Statement of Cash Flows
Revsine/Collins/Johnson: Chapter 17
Learning objectives
1. The major sources and uses of cash—operating, investing, and
financing.
2. Why accrual net income and operating cash flows differ, and the
factors that explain this difference.
3. The difference between the direct and indirect methods of
determining cash flow from operations.
4. How to prepare a statement of cash flows from comparative
balance sheet data, an income statement, and other information.
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Learning objectives
Concluded
5. Why changes in balance sheet accounts over a year may not
reconcile to the corresponding changes included in the statement
of cash flows.
6. What “cash burn rates” are and how they can be used to evaluate
the financial viability of start-up companies.
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Why cash flows are important
 Accrual earnings may not always provide a reliable measure of
enterprise performance and health.

Accrual accounting relies on subjective judgments that may introduce
measurement error and uncertainty into reported earnings.

One-time write-offs and restructuring charges can reduce the quality
of reported earnings.

Management can readily manipulate accrual income.
 For these reasons, analysts scrutinize a firm’s cash flows—not
just its accrual earnings—to evaluate performance and
creditworthiness.
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Statement format
Operating
cash flows
Result from events or transactions that enter into the
determination of net income; i.e., the cash-based
revenues and expenses of a company.
Investing
cash flows
Result from the purchase or sale of productive assets like
plant and equipment, marketable securities, and from
acquisitions and divestitures.
Financing
cash flows
Result when a company sells its own stocks or bonds,
pays dividends or buys back its own shares, or borrows
money and repays the amounts borrowed.
Changes in cash
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Statement format:
Direct approach
Measures the net cashbased revenues and
expenses of a company
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Statement format:
Direct approach continued
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Statement format:
Cash flows and accruals at ABM
Cash from operations
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$110.919
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$65.796
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Statement format:
Reconciling cash flows and net income
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Statement format:
Indirect approach
Accrual net income
Items included in
accrual net income
but did not affect
cash in the period
Items excluded from
accrual net income
but did affect operating
cash in the period
Non-cash revenues and gains
+
Non-cash expenses and losses
+
-
Cash inflows received but not
recognized as earned
Cash outflows paid but not recognized
for accrual purposes
Operating cash flows
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Statement format:
Special disclosure rules
 SFAS No. 95 allows a choice between the direct and indirect
approach for the cash flow statement.
 Firms using the direct approach are also required to provide a
reconciliation between accrual earnings and operating cash flow,
and to separately disclose income taxes paid.
 Firms using the indirect approach are required to separately
disclose interest paid and income taxes paid.
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Preparing the cash flow statement:
Overview
A three-step process:

