Statement of Cash Flows

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Statement of Cash Flows
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How much cash is generated from or used in operations?
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What expenditures are made with cash from operations?
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How are dividends paid when confronting an operating loss?
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What is the source of cash for debt payments?
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How is the increase in investments financed?
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What is the source of cash for new plant assets?
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Why is cash lower when income increased?
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What is the use of cash received from new financing?
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Along side with cash budget CFS is used:
To assess liquidity
 Determine if short-term financing is necessary
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To determine dividend policy
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Decide to distribute; or increase or decrease
 To evaluate the investment and financing decisions

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• calculating changes in all of the balance sheet accounts, including cash listing the changes in all of the accounts except cash as inflows or outflows categorizing the flows by operating, financing, or investing activities
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Cash
Operating activities
Investing activities
Financing activities
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Cash
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Cash and highly liquid short-term marketable securities
Also called cash equivalents
If a company separates marketable securities into two accounts (cash and cash equivalents and short-term investments), the short-term investments are classified as investing activities.
4-6

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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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;

Examples of investing activities include:
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 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;

Examples of financing activities are :
 cash received from issuing share capital;
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 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.

Name of the Company
Cash Flow Statement
For the period …
Cash from operating activities
Cash from investing activities
A
B
Cash from financing activities
Net Change in Cash
C
D = (A+B+C) increase or (decrease)
+ Beginning Cash balance
Ending Cash balance
CB, from the beginning balance sheet
=CB + D should equal to ending cash balance in the ending balance sheet
Non-cash Investing and Financing 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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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.
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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

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, 10 th ed. Financial Accounting Slides http://www.swlearning.com/accounting/stickney/tenth_edition/stickney.html

 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.

Adjusting Net Income of the period (accrual) to cash basis income
Assets
INCREASE
Increase in non-cash assets shows that cash was spent, so cash outflow.
DECREASE
Decrease in non-cash assets shows that they provided cash so cash inflow.
Liabilities and
Shareholders’ equity
Increase in liabilities cash savings; increase in SHE cash received; so cash inflow
Decrease in liabilities or SHE shows cash paid; so cash outflow

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, 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

Portakal Company
Prepare Cash Flow Statement
Accounts with Debit Balances
Cash
Notes Receivable (from loans to other companies)
Accounts Receivable
Merchandise Inventory
Prepaid Operating Expenses
Interest Receivable
Land
Property,Plant and Equipment-PPE-net
2008 2007
37.500
69.000
39.250
50.000
53.700
39.900
158.000
120.000
2.100
1.400
1.800
600
110.000
65.000
377.000
380.000
808.700
696.550
increase
(decrease)
(1.750)
19.000
13.800
38.000
300
800
45.000
(3.000)
112.150
Accounts with Credit Balances
Accounts Payable
Accrued Wages Payable
Income Taxes Payable
Unearned Revenues
Bank Notes Payable - long term
Common Stock; TL 15 par value
Additional Paid in Capital
Retained Earnings
45.000
3.000
6.000
38.000
2.400
4.500
2.500
1.250
215.000
200.000
405.000
375.000
70.000
50.000
62.200
25.400
808.700
696.550
7.000
600
1.500
1.250
15.000
30.000
20.000
36.800
112.150

Portakal Company
Income Statement
Sales Revenue
Cost of Goods Sold
Depreciation Expense
Salary and Wages Expense
Administrative Expenses
Loss on Sale of Equipment
Other Operating Expenses
Interest Revenue
Interest Expense
Income Tax Expense
Net Income
0
2008
750.000
(375.000)
(43.000)
(125.000)
(80.000)
(4.000)
(5.000)
4.000
(20.000)
(28.000)
74.000
The company paid TL 50.000 of Bank Notes and borrowed new bank loan.
The company declared and paid cash dividends.
The company sold equipment with a cost of TL 12000 and accumulated depreciation of TL
6000 for TL 2000 receving a note in return to be collected in 2009.
The company purchased equipment for TL 46.000; paid TL 44.000 in 2008 and gave a note for Jan. 2009.
The company issued common stock during the year .

Portakal Company
Cash Flow Statement
Cashflow from Operating Activities
Net Income
Add back noncash:
Depreciation Expense
Loss on Sale of Equipment
2008
74000
43.000
4.000
121.000

adjustments that increase cash: increase in Acct.Payable
Increase in Acc.Wages Payable increase in Income Taxes payable increase in unearned revenued adjustments that decrease cash: increase in Accts Rec.
increase in Merch. Inv.
Increase in Prepaid Expense increase in interest recev.
Cashflow from operations
7.000
600
1.500
1.250
10.350
(13.800)
(38.000)
(300)
(800)
(52.900)
78.450

Cashflow from investing
Sale of PPE (note will be received in 2009)
Purchase of PPE (44.000)
Loans extended( to other companies) (19.000)
Purchase of land
Cashflow from investing
(45.000)
(108.000)
Cashflow from financing
Bank Notes Payable - long term
Common Stock; TL 15 par value
Additional Paid in Capital
Payment of Bank loan
Payment of Dividends
Cashflow from financing
65.000
30.000
20.000
(50.000)
(37.200)
27.800
Net Change in Cash (1.750)

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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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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.

