Managerial Accounting Weygandt • Kieso • Kimmel Chapter 13 Statement of Cash Flows Prepared by Barbara Muller Arizona State University West and Alice Sineath Forsyth Technical Community College John Wiley & Sons, Inc. © 2005 1 Chapter 13 Statement of Cash Flows • • • • After studying Chapter 13, you should be able to: Indicate the usefulness of the statement of cash flows. Distinguish among operating, investing, and financing activities. Explain the impact of the product life cycle on a company's cash flows. Prepare a statement of cash flows using one of two approaches: – (a) the indirect method, or – (b) the direct method. • Use the statement of cash flows to evaluate a company. 2 The Primary Purpose of the Statement of Cash Flows Is... • To provide information about: – cash receipts, – cash payments, and – the net change in cash resulting from: •operating, •investing, and •financing activities of a company during a period. 3 Questions the Statement of Cash Flow Answers 4 Operating Activities... Include: – The cash effects of transactions that create revenues and expenses and – Enter into determination of net income. Involve Income Statement Items 5 Investing Activities... Include: – Purchasing and disposing of investments and productive long-lived assets using cash and – Lending money and collecting the loans. Involve Investments and Noncurrrent Asset Items 6 Financing Activities... Include: – Obtaining cash from issuing debt and repaying the amounts borrowed and – Obtaining cash from stockholders and paying dividends. Involve Noncurrent Liability and Stockholders’ Equity Items 7 Types of Cash Flows Operating Activities • Cash inflows: – From sale of goods or services – From return on loans (interest received) and on equity securities (dividends received) • Cash outflows: – To suppliers for inventory – To employees for services – To government for taxes – To lenders for interest – To others for expenses 8 Types of Cash Flows Investing Activities • Cash inflows: – From sale of property, plant, and equipment – From sale of debt or equity securities of other entities – From collection of principal on loans to other entities • Cash outflows: – To purchase property, plant, and equipment – To purchase debt or equity securities of other entities – To make loans to other entities 9 Types of Cash Flows Financing Activities • Cash inflows: – From sale of equity securities (company's own stock) – From issuance of debt (bonds and notes) • Cash outflows: – To stockholders as dividends – To redeem long-term debt or reacquire capital stock 10 Operating Activities - ALERT • Some cash flows relating to investing or financing activities are classified as operating activities. For example... – Receipts of investment revenue (interest and dividends) and – Payments of interest to lenders are classified as operating activities because these items are reported in the income statement. 11 Significant Noncash Activities... • That do NOT affect cash are NOT reported in the body of the statement of cash flows. • Are reported: – In a separate schedule at the bottom of the statement of cash flows or – In a separate note or supplementary schedule to the financial statements. 12 Significant Noncash Activities... 1. Issuance of common stock to purchase assets. 2. Conversion of bonds into common stock. 3. Issuance of debt to purchase assets. 4. Exchanges of plant assets. 13 Let’s Review Which is an example of a cash flow from an operating activity? a. Payment of cash to lenders for interest. b. Receipt of cash from the sale of capital stock. c. Payment of cash dividends to the company’s stockholders. d. None of the above. 14 Let’s Review Which is an example of a cash flow from an operating activity? a. Payment of cash to lenders for interest. b. Receipt of cash from the sale of capital stock. c. Payment of cash dividends to the company’s stockholders. d. None of the above. 15 Format of the Statement of Cash Flows Three parts: – operating – investing – financing Plus significant noncash investing and financing activities in separate schedule or at bottom of the statement of cash flows. 16 Format of the Statement of Cash Flows Three activities: – operating – investing – financing Body of Statement PLUS – noncash investing and financing activities 17 The Product Life Cycle • A series of phases all products go through • The phases are often referred to as the: – introductory phase – growth phase – maturity phase – decline phase • The phase a company is in affects its cash flows. 18 Introductory Phase To support asset purchases the company may issue stock or debt. Expect: • cash from operations to be negative. • cash from investing to to be negative. • cash from financing to be positive. 19 Growth Phase The company is striving to expand its production and sales. Expect: • small amounts of cash to be generated from operations. • cash from investing to be negative. • cash from financing to be positive. 20 Maturity Phase Sales and production level-off. Expect: • cash from operations to exceed investing needs. • cash from investing to be neutral. • cash from financing to be negative. 21 Decline Phase Sales and production decline. Expect: • cash from operations to decline. • cash from investing to possibly become positive. • cash from financing to possibly become negative. 22 Impact of Product Life Cycle on Cash Flows 23 Why Report the Causes of Changes in Cash? Because investors, creditors, and other interested parties want to know what is happening to a company’s most liquid asset: CASH 24 Statement of Cash Flows Helps Users Evaluate 1. The entity's ability to generate future cash flows. 2. The entity's ability to pay dividends and meet obligations. 