c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.
Learning Objectives
1.Describe the cash flow activities reported in
the statement of cash flows.
2.Prepare a statement of cash flows, using the
indirect method.
3.Prepare a statement of cash flows, using the
direct method.
4.Describe and illustrate the use of free cash
flow in evaluating a company’s cash flow.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.
Reporting Cash Flows
o The statement of cash flows reports a firm’s
major cash inflows and outflows for a period. It
provides useful information about a company’s
ability to do the following:
 Generate cash from operations
 Maintain and expand its operating capacity
 Meet its financial obligations
 Pay dividends
Reporting Cash Flows
o The statement of cash flows reports cash flows
from three types of activities:
 Cash flows from operating activities are cash flows
from transactions that affect net income.
 Cash flows from investing activities are cash flows
from transactions that affect investments in the
noncurrent assets of the company.
 Cash flows from financing activities are cash flows
from transactions that affect the equity and debt of
the company.
REPORTING CASH
FLOWS
Cash Flows from Operating Activities
o The direct method reports operating cash
inflows (receipts) and cash outflows
(payments) as follows:
The primary
operating cash
inflow is cash
received from
customers.
Cash Flows from Operating Activities
o The primary operating cash outflows are cash
payments for merchandise, operating
expenses, interest, and income tax payments.
Reporting Cash Flows
o The indirect method reports the operating
cash flows by beginning with net income and
adjusting it for revenues and expenses that do
not involve the receipt or payment of cash as
follows:
Reporting Cash Flows
o The primary advantage of the indirect method
is that it reconciles the differences between net
income and net cash flows from operations.
Also, the indirect method is less costly to use
than the direct method.
Over 99% of companies
use the indirect method.
Reporting Cash Flows
o Whether the direct or indirect method is used,
the amount of net cash flow from operating
activities will be the same. This is illustrated in
Exhibit 2 in the next slide.
REPORTING CASH
FLOWS
Cash Flows from Investing Activities
o Cash inflows from investing activities normally
arise from selling fixed assets, investments,
and intangible assets.
o Cash outflows from investing activities
normally include payments to acquire fixed
assets, investments, and intangible assets.
Cash Flows from Financing Activities
o Cash inflows from financing activities normally
arise from issuing long-term debt or equity
securities.
o Cash outflows from financing activities
normally include paying cash dividends,
repaying long-term debt, and acquiring
treasury stock.
Noncash Investing and Financing Activities
o Noncash investing and financing activities are
transactions that do not directly affect cash. The
effect of such transactions is recorded in a
separate schedule that appears at the bottom
of the statement of cash flows.
No Cash Flow Per Share
o Cash flow per share should not be reported on
a company’s financial statements for the
following reasons:
 Users may misinterpret cash flow per share as the
per-share amount available for dividends.
 Users may misinterpret cash flow per share as
equivalent to earnings per share.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.
The Indirect Method
o The indirect method of reporting cash flows
from operating activities uses the logic that a
change in any balance sheet account
(including cash) can be analyzed in terms of
changes in other balance sheet accounts.
o Any change in the cash account can be
determined by analyzing changes in liability,
stockholders’ equity, and noncash asset
accounts.
THE INDIRECT
METHOD
(continued)
(concluded)
Retained Earnings
o A good starting point for determining the cash
flows from operating activities is to analyze the
retained earnings account.
The retained earnings account for Rundell Inc. is
shown below.
Retained Earnings
o The retained earnings account for 2014
indicates that the $80,000 ($108,000 – $28,000)
change resulted from net income and cash
dividends. The net income of $108,000 is the
first amount reported in the Cash Flows from
Operating Activities section.
Adjustments to Net Income
Cash flows from operating activities:
Net income
$108,000
Adjustments to reconcile net income
to net cash flow from operating activities:
This phrase beginning with
“Adjustments to…” is added to
indicate that accrual basis net
income is being adjusted to arrive
at cash flows from operations.
Rundell Inc.
Step 1
o Expenses that do not affect cash are added.
Such expenses decrease net income, but do
not involve cash payments and, thus, are added
to net income. Examples include depreciation
of fixed assets and amortization of intangible
assets.
