Chapter 11:
The Statement of Cash Flows
Financial and Managerial Accounting:
The Cornerstones of Business Decisions, 2e
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1
The Role of
the Statement of Cash Flows
► Information in a statement of cash flows helps investors,
creditors, and others in the following ways:
►Assessing a company’s ability to produce future net cash
inflows;
►Judging a company’s ability to meet its obligations and pay
dividends;
►Estimating the company’s needs for external financing;
►Understanding the reasons for the differences between
net income and related cash receipts and cash payments;
and
►Evaluating the balance sheet effects of both cash and
noncash investing and financing transactions.
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2
Cash Flow Classifications
► Because our focus is on cash flows, it is important to have a clear
understanding of what is included in the term cash.
► For purposes of the statement of cash flows, cash includes both funds
on hand (coins and currency) and cash equivalents.
► Cash equivalents are short-term, highly liquid investments that are
readily convertible to cash and have original maturities of three
months or less.
► Examples: Money market funds, investments in U.S. government
securities (treasury bills)
► Because of their high liquidity or nearness to cash, cash
equivalents are treated as cash in the statement of cash flows.
► During an accounting period, a company engages in the three
fundamental business activities—operating activities, investing
activities, and financing activities. Each of these activities can
contribute to (a cash inflow) or reduce (a cash outflow) a company’s
cash balance.
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2
How the Statement of Cash Flows
Links the Two Balance Sheets
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2
Summary of the
Classification of Cash Flows
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2
Format of
the Statement of Cash Flows
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3
Analyzing the Accounts
for Cash Flow Data
► Unlike the balance sheet and the income statement, the
statement of cash flows cannot be prepared by simply using
information obtained from an adjusted trial balance prepared
using the accrual basis of accounting.
► The accrual-basis numbers in the balance sheet and the
income statement must be adjusted to a cash basis to
understand why cash changed.
► Using the fundamental accounting equation, these changes
can be summarized as:
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3
Cash Flow Classifications and
Changes in the Balance Sheet Accounts
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3
Preparing a
Statement of Cash Flows
►To prepare a statement of cash flows, you need:
►Comparative balance sheets: Used to determine the changes
in assets, liabilities, and stockholders’ equity during a period
►Current income statement: Used to determine cash flows
from operating activities
►Additional information about selected accounts: Used to
determine the reason why cash was received or paid
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3
Preparing a
Statement of Cash Flows (Continued)
►Five basic steps are required to prepare the
statement of cash flows.
►Step 1: Compute the net cash flow from operating
activities.
►Step 2: Compute the net cash flow from investing activities.
►Step 3: Compute the net cash flow from financing activities.
►Step 4: Combine the net cash flows from operating,
investing, and financing activities to obtain the net increase
(decrease) in cash for the period.
►Step 5: Compute the change in cash for the period and
compare this with the change in cash from Step 4.
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4
Preparing Cash Flows
from Operating Activities
► The cash flows from operating activities section of the statement of cash
flows may be prepared using either of two methods: the direct method or
the indirect method.
► In the direct method, cash inflows and cash outflows are listed for each
type of operating activity that a company performs.
► These cash flows are generally computed by adjusting each item on the
income statement by the changes in the related current asset or liability
accounts.
► The indirect method does not report individual cash inflows and outflows.
► Instead, it focuses on the differences between net income and operating cash
flow. The indirect method begins with net income and then adjusts it for
noncash items to produce net cash flow from operating activities.
► Adjustments to net income are necessary for two reasons under the
indirect method:
► to eliminate income statement items that do not affect cash (such as
depreciation and gains/losses on sales of assets) and
► to adjust accrual-basis revenues and expenses to cash receipts and cash
payments.
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4
Preparing the Statement of Cash Flows
Using The Indirect Method
► Under the indirect method, four types of adjustments must
be made to net income to adjust it to net cash flow from
operating activities:
►Add to net income any noncash expenses and subtract from
net income any noncash revenues.
►Add to net income any losses and subtract from net income
any gains.
►Add to net income any decreases in current assets or
increases in current liabilities that are related to operating
activities.
►Subtract from net income any increases in current assets and
decreases in current liabilities that are related to operating
activities.
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4
Summary of Adjustments Required to
Calculate Cash Flow from Operating
Activities under the Indirect Method
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5
Preparing and Analyzing
Cash Flows from Investing Activities
► The second major section of the statement of cash flows reports the net
cash flow from investing activities.