(1)
Start with Net Income
(2)
Adjust Net Income for non-cash expenses and gains
(3)
Recognize cash inflows (outflows) from changes in current assets and liabilities
(4)
Sum to yield net cash flows from operations
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Changes in long-term assets yield net cash flows from investing activities
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Changes in long-term liabilities and equity accounts yield net cash flows from financing activities
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Sum cash flows from operations, investing, and financing activities to yield net change in cash
(8)
Add net change in cash to the beginning cash balance to yield ending cash

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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)?

Analysis Implications of Cash Flows
Limitations in Cash Flow Reporting
• Some limitations of the current reporting of cash flow:
– Practice does not require separate disclosure of cash flows pertaining to either extraordinary items or discontinued operations.
– Interest and dividends received and interest paid are classified as operating cash flows.
– Income taxes are classified as operating cash flows.
– Removal of pretax (rather than after-tax) gains or losses on sale of plant or investments from operating activities distorts our analysis of both operating and investing activities.

Analysis Implications of Cash Flows

Analysis Implications of Cash Flows
Interpreting Cash Flows and Net Income

Analysis of Cash Flows
• In evaluating sources and uses of cash, the analyst should focus on questions like:
 Are asset replacements financed from internal or external funds?
 What are the financing sources of expansion and business acquisitions?
 Is the company dependent on external financing?
 What are the company’s investing demands and opportunities?
 What are the requirements and types of financing?
 Are managerial policies (such as dividends) highly sensitive to cash flows?

Analysis of Cash Flows
Inferences from Analysis of Cash Flows
• Inferences from analysis of cash flows include:
– Where management committed its resources
– Where it reduced investments
– Where additional cash was derived from
– Where claims against the company were reduced
– Disposition of earnings and the investment of discretionary cash flows
– The size, composition, pattern, and stability of operating cash flows

Analysis of Cash Flows
Alternative Cash Flow Measures
– EBITDA (earnings before interest, taxes, depreciation, and amortization)

Analysis of Cash Flows
Issues with EBITDA
• The using up of long-term depreciable assets is a real expense that must not be ignored.
• The add-back of depreciation expense does not generate cash. It merely zeros out the noncash expense from net income as discussed above.
Cash is provided by operating and financing activities, not by depreciation.
• Net income plus depreciation ignores changes in working capital accounts that comprise the remainder of net cash flows from operating activities. Yet changes in working capital accounts often comprise a large portion of cash flows from operating activities.

Analysis of Cash Flows
Company and Economic Conditions
• While both successful and unsuccessful companies can experience problems with cash flows from operations, the reasons are markedly different.
• We must interpret changes in operating working capital items in light of economic circumstances.
• Inflationary conditions add to the financial burdens of companies and challenges for analysis.

Analysis of Cash Flows
Free Cash Flow
Another definition that is widely used:
FCF = NOPAT - Change in NOA
(net operating profits after tax (NOPAT) less the increase in net operating assets (NOA))

Analysis of Cash Flows
Free Cash Flow
Positive free cash flow reflects the amount available for business activities after allowances for financing and investing requirements to maintain productive capacity at current levels.
Growth and financial flexibility depend on adequate free cash flow.
Recognize that the amount of capital expenditures needed to maintain productive capacity is generally disclosed—instead, most use total capital expenditures, which is disclosed, but can include outlays for expansion of productive capacity.
not

Analysis of Cash Flows
Cash Flow as Validators
• The SCF is useful in identifying misleading or erroneous operating results or expectations.
SCF provides us with important clues on:
 Feasibility of financing capital expenditures.
 Cash sources in financing expansion.
 Dependence on external financing.
 Future dividend policies.
 Ability in meeting debt service requirements.
 Financial flexibility to unanticipated needs/opportunities.
 Financial practices of management.
 Quality of earnings.

Cash Flow Adequacy Ratio – Measure of a company’s ability to generate sufficient cash from operations to cover capital expenditures, investments in inventories, and cash dividends:
Three-year sum of cash from operations
Three-year sum of expenditures, inventory additions, and cash dividends
Cash Reinvestment Ratio – Measure of the percentage of investment in assets representing operating cash retained and reinvested in the company for both replacing assets and growth in operations:
Operating cash flow – Dividends
Gross plant + Investment + Other assets + Working capital