Chapter
3
Analysis of Cash Flows
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Chapter Objectives
• Describe the three components of a cash flow statement
• Distinguish between direct method and indirect method cash flow
statements
• Show how to use the transactional analysis method to prepare a
direct method cash flow statement using financial statement data.
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Statement of Cash Flows
Cash flow data supplement the information provided by the income
statement as both link consecutive balance sheet. The statement of
cash flows reports all the cash inflows and outflows of a specified
period.
The classification of cash flows among the following activities are
essential to the analysis of cash flow data:
• Cash flows among operating activities
• Investing Cash Flow (CFI)
• Financing Cash Flow (CFF)
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Statement of Cash Flows, cont.
Cash Flow from operating Activities:
(cash form operations or CFO) measures the amount of cash generated
or used by the firm as a result of its production and sales of goods and
services. Internally generated funds can be used to pay dividends or
repurchase equity, repay loans, replace existing capacity, or invest in
acquisition and growth.
Investing Cash Flow:
(CFI) reports the amount of cash used to acquire assets such as plant
and equipment as well as investments and entire businesses. CFI also
includes cash received from the sale or dispose of assets or segments
of the business.
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Statement of Cash Flows, cont.
Financing Cash Flows:
(CFF) contains the cash flow consequences of the firm’s capital
structure (debt and equity) decisions, including proceeds from the
issuance of equity.
Firms with significant Foreign operations separately report a fourth
category, The effect of exchange rate changes on cash, which
accumulate s the effects of changes in exchange rates on the
translation of foreign currencies
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Direct and Indirect Method of Cash Flow
Statement:
SFAS 95, statement of cash flows (1987), and IAS 7 (1992)
govern the preparation of cash flow statement under U.S and IAS
GAAP, respectively. Both standard permit firms to report cash
from operation either directly by reporting major categories of
gross cash receipts and payments, or indirectly by reconciling
accrual-based net income to CFO. Both investing and financing
cash flows are usually computed identically under two methods.
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Direct and Indirect Method of Cash Flow
Statement:, cont.
Under the indirect method, CFO is computed by adjusting net
income y adjusting net income for all:
Noncash revenues and expenses (for example, depreciation
expense)
• Non-operating items included in net income (for example,
gains from property sales)
• Noncash changes in operating assets and liabilities (operating
• changes in receivables, payables)
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Direct and Indirect Method of Cash Flow
Statement:, cont.
Cash flow statement prepared using the indirect method have a
significant Drawback. Because the
indirect format reports the net cash flow form operations, it does
not
facilitate the comparison and analysis of operating cash inflows and
outflows by function with the revenue and expense activity that
generated them, as is possible from direct method cash flow
statements.
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Preparation of a Statement of Cash Flows
Transactional Analysis
Transactional analysis is a technique that can be used to create a cash
flow statement for firms that do not prepare such statements in
accordance with SFAS 95 and IAS 7. It can also be used to convert
indirect method cash flow from operations to the direct method.
The relationship between balance sheet changes and cash flows can
be summarized as follows:
Increases (decreases) in assets represent net cash outflows (inflows).
If an asset increases, the firm must have paid cash in changes.
Increases (decreases) in liabilities represent net cash inflows
(outflows). When a liability increases, the firm must have received
cash in exchange.
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