3. The reasons for the difference between net income and net cash provided (used) by operating activities. 4. The investing and financing transactions during the period. 25 Statement of Cash Flows Helps Answer the Following Questions • How did cash increase when there was a net loss for the period? • How were the proceeds of the bond issue used? • How was the expansion in the plant and equipment financed? • Why were dividends not increased? • How was the retirement of debt accomplished? • How much money was borrowed during the year? • Is cash flow greater or less than net income? 26 Sources of Information for the Statement of Cash Flows • Comparative balance sheet • Current income statement • Additional information 27 Comparative Balance Sheet Indicates the amount of changes in assets, liabilities, and stockholders' equities from the beginning to the end of the period. 28 Technology Services Company Comparative Balance Sheet December 31, 2005 Assets Cash Accounts rec. Equipment Total Dec. 31, Jan.1, 2005 2005 $34,000 $0 30,000 0 10,000 0 $74,000 $0 Increase/Decrease $34,000 increase 30,000 increase 10,000 increase Liabilities and stockholders’ equity Accounts payable Common stock Retained earnings Total $4,000 50,000 20,000 $0 0 0 $74,000 $0 $4,000 increase 50,000 increase 20,000 increase 29 Current Income Statement Information in this statement helps the reader determine the amount of cash provided or used by operations during the period. 30 Income Statement and Additional Information Technology Services Company Income Statement For the Year Ended December 31, 2005 Revenues $85,000 Operating expenses 40,000 Income before income taxes 45,000 Income tax expense 10,000 Net income $35,000 Additional Information: (a) Examination of selected data indicates that a dividend of $15,000 was declared and paid during the year. (b) The equipment was purchased at the end of 2005. No depreciation was taken in 2005. 31 3 Major Steps in Preparing the Statement of Cash Flows 32 Indirect and Direct Methods • Convert net income from an accrual basis to a cash basis. • This conversion may be done by two methods: – indirect – direct 33 Indirect and Direct Methods • Both methods arrive at the same total amount for “Net cash provided by operating activities”. • The methods differ in disclosing the items that make up the total amount. • The choice of methods affects only the operating activities section; the investing and financing activities sections are the same. 34 Indirect Method • The indirect method is used extensively in practice. • Most companies favor the indirect method for the following reasons: – it is easier to prepare. – it focuses on the differences between net income and net cash flow from operating activities. – it tends to reveal less company information to competitors. 35 Direct Method • The FASB prefers the direct method but allows the use of either method. • When the direct method is used, the net cash flow from operating activities as computed using the indirect method must also be reported in a separate schedule. 36 Statement Of Cash Flows - Indirect Method • The transactions of Technology Services Company for the year ended 2005 are used to illustrate the preparation of a statement of cash flows . • Technology Services Company started in January 1, 2005, when it issued 50,000 shares of $1 par value common stock for $50,000 cash. • The company rented its office space and furniture and performed consulting services throughout the first year. 37 Determine Net Cash Provided/Used By Operating Activities • Adjust net income for items that did not affect cash. • Net income must be converted because earned revenues may include credit sales that have not been collected in cash and expenses incurred that may not have been paid in cash. 38 Determine Net Cash Provided/Used By Operating Activities Receivables, payables, prepayments, and inventories must be analyzed for their effects on cash. 39 Determine Net Cash Provided/Used By Operating Activities • Technology Services Company had revenues of $85,000 in its first year of operations. • However, TSC collected only $55,000 in cash. Accrual basis revenue was $85,000, cash basis revenue would be $55,000. • The increase in accounts receivable of $30,000 must be deducted from net income. • If accounts receivable decrease, the decrease must be added to net income. 40 Technology Services Company Statement of Cash Flows--Indirect Method (Partial) For the Year Ended December 31, 2005 Cash flows from operating activities Net income $35,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(30,000) 41 Determine Net Cash Provided/Used By Operating Activities • Accounts payable - When accounts payable increase during a year, operating expenses on an accrual basis are higher than they are on a cash basis. • For TSC, operating expenses reported in the income statement were $40,000. • Since Accounts Payable increased $4,000, $36,000 ($40,000 – $4,000) of the expenses were paid in cash. • To convert net income to net cash provided by operating activities, an increase in accounts payable must be added to net income, a decrease subtracted. 42 Technology Services Company Statement of Cash Flows--Indirect Method (Partial) For the Year Ended December 31, 2005 Cash flows from operating activities Net income $35,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(30,000) Increase in accounts payable 4,000 (26,000) Net cash provided by operating activities $ 9,000 43 Determine Net Cash Provided/Used By Investing and Financing Activities • No data are given for the increases in Equipment of $10,000 and Common Stock of $50,000. Assume any differences involve cash. • The increase in equipment is from a purchase of equipment for $10,000 cash. This purchase is reported as a cash outflow in the investing activities section. • The increase of common stock results from the issuance of common stock for $50,000 cash. It is reported as an inflow of cash in the financing activities section of the statement of cash flows. 