► Information for preparing the investing activities portion of the statement
of cash flows is obtained from the investment and long-term asset
accounts.
► To analyze investing activities, use the three basic steps shown below:
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6
Preparing Cash Flows
from Financing Activities
► The intent of the financing activities section of the statement
of cash flows is to identify inflows and outflows of cash arising
from business activities that either produced capital (longterm debt or stockholders’ equity) for the company or repaid
capital supplied to the company.
► Three basic steps are used to analyze financing activities:
► Step 1: Recreate the journal entries to describe the activities that took
place during the period.
► Step 2: Record the cash flows as inflows or outflows of cash in the
financing activities section of the statement of cash flows.
► Step 3: Analyze the account to make sure the account activity has
been completely explained.
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7
Using the Statement of Cash Flows
►Effective analysis of the statement of cash flows
requires the following:
►an examination of the statement of cash flows itself,
► a comparison of the information on the current statement
of cash flows with earlier statements, and
► a comparison of the information in the current statement
of cash flows with information from other companies’
statements of cash flow.
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7
Comparing the Statement of
Cash Flows from Several Periods
►An analysis of the statement of cash flows also requires a
comparison of the company’s current statement of cash
flows with earlier statements of cash flow.
►Typically, several consecutive years should be analyzed in
order to determine trends in cash inflows and cash
outflows.
►Financial statement users rely on summary cash flow
measures to help them make assessments.
►Free cash flow
►Cash flow adequacy
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7
Free Cash Flows
►A company’s free cash flow represents the cash flow
that a company is able to generate after considering
the maintenance or expansion of its assets (capital
expenditures) and the payment of dividends.
►Free cash flow allows a company to pursue profitgenerating opportunities.
►However, negative free cash flow is not necessarily a
bad thing, but may indicate large investments in
productive assets, which is good for a long-run
strategy.
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7
Cash Flow Adequacy Ratio
►A second useful measure is the cash flow adequacy
ratio.
►The cash flow adequacy ratio provides a measure of the
company’s ability to meet its maturing debt obligations
and is calculated as:
►The cash flow adequacy ratio is also an indicator of
whether the company has the capacity to borrow
additional debt.
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7
Comparing the Statement of Cash
Flows to Similar Companies
► Finally, the analysis of the statement of cash flows requires
comparisons with similar companies.
► Such comparisons provide good reference points because
similar companies generally secure cash from similar sources
and are likely to spend cash for similar activities.
► Comparative analysis can reveal significant deviations in
► the amounts of cash inflows,
► the source of those inflows, and
► the types of activities to which cash is applied.
► When significant differences are found among similar
companies, explanations should be searched for in the other
financial statements, notes accompanying the statements, or
from management.
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8
Appendix 11A:
The Direct Method
►In the direct method of computing net cash flow
from operating activities, inflows and outflows of
cash are listed for each type of operating activity
that a company performs.
►This involves adjusting each item on the income
statement by the changes in the related current
asset or liability accounts.
►Typical operating cash flows and adjustments
necessary to compute them follow.
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9
Appendix 11B: Using a Spreadsheet to Prepare
The Statement of Cash Flows
►To construct the spreadsheet, follow three steps:
►Step 1: Construct five columns.
►Column 1: Insert balance sheet account titles. Immediately
beneath the balance sheet accounts, set up the three sections of
the statement of cash flows.
►Column 2: Insert the beginning balances of the balance sheet
accounts (enter the amounts at this time).
►Column 3: Insert the debit adjustments
►Column 4: Insert credit adjustments
►Column 5: Insert the ending balances of the balance sheet
accounts (enter the amounts at this time).
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Appendix 11B: Using a Spreadsheet to Prepare
9
The Statement of Cash Flows (continued)
►Step 2: Analyze each change in the balance sheet accounts
in terms of debits and credits.
►Enter the effects in the adjustments column.
►Note that each entry will adjust both the balance sheet account
being considered and either a statement of cash flows section of
the spreadsheet or another balance sheet account (other than
cash).
►Note that all inflows of cash are recorded as debits and all
outflows of cash are recorded as credits.
►Step 3: Prepare the statement of cash flows from the
information contained in the statement of cash flows
section of the spreadsheet.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.