Statement of Cash
Flows
Chapter 5
Objectives of the Statement
of Cash Flows
• The statement of cash flows provides
information about a firm's inflows and
outflows of cash during a period of
time.
– It states where a firm's money comes
from and how it is used.
Objectives of the Statement
of Cash Flows
• The statement of cash flows provides
information about a firm's inflows and
outflows of cash during a period of
time.
– This information is not that easy to find
by simply studying the other three
financial statements.
Objectives of the Statement
of Cash Flows
• The statement also explains the
change in the Cash account from the
beginning to the end of the period.
Objectives of the Statement
of Cash Flows
• SFAS No. 95 requires a business to
prepare a statement of cash flows.
The statement helps readers
assess the following:
• A firm's ability to generate positive
future net cash flows.
• A firm's ability to meet its obligations,
its ability to pay dividends, and its
needs for external financing.
The statement helps readers
assess the following:
• The reasons for differences between
net income and associated cash
receipts and payments.
The statement helps readers
assess the following:
• The effects on a firm's financial
position of both its cash and noncash
investing and financing transactions.
Statement of Cash Flows
Cash flows from operating activities:
Cash received from customers
Interest received
Payments to employees
Payments to suppliers
Interest paid
Taxes paid
Net cash provided from operating activities
Cash flows from investing activities
Purchase of equipment
Purchase of equipment and shares
Net cash used in investing activities
$ 68,200
1,300
(17,100)
(40,500)
(800)
(2,000)
$ 9,100
(3,500)
(12,000)
(15,500)
Statement of Cash Flows
(continued)
Cash flows from financing activities
Proceeds from issuing long term debt
Proceeds from issuing common stock
Payment of short-term debt
Net cash provided by financing activities
Net increase in cash
Cash at the beginning of the year
Cash at the end of the year
25,000
5,000
(12,000)
18,000
11,600
22,000
$ 33,600
The Nature of Accrual
Earnings and Cash Flows
• Accrual earnings do not necessarily
reflect cash flows.
– For example, depreciation expense
reduces accrual net income but is not
related at all to cash flow.
The Nature of Accrual
Earnings and Cash Flows
• Earnings and cash flows should be
viewed as complements, not
substitutes—each has information not
necessarily contained in the other.
The Nature of Accrual
Earnings and Cash Flows
• The statement provides information
about a firm's liquidity and financial
flexibility.
The Nature of Accrual
Earnings and Cash Flows
• It helps gauge the ability to respond to
unexpected events by altering the
amounts and timing of its cash flows.
Cash and Cash Equivalents
• A firm must decide whether to focus
the statement on cash or on cash and
cash equivalents.
– Cash equivalents are short-term, highly
liquid financial instruments with
maturities of less than months.
– They include money market funds,
treasury bills, and certificates of deposit
(CDs).
Types of Activities That
Generate and Use Cash
• Operating Activities
• Investing Activities
• Financing Activities
Operating Activities
• Operating activities involve
transactions related to providing
goods and services to customers.
– They show the cash flow effects of the
typical transactions which appear on the
income statement.
– Examples include receipt of payment
from customers and payments to
employees and suppliers.
Investing Activities
• Investing activities usually involve
cash flows from the acquisition and
disposal of noncurrent assets.
– Examples include the purchase or sale of
property, plant, and equipment and the
purchase or sale of investments in other
corporations.
Financing Activities
• Financing activities include cash flows
from obtaining and repaying
financing.
– This includes transactions involving longterm liabilities and shareholders' equity.
– Examples include payment of dividends
and buying back shares from
shareholders.
Types of Activities That
Generate and Use Cash
Operating Activities
Cash Inflows
Cash Outflows
From customers
To employees
From interest
To suppliers
From dividends
For interest
All other cash inflows
All other cash outflows
not defined as an
not defined as an
investing or financing
investing or financing
activity
activity
Types of Activities That
Generate and Use Cash
Investing Activities
Cash Inflows
Cash Outflows
Sale of property, plant
Purchase of property,
and equipment
plant and equipment
Collection of loans
Making of loans
Sale of investments
Acquisition of
investments
Types of Activities That
Generate and Use Cash
Financing Activities
Cash Inflows
Cash Outflows
Obtaining loans
Repaying loans
Issuing common stock Paying dividends
Reacquiring commons
stock
Methods of Presenting a
Statement of Cash Flows
• Direct Versus Indirect Approach
– SFAS No. 95 allows the use of the direct
or the indirect methods for preparation of
the operating activities section of the
statement of cash flows.
Direct Versus Indirect
Approach
• Under the direct method, a separate
line item is provided for each type of
operating cash inflow and outflow.
– These line items correspond to categories
on the income statement.
– A major advantage of this method is that
the primary sources and uses of cash are
listed.
Direct Versus Indirect
Approach
• The indirect method begins with
accrual-basis net income and makes
adjustments to it in order to arrive at
cash generated by operating activities.
Direct Versus Indirect
Approach
• A major advantage of the indirect
method is that the reasons for the
difference between net income and
cash generated by operations are
detailed.
Direct Versus Indirect
Approach
• While the FASB prefers the direct
method, businesses use the indirect
method more frequently.
Direct Versus Indirect
Approach
• The indirect approach is similar to the
approach used for preparation of the
statement required before the issuance
of SFAS No. 95.
Direct Versus Indirect
Approach
• A firm using the direct approach must
provide a schedule that reconciles net
income with cash provided by
operating activities.
Direct Versus Indirect
Approach
• This schedule consists of the
information contained in the indirect
approach.