44 Technology Services Company Comparative Balance Sheet December 31, 2005 Assets Cash Accounts rec. Equipment Total Dec. 31, Jan.1, 2005 2005 $34,000 $0 30,000 0 10,000 0 $74,000 $0 Increase/Decrease $34,000 increase 30,000 increase 10,000 increase Liabilities and stockholders’ equity Accounts payable Common stock Retained earnings $4,000 50,000 20,000 $0 0 0 $4,000 increase 50,000 increase 20,000 increase l 45 Determine Net Cash Provided/Used By Investing and Financing Activities • Reasons for the increase of $20,000 in the Retained Earnings. – Net income increased retained earnings by $35,000. REPORTED IN THE OPERATING ACTIVITIES SECTION. – The additional information indicates that a cash dividend of $15,000 was declared and paid. REPORTED IN THE FINANCING ACTIVITIES SECTION. 46 Technology Services Company Statement of Cash Flows--Indirect Method (Partial) For the Year Ended December 31, 2005 Cash flows from operating activities Net income $35,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(30,000) Increase in accounts payable 4,000 (26,000) Net cash provided by operating activities $ 9,000 Cash flows from investing activities Purchase of equipment (10,000) Cash flows from financing activities Issuance of common stock $50,000 Payment of cash dividends (15,000) Net cash provided by financing activities 35,000 Net increase in cash $34,000 47 Major Classes of Cash Receipts and Payments -Direct Method 48 Formula to Compute Cash Receipts from Customers-Direct Method 49 Formula to Compute Cash Payment to SuppliersDirect Method 50 Formula to Compute Cash Payments for Operating Expenses-Direct Method 51 Technology Services Company Statement of Cash Flows--Direct Method (Partial) For the Year Ended December 31, 2005 Cash flows from operating activities Cash receipts from customers $ 765,000 Cash payments To supplier $550,000 For operating expenses 158,000 For income taxes 48,000 756,000 Net cash provided by operating activities $ 9,000 52 Free Cash Flow • In the Statement of Cash Flows, cash from operations is intended to indicate the cashgenerating capability of the company. • Statement of Cash flows fails to take into account that a company must invest in new fixed assets to maintain its current level of operations and it must maintain dividends at current levels to satisfy investors. 53 Free Cash Flow Cash Provided By Operations – Capital Expenditures – Dividends Paid Free Cash Flow 54 Using Cash Flows to Evaluate a Company The 2001 statement of cash flows of Microsoft Corporation provides information for the computations of these measures. MICROSOFT CORPORATION STATEMENT OF CASH FLOWS (PARTIAL) 2001 Cash flows from operations $13,422 Additions to property, plant, and equipment $ (1,103) Other assets and investments ( 66,346) Short-term investments 58,315 Cash used by investing activities (9,134) Cash paid for dividends on preferred stock (0) 55 MICROSOFT CORPORATION STATEMENT OF CASH FLOWS (Partial) 2001 Cash flows from operations 13,422 Less: Expenditures on property, plant, and equipment 1,103 Dividends 0 Free Cash Flow 12,319 56 Assessing Liquidity, Solvency, and Profitability Using Cash Flows Rather than using numbers from the income statement for assessment purposes, we use numbers from the statement of cash flows. The ratios are cash-based instead of accural-based. 57 Cash-Based Measures • Accrual-based measures allows too much management discretion. • One disadvantage to the cash-based measures is no readily available published industry averages for comparison are available. 58 Liquidity • Liquidity is the ability of a business to meet its immediate obligations. • One measure of liquidity is the current ratio. – A disadvantage of the current ratio is that it uses year-end balances of current assets and current liabilities (may not be representative of a company's position during most of the year.) 59 Current Cash Debt Coverage Ratio Cash Debt Coverage Ratio 60 Current Cash Debt Coverage Ratio • A ratio that partially corrects this is the current cash debt coverage ratio. Cash provided by operations Average current liabilities • Since cash from operations involves the entire year rather than a balance at one point in time, it is often considered a better representation of liquidity on the average day. 61 Solvency • Solvency is the ability of a firm to survive over the long term. – One measure of solvency is the debt to total assets ratio. • A measure of solvency that uses cash figures is the cash debt coverage ratio. Cash Provided By Operations Average Total Liabilities • This ratio measures a company's ability to repay its liabilities from cash generated from operations. 62 Profitability • Profitability refers to a company's ability to generate a reasonable return. • Accrual-based ratios that measure profitability are the gross profit rate, profit rate margin, and return on assets. • A cash-based measure of performance is the cash return on sales ratio. 63 Let’s Review Which is an example of a cash flow from a financing activity? a. Receipt of cash from sale of land. b. Issuance of debt for cash. c. Purchase of equipment for cash. d. None of the above. 64 Let’s Review Which is an example of a cash flow from a financing activity? a. Receipt of cash from sale of land. b. Issuance of debt for cash. c. Purchase of equipment for cash. d. None of the above. 65 Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that named in Section 117 of the United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. 66