1. Identify the journal entry that
led to the reported change in
each non-cash balance sheet
account.
The purpose of the cash flow
statement is to explain the
underlying causes for the change
in the cash balance.
2. Determine the net cash flow
effect of the journal entry.
Operating
3. Compare the financial
statement effect of the entry
(Step 1) with its cash flow effect
(Step 2) to determine what
cash flow statement treatment
is needed .
Investing
Financing
Changes in cash
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Preparing the cash flow statement:
Burris Products Illustration
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Preparing the cash flow statement:
Burris Products solution
The starting point
for computing cash
from operations
Why the cash
balance changed.
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Preparing the cash flow statement:
Burris Products—depreciation
Step 1: The journal entry that generated the account change was:
Step 2: Neither of these two accounts involve cash.
Step 3: Because depreciation expense was included in the
determination of net income but does not represent a cash
outflow, the expense must be added back to net income.
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Preparing the cash flow statement:
Burris Products—gain on equipment sale
Step 1: The journal entry was:
Step 2: The sale resulted in a cash inflow of $57,000.
Step 3: The recognized accrual gain ($17,000) does not correspond
to the cash inflow ($57,000). The gain is removed from
income, and the cash inflow is shown as an investing activity.
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Preparing the cash flow statement:
Burris Products—amortization of bond discount
Step 1: The journal entry to record interest expense was:
Step 2: The cash outflow as only $40,000.
Step 3: Because interest expense ($44,000) exceeds the cash
outflow ($40,000), the $4,000 difference is added back to
net income.
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Preparing the cash flow statement:
Burris Products—deferred income taxes
Step 1: The journal entry to record tax expense was:
Step 2: The cash outflow for taxes was only $96,375.
Step 3: Because the income statement expense is larger than the
cash outflow, the $6,000 difference must be added in the
operating activities section of the cash flow statement.
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Preparing the cash flow statement:
Burris Products—accounts receivable
Step 1: The two journal entries associated with the account were:
Step 2: The amount of cash collections ($3,039,000) exceeded the
amount of accrual revenues included in income ($3,030,000).
Step 3: The $9,000 excess of cash collections over accrual revenue is
added back to net income to obtain cash from operations.
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Preparing the cash flow statement:
Burris Products—customer advance deposits
Step 1: The journal entry for this account was:
Step 2: There was no corresponding cash flow effect.
Step 3: Because revenues exceed 2005 cash inflows by $11,000,
this amount must be deducted in the operating section of
cash flow statement.
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Preparing the cash flow statement:
Burris Products—inventories
Step 1: The journal entries associated with this account were:
Step 2: The cost-of-goods-sold deduction from net income ($4,526,625)
is $12,000 lower than the cash outflow to buy inventory.
Step 3: Because net income understates cash flow to buy inventory,
$12,000 must be deducted in the computation of operating
cash flow.
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Preparing the cash flow statement:
Burris Products—accounts payable
Step 1: The inventory adjustment was computed under the
assumption that all inventory was purchased for cash. We
now relax that assumption, and note that accounts payable
increased by $3,000 during the year.
Step 2: This accounts payable increase means that $3,000 of the
$12,000 inventory increase was not paid for in cash.
Step 3: Therefore, $3,000 is added to net income in the cash flow
statement.
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Preparing the cash flow statement:
Operating cash flow summary
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Preparing the cash flow statement:
Burris Products—land
Step 1: The journal entry to reflect the increase in land was:
Step 2: This transaction represents an $86,000 cash outflow.
Step 3: The cash outflow is categorized as an investment outflow.
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Preparing the cash flow statement:
Burris Products—Buildings and equipment
Step 1: The changes in this account are summarized by :
Step 2: The transaction represents a $261,000 cash outflow.
Step 3: The outflow is again categorized as an investment outflow.
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Preparing the cash flow statement:
Burris Products—stock sale and dividend paid
Step 1: The journal entries were:
Step 2: The cash effects involve a $50,000 inflow and a $90,000
dividend outflow.
Step 3: Both the cash inflow and cash outflow are shown as financing
activities.
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Reconciling between statements:
Some complexities
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Reconciling between statements:
Source of complexities
 There are at least four reasons why changes in working capital
accounts (like inventory) and fixed assets don’t correspond to the
changes shown on the cash flow statement:
1. Asset write-offs due to impairment, restructuring or retirement.
2. Translation adjustments on assets and liabilities held by foreign
subsidiaries.
3. Acquisition and divestitures of other companies.
4. Simultaneous investing and financing activities not directly affecting
cash.
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Reconciling between statements:
Inventories—write-offs due to restructuring
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Reconciling between statements:
Inventories—other complexities
 Translation adjustments
Balance sheet
inventory change
Cash flows
inventory change
• Computed using BOP and EOP foreign exchange rates.
• Computed by comparing purchases with cost of goods sold.
• Translated amounts are used for foreign subsidiaries.
 Acquisitions and divestitures
Balance sheet
inventory change
Cash flows
inventory change
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• Includes the effects of acquisitions and divestitures.
• Includes cash flows from business segments owned at both
the start and end of period.
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Reconciling between statements:
Plant and equipment—retirements
 The journal entry to record a retirement is:
 It is often not possible for statement readers to determine the
exact dollar amount of retirements.
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Reconciling between statements:
Plant and equipment—other complexities
 Foreign currency translation adjustments:

Changes in the balance sheet accounts that are due to foreign
currency exchange rate fluctuations are not reflected in the cash flow
statement.
 Acquisitions and divestitures:

Changes in the balance sheet accounts that arise from acquisitions
are often shown on a line separate from “Capital expenditures”.
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Reconciling between statements:
Simultaneous non-cash investing & financing
 Some investing and financing activities occur simultaneously as
part of a single transaction:

Buy a building and borrow the full amount as a mortgage.

Acquire an asset by entering into a capital lease.

Issue stock for non-cash assets as part of a business combination.
 SFAS No. 95 requires firms to disclose these non-cash
simultaneous investing and financing activities.
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Reconciling between statements:
Simultaneous non-cash investing & financing
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Cash burn rate
 The ability to generate positive operating cash flow is critical to
the survival and success of any company.
 This is particularly true for start-up companies:

Cash is essential for establishing the business and for growth.
Investment outlays are often large.

Operating cash flows are negative.

 Cash burn rate is a popular metric for assessing how quickly a
start-up firm will consume its cash reserves:
Cash used for
operations
+
Cash used for capital
expenditures or acquisitions
Cash burn rate =
# of months covered by cash flow statement
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Cash burn rate:
Amazon.com illustration
 Cash burn rate:
= - ($119.782 + $50.321 +$6.198)/12 months = -$14.692 per month
 Months to burnout:
= $996.585/14.692 = 67.8 months
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Cash burn rate:
Selected companies
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Summary
 The statement of cash flows helps readers gauge the firm’s ability
to generate sufficient cash to pay for operating expenses, capital
improvements, and currently maturing obligations.
 Firms that generate consistently strong positive cash flows from
operations are considered better credit risks and benefit from a
lower cost of capital.
 The two alternative methods for presenting the operating section
of a cash flow statement are the direct approach and the indirect
approach.
 Most firms use the indirect approach.
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Summary concluded
 Changes in non-cash balance sheet accounts may not
correspond to the adjustments shown on the cash flow statement
because of:




Asset write-offs due to impairment, restructuring, or retirement
Translation adjustments on assets and liabilities held by foreign
subsidiaries.
Acquisitions and divestitures of other companies.
Simultaneous investing and financing activities.
 Cash burn rates can be helpful in evaluating the financial viability
of start-up companies.
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