Statement of Cash Flows
Indirect Approach
Cash flows from operating activities:
Net income
Adjustments to net income
Depreciation expense
Increase in accounts receivable
Decrease in accounts receivable
Decrease in salaries payable
Increase in interest payable
Net cash provided from operating activities
$ 5,300
2,000
(500)
3,000
(100)
200
$ 9,100
Statement of Cash Flows
Indirect Approach
Cash flows from investing activities:
Purchase of equipment
Purchase of IBM stock
Net cash used in investing activities
Cash flows from financing activities
Proceeds from issuing long-term debt
Proceeds from issuing common stock
Payment of short-term debt
Net cash provided by financing
activities
Net increase in cash
Cash at beginning of year
Cash at end of year
$ (3,500)
(12,000)
(15,500)
25,000
5,000
(12,000)
18,000
11,600
22,000
$ 33,600
Noncash Investing and
Financing Activities
• Noncash investing and financing
activities do not appear in the body of
the statement.
– They are summarized in a schedule that
appears at the end of the statement.
– Examples include the purchase of land by
issuing common stock or the purchase of
equipment by issuing a note payable.
Using Cash Flow
Information
• Creditors, shareholders, and analysts
find the statement's operating
activities section to be very useful.
Using Cash Flow
Information
• Many analysts prefer operating
activities to net income as a
performance measure because net
income can be manipulated by
accounting conventions.
Using Cash Flow
Information
• A variety of ratios can be computed
using the operating activities section.
Cash Return on Assets
• Cash return on assets is calculated by
dividing average total assets into the
sum of cash flow from operating
activities (CFOA), interest paid, and
taxes paid.
CFOA + Interest paid
Cash return on assets =
Average total assets
Cash Return on Assets
• This ratio measures management's
success in generating cash from
operating activities, and a high ratio is
desirable.
Cash Return on Assets
• Some analysts use free cash flow
instead of CFOA.
Cash Return on Assets
• Free cash flow is calculated by
subtracting from CFOA the cash
payment necessary to replace wornout equipment.
The Quality of Sales Ratio
• The quality of sales ratio is computed
by dividing sales into cash received
from customers.
Cash received from customers
Quality of sales =
Sales
The Quality of Sales Ratio
• Cash received from customers can be
computed by adding the beginning
balance of accounts receivable and
sales and then subtracting the ending
balance of accounts receivable.
The Quality of Sales Ratio
• This ratio is useful in analyzing firms
that use liberal revenue recognition
policies or firms which must exercise
considerable judgment in selecting
revenue recognition policies.
The Quality of Sales Ratio
• This ratio can reflect a firm's
performance in collecting from
customers.
The Quality of Sales Ratio
• A high ratio is desirable.
The Quality of Income Ratio
• The quality of income ratio is
computed by dividing net income into
CFOA.
CFOA
Quality of income =
Net income
The Quality of Income Ratio
• This ratio indicates the proportion of
income which has been realized in
cash, and high levels of the ratio are
desirable.
The Quality of Income Ratio
• The ratio often exceeds 100%.
The Cash Interest Coverage
Ratio
• The cash interest coverage ratio is
computed by adding CFOA and
interest and tax payments and then
dividing the total by interest
payments.
CFOA+ Interest paid + Taxes paid
Cash interest coverage =
Interest paid
The Cash Interest Coverage
Ratio
• It is used by creditors to assess a firm's
ability to pay interest.
The Cash Interest Coverage
Ratio
• As is true with the three ratios
discussed above, a high ratio is
desirable.
Investing and Financing
Activities
• The investing activities section of the
statement of cash flows summarizes
the cash in- and outflows from
disposing and purchasing of
investments.
Investing and Financing
Activities
• These sections are scrutinized less
closely by financial statement users.
Preparing a Statement
of Cash Flows
Appendix 5
Preparing a Statement of
Cash Flows
• Cash flows are inferred from items on
the balance sheet and income
statement.
Collections from Customers
• Equals beginning Accounts Receivable
+ Sales – ending Accounts Receivable
Interest Received
• Equals beginning Interest Receivable +
Interest Revenue – ending Interest
Receivable
Payments to Employees
• Equals beginning Salaries Payable +
Salary Expense – ending Salaries
Payable
Interest Paid
• Equals beginning interest payable +
interest expense – ending interest
payable
Payments to Suppliers
• First solve for cost of goods sold.
COGS = Beginning inventory + Purchases
– Ending inventory
• Then rearrange the equation to solve
for purchases.
Purchases = COGS – Beginning inventory
+ Ending inventory
Payments to Suppliers
• Then solve for Payments to Suppliers
Payments to Suppliers = Beginning
accounts payable + Purchases – Ending
accounts payable
General Guide
• Depreciation expense is not
considered when using the direct
method.
• Do not consider gains and losses
associated with nonoperating
activities.
General Guide
• Adjust remaining income statement
items by the changes in related
balance sheet accounts.
Indirect Approach
• When using the indirect approach,
accrual-basis net income is converted
to cash flows from operating activities.
Indirect Approach
• Expense items, such as depreciation,
which have reduced net income must
be added back because they do not
involve cash flow.
Indirect Approach
• Other items, such as Accounts
Receivable, must be addressed.
Indirect Approach
• If Accounts Receivable has increased
during the period, then the increase
must be deducted from accrual-basis
net income because this indicates that
credit sales, which do not involve cash
flow, have increased the net income
number.
Indirect Approach
• The opposite will be true if Accounts
Receivable has decreased during the
period.
Indirect Approach
• The investing and financing activities
sections will be exactly the same
under both the direct and the indirect
methods.
Statement of Cash
Flows
End of Chapter 5