Step 2
o Losses and gains on disposal of assets are
added or deducted. The disposal (sale) of
assets is an investing activity, rather than an
operating activity. Losses on disposal of assets
are added back to net income. Gains on
disposal of assets are deducted from net
income.
Step 3
o
Changes in current operating assets and
liabilities are added or deducted as follows:
 Increases in noncash current operating assets are
deducted.
 Decreases in noncash current operating assets are
added.
 Increases in current operating liabilities are
added.
 Decreases in current operating liabilities are
deducted.
ADJUSTMENTS TO
NET INCOME
Rundell Inc.
Let’s start
with
depreciation
Step 1: The comparative balance sheet indicates that
Accumulated Depreciation—Building increased by
$7,000.
ADJUSTMENTS TO
NET INCOME
Step 1: The account indicates that depreciation for the year
was $7,000 for the building.
ADJUSTMENTS TO
NET INCOME
Rundell Inc.
ADJUSTMENTS TO
NET INCOME
Rundell Inc.
Next, let’s
look at this
gain
Now,
consider the
gain
ADJUSTMENTS TO
NET INCOME
STEP 2. Deduct the gain on the sale of land of $12,000. The
proceeds, which include the gain, are reported in the
Investing section of the statement of cash flows. Thus,
the gain of $12,000 is deducted from net income in
determining cash flows from operating activities.
Rundell Inc.
ADJUSTMENTS TO
NET INCOME
Rundell Inc.
Step 3: Select the current operating assets and liabilities that
impact cash flows and determine their increases and
decreases.
Adjustments to Net Income
o Accounts receivable (net): The $9,000 increase
is deducted from net income. This is because
the $9,000 increase in accounts receivable
indicates that sales on account were $9,000
more than the cash received from customers.
Thus, sales (and net income) includes $9,000
that was not received in cash during the year.
(continued)
Adjustments to Net Income
o Inventories: The $8,000 decrease is added to net
income. This is because the $8,000 decrease in
inventories indicates that the cost of merchandise
sold exceeds the cost of merchandise purchased
during the year by $8,000.
o Accounts payable (merchandise creditors): The
$3,200 decrease is deducted from net income. This
is because a decrease in accounts payable
indicates that the cash payments to merchandise
creditors exceed the merchandise purchased on
account by $3,200.
(continued)
Adjustments to Net Income
o Accrued expenses payable (operating expenses):
The $2,200 increase is added to net income. This is
because an increase in accrued expenses payable
indicates that operating expenses reported on the
income statement exceed the cash payments for
operating expenses by $2,200.
o Income taxes payable: The $500 decrease is
deducted from net income. This is because a
decrease in income taxes payable indicates that
taxes paid exceed the amount of taxes incurred
during the year by $500.
ADJUSTMENTS TO
NET INCOME
Rundell Inc.
ADJUSTMENTS TO
NET INCOME
Rundell Inc.
Transferring the previous slide to a formal
statement of cash flows for Rundell, we can see
that part of the statement is now complete.
Dividends
o Cash dividends of $28,000 were declared
during 2014.
Dividends
o However, as can be seen from the dividends
payable account, only $24,000 was paid.
Since dividend payments are a financing
activity, the dividend payments totaling
$24,000 are reported in the Financing
Activities section.
Common Stock
o Rundell Inc.’s common stock account increased
by $8,000 during 2014.
Common Stock
o The paid-in capital in excess of par—common
stock account increased by $40,000 during the
year.
Issuing company stock is a financing
activity, so cash flows from financing
activities increase by $48,000 ($8,000 +
$40,000).
Bonds Payable
Bonds Payable decreased by $50,000 during
2014, due to retiring the bonds. A check of
Rundell’s income statement shows that there was
no gain or loss on the retirement.
Retiring a bond payable is a financing
activity, so a cash outflow of $50,000 is
reported in the Financing Activities
section of the statement of cash flows.
Building
o The building account increased by $60,000.
The cash outflow for this purchase is
shown in the Investing Activities section
of the statement.
Land
o The $45,000 decline in the land account was
from two transactions.
