Chapter 7--Learning Objectives
1. Understand how the statement of
cash flows assists users in evaluation
of firm performance
Current operating cash flows
a major user need
Current operating cash flows
(COCF)
is cash available from
normal operations
Current operating cash flows
must be adequate for:
 1. Permanent working capital
 2. Seasonal working capital
 3. Net fixed (and other long-term) assets
 4. Repayment of debt principal & interest
 5. Payment of dividends
Permanent working capital
 a firm’s permanent investment in net
operating asset
 receivables and inventory less the amount
of this investment financed by trade
creditors through accounts payable
Seasonal working capital
 increases in inventory levels required by
seasonally increased demands for the firm’s
product or service
Adequacy ratios
 The following ratios help assess the
adequacy of COCF to meet firm needs:
 Capital acquisition ratio
 Debt coverage ratio
 Dividend coverage ratio
 Cash flow adequacy ratio
Adequacy ratios (cont.)
 Capital Financing
 Reinvestment
 Cash-Interest Coverage
 Dividend Payout
Performance and quality ratios
 Cash flow return on assets
 Cash flow return on common equity
 Quality of sales ratio
 Quality of income ratio (2)
 Cash flow per share
Cash flow return on assets
COCF before interest and taxes *
Average total assets
* inclusion of taxes varies in practice
Cash flow return on common
equity
COCF - preferred dividends
Average common equity
Quality of sales ratio
Cash from sales
Sales
Quality of income ratio # 1
Current operating cash flows
Operating income
Quality of income ratio # 2
C O C F before interest and taxes
Income before interest, taxes & deprec.
Cash flow per
*
share
C O C F - preferred dividends
Average number of common shares
*explicitly prohibited from disclosure in annual
report
Chapter 7--Learning Objectives
2. Interpret the format and content of
the statement of cash flows
Statement of cash flows
The purpose of the cash flow statement is to
show the sources and uses of cash
Where did the cash come from ?
Where did it go ?
Statement of cash flows
 The statement has three principal sections:

1. Operating activities

2. Investing activities

3. Financing activities
 And two ancillary sections

1. Noncash investing / financing

2. Reconciliation
Statement of cash flows
 The statement can be prepared two ways


1.
2.
The indirect method
The direct method
Operating activities
 Routine inflows and outflows from regular
operations
 Net income used as a starting point in
indirect method
 Net income must be adjusted for items
which affect income but not cash and for
noncash items
Adjustments to net income in the
operating section
 Items which affect income but not cash

-- Depreciation and amortization
 Noncash items

-- Changes in current asset accounts

(except certain investments)

-- Changes in current liability accounts
Relationships to remember
An increase in another asset account
results in a decrease in cash
ANOTHER ASSET UP -- CASH DOWN
ANOTHER ASSET DOWN -- CASH UP
Relationships to remember
Similarly, a decrease in a liability account
results in a decrease in cash
LIABILITY DOWN -- CASH DOWN
LIABILITY UP -- CASH UP
Investing activities
 Investments in our own business

Purchase of operational assets

Sale of operational assets
 Investments in other businesses

Purchase of securities

Sale of securities

Making loans to other entities

Collecting such loans
Financing activities
 Transactions involving owners

Sale of stock

Payment of dividends

Treasury stock transactions
 Transactions involving creditors

Borrowing long-term

Repaying long-term debt
Some special cases
 Purchase and sale of investments, whether
short-term or long-term are INVESTING
activities
 Dividends and interest received from
investments are considered to be
OPERATING activities
More special cases
 Interest paid to creditors is considered to be
an OPERATING activity
 Dividends paid to stockholders are
considered to be a FINANCING activity
Noncash investing and financing
activities
 Transactions in which no cash is involved
 Example: Purchase of equipment with no
down payment by issuing a long-term note
payable
The direct method
 Starts with cash received from customers
 Subtracts cash paid to





Suppliers
Employees
Creditors (interest payments)
Governments (taxes)
Others (for operations)
A separate reconciliation
from net income
to
net cash flow from operating activities
is required
when the direct method
is used
The indirect method
 Begins with net income
 Adjusts for items which affect income but
not cash and for noncash items
 Only the operating section is different
between the indirect and direct methods
 The investing and financing sections are
identical
Chapter 7--Learning Objectives
3. Derive cash flow information
analytically from accrual information
Accrual based financial
statements do not reveal cash
received from customers or cash
paid to suppliers
We have to dig this
information out for
ourselves
What do we know ?
 From the income statement, we know sales
revenue
 From the balance sheet, we know beginning
and ending accounts receivable
 These numbers can be used to work toward
cash received from customers
Cash received from customers
Sales revenue
Plus:
Beginning accts. receivable
Less:
Ending accts. receivable
Less:
Accts. receivable written off
Equals: Cash recd. from customers
 (Now how do we get accounts written off?)
Account receivable write-offs
Beginning Allow. for Bad Debts
Plus:
Bad Debt Expense
Less:
Ending Allow. for Bad Debts
Equals: Accounts written off
What about cash paid to suppliers
?
Plus:
Less:
Equals
Purchases
Beginning Accts. Payable
Ending Accts. Payable
Cash paid to suppliers
If necessary, Purchases is
calculated
Cost of Goods Sold
Plus:
Ending Inventory
Less:
Beginning Inventory
Equals: Purchases
Chapter 7--Learning Objectives
4. Differentiate between the direct and
indirect method of presentation
East-West Industries
Statement of Cash Flows - Direct Method
For the year ended June 30, 1995
Cash flows from operating activities
Collections from customers
$200,000
Payments to vendors
(60,000)
Payments to employees
(40,000)
Payments to creditors
(20,000)
Payments to utilities
(20,000)
Payments to governments
(30,000)
Cash flow from operations
$30,000
East-West Industries
Statement of Cash Flows - Direct Method
(continued)
Cash flows from investing activities
Proceeds from sale of PP&E
Proceeds from sale of land
Proceeds from sale of patents
Purchase of PP&E
Purchase of land
Purchase of intangibles
Cash flow from investing
100,000
110,000
70,000
(200,000)
( 50,000)
( 20,000)
10,000
East-West Industries
Statement of Cash Flows - Direct Method
(continued)
Cash flows from financing activities
Sale of stock
30,000
Issuance of bonds
100,000
Repurchase of stock
(90,000)
Retirement of debt
(10,000)
Payment of dividends
Cash flow from financing
Net increase in cash
Balance, June 30, 1994
Balance, June 30, 1995
(20,000)
10,000
50,000
120,000
170,000
Operating Section - Indirect Method
Cash flows from operating activities
Net income
$97,000
Depreciation expense
48,000
Amortization of patents
4,000
Depletion of natural res.
6,000
Deferred income taxes
17,000
Noncash interest expense
19,000
Gain on sale of land
(47,000)
Loss on sale of PP&E
12,000
Gain on debt retirement
(40,000) 19,000
Operating Section - Indirect Method-continued
Cash flows from operating activities
Gain on debt retirement
(40,000)
Decrease in accts. receivable
Increase in AFBD
Increase in inventory
Decrease in accts. payable
Decrease in wages payable
Increase in utilities payable
Net cash flow from operations
19,000
9,000
3,000
(60,000)
(30,000)
(12,000)
4,000
$30,000
Chapter 7--Learning Objectives
5. Prepare a statement of cash flows