Chapter 3
Income Flows
versus Cash Flows:
Understanding the
Statement of Cash
Flows
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Statement of Cash Flow
 Provides Key Insights into
 The three sections logically corresponding to
the primary pursuits to generate profits.
 The cash flows to and from the entities with
which the business conducts business.
 Can be combined with other financial
statements to assess the overall quality of
overall financial statements.
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Statement of Cash Flows (Contd.)
 SFAS 95, FASB Codification Topic 230
 Cash equivalents include highly liquid
investments, very short-term treasury bills,
commercial paper, and money market funds.
 Reporting:


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Interest paid and dividends paid - Operating or
Financing activities.
Interest received and dividends received - Operating
or Investing activities.
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Statement of Cash Flows (Contd.)
 IAS 7
 Cash equivalents include those under
U.S.GAAP and bank overdrafts
 Reporting


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Interest paid/received and dividends received Operating activities.
Dividends paid - Financing activity.
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Income Flows vs. Cash Flows
 Why cash flows do not equal income
flows?
 Accrual accounting used for net income
 Noncash expenses
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Cash Flows from Operations
 Direct Method
 Indirect Method
 2 types of adjustments:
 Non-working capital accounts
 Adjustments for changes in working capital accounts
 Working Capital = Current Assets minus Current Liabilities
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Non-Working Capital Accounts
 Examples
 Depreciation and amortization
 Deferred income taxes
 Employee stock option expense
 Gain/loss on disposition of asset
 Pension cost
 Impairment charges
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Working Capital Accounts
 Examples
 Accounts receivable
 Inventories
 Prepaid expenses
 Accounts payable
 Income taxes payable
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Net Income relative to Cash Flows from
Operations
 Type 1 adjustments
 Usually increase cash flows over net income
 Type 2 adjustments’ effects depend on:
 Firm’s stage in life cycle
 Length of firm’s operating cycle
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Simplified Schematic of the computation of Accruals from the
Operating Section of the Statement of Cash Flows
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Net Income relative to Cash Flows
Relation among PepsiCo's Net Income, Cash Flows from Operations, Cash Flows from Investing
Activities, and Cash Flows from Financing Activities
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Product Life Cycle
 Introduction
 Revenues are low
 Net income may be negative
 Negative CF from operating activities
 Negative CF from investing activities
 External financing (Positive CF from financing)
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Product Life Cycle (Contd.)
 Growth
 Increasing revenues.
 Net income becomes positive.
 Increasing cash flows from operations.
 Continuing negative cash flows from investing
activities.
 Decreasing positive cash flows from financing
activities.
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Product Life Cycle (Contd.)
 Maturity
 Peak revenues.
 Peak net income.
 Positive cash flows from operations.
 Cash flows from investing activities may begin
to increase.
 Cash flows from financing activities may
become negative (repayment of debt, stock
repurchases, etc.).
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Product Life Cycle (Contd.)
 Decline
 Revenues decrease.
 Net income decreases (may become
negative).
 Cash flows from operations decreases.
 Cash flows from investing activities positive
(as firm divests).
 Cash flows from financing activities negative.
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The Relation between Cash Balances and
Net Cash Flows
 Net cash flows equal the (net) sum of cash
flows provided by or used for operating,
investing, and financing activities.
 Ending Cash Balance = Beginning Cash +
Cash Receipts – Cash Expenditures
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Preparing a Statement of Cash Flows
 May be necessary for firms outside U.S.
 Estimates made should approximate actual
values.
Change in
 Non-cash assets
 Liabilities
Cash flow
 Shareholders’ equity
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Preparing a Statement of Cash Flows
(Contd.)
 Accounting equation
 Δ Cash = Δ Liabilities + Δ Shareholders’ Equity
- Δ Non-Cash Assets
 In general:



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Changes in current assets and current liabilities
affect Operating Activities.
Changes in Fixed Assets and other noncurrent
assets affect Investing Activities.
Changes in Long-term liabilities and Stockholders’
Equity accounts (except net income) affect
Financing Activities.
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Preparing a Statement of Cash Flows
(Contd.)
 Notable Exceptions
 Marketable securities
 These are considered to be Investing Activities,
regardless of short-term nature.
 Notes payable
 If payable to banks, are considered financing
activities, even if very short-term.
 Current portion of long-term debt
 Financing
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Statement of Cash Flows Assess Earnings
Quality
 Gauge whether reported net income
reflects the underlying economics of the
business.
 Highlights accounting accruals, which can
provide insight into the overall
sustainability and quality of a firm’s
reported earnings.
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Statement of Cash Flows to Assess
Earnings Quality (Contd.)
Patterns of Earnings Surrounding High and Low Accruals
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