Land
o Earlier, as part of Step 2 in preparing the
Operating Activities section, the $12,000 gain
was deducted from net income.
The proceeds of $72,000 from the sale of
land are reported in the Investing
Activities section of the statement of cash
flows.
Land
The October 12 transaction is the purchase of
land for cash of $15,000. This transaction is
reported as an outflow of cash in the Investing
Activities section.
Preparing the Statement of Cash Flows
o The completed statement of cash flows for
Rundell Inc. using the indirect method is shown
in Exhibit 6 (next slide). The increase in cash
shown on the statement ($71,500) should
match the increase in cash in Rundell Inc.’s
cash account.
Note that cash increased
$71,500.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.
The Direct Method
o The direct method reports cash flows from
operating activities as follows:
The Direct Method
o The final amount reported in the Cash Flows
from Operating Activities section will be the
same whether the direct or indirect method is
used. The methods differ in how the data are
obtained, analyzed, and reported.
The Direct Method
o Under the direct method, the income statement
is adjusted to cash flows from operating
activities as follows:
The Direct Method
o Depreciation expense is not adjusted or
reported as part of cash flows from operating
activities. This is because depreciation
expense does not involve a cash outflow.
The Direct Method
o Gains and losses are also not adjusted,
because the cash flow from operating activities
is determined directly, rather than by
reconciling net income. Proceeds from the sale
of land, which include any gains or losses, are
reported as an investing activity.
Cash Received from Customers
o Rundell Inc. reports sales of $1,180,000 for
2014. To determine the cash received from
customers, sales are adjusted by any increase
or decrease in accounts receivable.
CASH RECEIVED
FROM CUSTOMERS
$0
= $1,171,000
$1,180,000
($9,000)
Cash Payments for Merchandise
o Rundell Inc. reports cost of merchandise sold
of $790,000. To determine the cash payments
for merchandise, the $790,000 is adjusted for
any increase or decrease in inventories and
accounts payable (assuming the accounts
payable are owed to merchandise suppliers).
CASH PAYMENTS
FOR MERCHANDISE
($8,000)
$790,000
= $785,200
$3,200
Cash Payments for Operating Expenses
o Rundell Inc. reports total operating expenses
of $203,000, which includes depreciation
expense of $7,000. To determine cash
payments for operating expenses, the other
operating expenses (excluding depreciation)
of $196,000 are adjusted for any increase or
decrease in accrued expenses payable.
CASH PAYMENTS
FOR OPERATING
EXPENSES
$0
= $193,800
$196,000
($2,200)
Interest Expense
o Rundell Inc. reports interest expense of $8,000.
To determine the cash payments for interest, the
$8,000 is adjusted for any increases or
decreases in interest payable.
INTEREST EXPENSE
Cash Payments for Income Taxes
o Rundell Inc. reports income tax expense of
$83,000. To determine the cash payments for
income taxes, the $83,000 is adjusted for any
increases or decreases in income taxes
payable.
CASH PAYMENTS
FOR INCOME TAXES
$500
= $83,500
$83,000
$0
REPORTING CASH
FLOWS FROM
OPERATING
ACTIVITIES
(continued)
REPORTING CASH
FLOWS FROM
OPERATING
ACTIVITIES
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Free Cash Flow
o Free cash flow measures the operating cash
flow available for a company to use after
purchasing the property, plant, and equipment
(PP&E) necessary to maintain current
productive capacity.
Free Cash Flow
Cash flow from operating activities
Less: Investments in fixed assets
to maintain current production
Free cash flow
o Positive free cash flow is considered favorable.
A company that has free cash flow is able to
fund internal growth, retire debt, pay
dividends, and enjoy financial flexibility.
Free Cash Flow
o Research in Motion, Inc., maker of BlackBerry®
smartphones, had cash flow from operating
activities of $4,009 million in a recent fiscal
year. The statement of cash flows indicated that
the cash invested in property, plant, and
equipment was $1,039 million. The free cash
flow would be computed as follows (in
millions):
Cash flow from operating activities
$4,009
Less: Investment in PP&E needed to maintain
current production
1,039
Free cash flow
$ 2,970
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.
c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.