end of the
period. Split into three categories:
• Operating activities - related to earnings from normal operations
• Cash inflows and outflows that relate directly to revenues and expenses reported on the
income statement
• Direct method
• Indrect Method
• Investing activities - related to acquisition or sale of productive facilities and investments in the
securities of other companies
• Cash inflows and outflows related to the purchase and disposal of long-lived
productive assets and investments in the securities of other companies
• Typical cash flows from investing activities include
•
•
Financing activities - related to external sources of financing (owners and creditors) for the
enterprise.
Typical cash flows from financing activities include the following:
“Cash” refers to both regular cash and cash equivalents, which are short-term, highly liquid investments
that are:
1. Readily convertible to known amounts of cash
2. So near to maturity that there is little risk that their value will change if interest rates change
(usually maturing in 3 months or less).
Examples include treasury bills, market funds, and commercial paper
Inflows
Cash received from:
Outflows
Cash paid for:
Operating
activities
Customers, dividends, and
interest on investments
Purchases of services, goods for resale, salaries,
wages, income taxes, and interest on liabilities
Investing
activities
Sale or disposal of PPE, sale or
maturity of investments in
securities
Purchase of PPE or investments in securities
Financing
activities
Borrowings on notes, mortgages,
bonds, etc., from creditors and
issuing stock to owners
Repayment of principal to creditors (excluding
interest with is an operating activity), repurchasing
stock from owners, and dividends to owners
The combination of the net cash flows from operating, investing, and financing activities must equal the
net increase or decrease in cash
What do we need to prepare a statement of cash flows?
1. Comparative balance sheet (shows change in balance sheet accounts from one time to the next)
2. Current income statement (see below)
3. Additional details concerning selected accounts
Relationship between income statement and balance sheet:
By manipulating the accounting equation, we derive that
Δ cash = Δ liabilities + Δ stockholders’ equity - Δ noncash assets
Methods for reporting cash from operating activities (both should give the same result):
1. Direct method - report the cash effects of each operating activity as they occur (tends to be more
expensive to implement)
2. Indirect method - starts with accrual net income and converts to cash flow from operating
activities
Indirect method - adjusts net income by eliminating noncash items. It starts with net income from the
income statement and then eliminates noncash items to arrive at net cash inflow(outflow) from operating
activities.
Net income + non-cash expenses + losses - gains +/- changes in current assets and current liabilities =
cash flows from operating activities
• Must subtract gains and subtract losses to avoid double counting
Example: Accounts receivable
• If AR increases, then cash collected from customers is lower than revenue, and thus the change
must be subtracted from net income. The reverse is true for a decrease in AR.
Example: Inventory
• If inventory increases, then the amount of purchases is more than the amount of merchandise
sold, and thus the change must be subtracted from net income. The reverse is true for a decrease
in AR.
Quality of the income ratio
Quality of income ratio = cash flow from operating activities / net income
• The higher the ratio, the greater the ability to finance operating and other cash needs from
operating cash inflow and the less likely that they are using aggressive revenue recognition
policies
• May not be equal to 1 due to corporate life cycle, seasonality, changes in revenue and expense
recognition, and changes in management of operating assets and liabilities
Note on fraud… big differences between net income and cash flows can mean manipulation of accruals
and deferrals of revenues and expenses may have occurred
Learning Objective 12.4: Report and Interpret Cash Flows from Investing Activities
Preparing this section of the cash flow statement requires an analysis of the accounts related to property,
plant, and equipment; intangible assets; and investments in the securities of other companies.
The table above describes the relationships you will encounter most frequently.
*You must individually report the cash used to purchase equipment and cash proceeds received from
sale of equipment because it is recorded as part of investing activities !!!
The balance sheet indicates that property, plant, and equipment, net, increased by $3,835 during the
year. However, if you had access to additional company information, you would discover that the
company actually purchased $14,015 of new equipment and sold old equipment for $28. This is offset
by $10,152 in depreciation expense (as noted in the Operating Activities section). $14,015 - $10,152 $28 = $3,835
*You must include short-term investments under investing activities because, by nature, they relate to the
investing activities of the company.
National Beverage’s records also indicate that it purchased $1,463 in short-term investments during the
year for cash, which is an investing cash outflow. The company also sold short-term investments for
$2,011. Together, these investing items explain the $548 decrease in short-term investments
reported on the balance sheet. $2,011 - $1,463 = $548
Learning Objective 12.5: Analyze and Interpret the Capital Acquisition Ratio
The capital acquisitions ratio is computed as cash flow from operating activities divided by cash paid for
property, plant, and equipment.
The capital acquisitions ratio reflects the portion of purchases of property, plant, and equipment financed
from operating activities (without the need for outside debt or equity financing or the sale of other
investments or fixed assets). A high ratio indicates less need for outside financing for current and future
expansion. It benefits the company because it provides opportunities for strategic acquisitions, avoids the
cost of additional debt, and reduces the risk of bankruptcy that comes with additional leverage (see
Chapter 10).
Free cash flow is computed as cash flow from operating activities minus dividends minus capital
expenditures.
Any positive free cash flow is available for additional capital expenditures, investments in other
companies, and mergers and acquisitions without the need for external financing or reductions in
dividends to shareholders. While free cash flow is considered a positive sign of financial flexibility, it also
can represent a hidden cost to shareholders. Sometimes managers use free cash flow to pursue
unprofitable investments just for the sake of growth or to obtain perquisites (such as fancy offices and
corporate jets) that do not benefit the shareholders. In these cases, the shareholders would be better off if
free cash flow were paid as additional dividends or used to repurchase the company’s stock on the open
market.
Learning Objective 12.6: Report and Interpret Cash Flows from Financing Activities
Financing activities are associated with generating capital from creditors and owners. This section of
the cash flow statement reflects changes in two current liabilities, Notes Payable to Financial Institutions
(often called short-term debt) and Current Maturities of Long-Term Debt, as well as changes in long-term
liabilities and stockholders’ equity accounts. These balance sheet accounts relate to the issuance and
retirement of debt and stock and the payment of dividends.
To compute cash flows from financing activities, you should review changes in debt and
stockholders’ equity accounts.
During 2017, the company received proceeds of $1,333 from issuance of long-term debt. There were no
repayment of principal of long-term debt during the year.
National Beverage’s change in contributed capital resulted from two decisions. National Beverage did not
repurchase any outstanding stock during the year, but the company did issue stock for $1,068 in cash,
which is a financing inflow. This accounts for the $1,068 increase in common stock and additional paidin capital on the balance sheet.
Finally, retained earnings should be analyzed. Retained earnings rise when income is earned and fall
when dividends are declared and paid. National Beverage earned $107,045 in income and paid $68,647 in
dividends during 2017, resulting in an increase of $38,398 and an ending balance of $227,324 in Retained
Earnings.
Ending Retained Earnings = Beginning Retained Earnings + Net Income – Dividends
The long-term growth of a company is normally financed from three sources
Format of the statement of cash flows using the indirect method:
Supplemental cash flow information is needed in the disclosures at the bottom of the statement or in the
notes:
1. Noncash investing and financing activities. E.g. purchase of a building with a mortgage given by
former owner
2. Cash paid for interest and income taxes (when using indirect method)