Chapter 16 Lecture and Notes

Explain the Purpose of the Statement of Cash Flows

One purpose of the statement of cash flows is to answer the following two questions:

• What are the sources of cash (where does the cash come from)?
• What are the uses of cash (where does the cash go)?

The statement of cash flows shows the amount of cash inflows and outflows during a year.

The statement of cash flows provides information about the quality of a company’s net income.

• A company that shows significantly less cash inflow on the statement of cash flows than the reported net income on the income statement could very well be reporting revenue for which cash will never be received from the customer or underreporting expenses.

A third use of the statement of cash flows is that it provides information about a company’s sources and uses of cash not related to the income statement.

Methods of Generating the Statement of Cash Flows

Two methods:

• The indirect method approach reconciles net income to cash flows by subtracting noncash expenses and adjusting for changes in current assets and liabilities, which reflects timing differences between accrual-based net income and cash flows. A noncash expense is an expense that reduces net income but is not associated with a cash flow; the most common example is depreciation expense.
• The direct method lists net cash flows from revenue and expenses; in other words, accrual basis revenue and expenses are converted to cash basis collections and payments.

Differentiate between Operating, Investing, and Financing Activities

The statement of cash flows presents sources and uses of cash in three distinct categories:

• The same net cash flow will be derived from both the indirect and the direct method. The investing and financing activities will be identical under the two methods. Only the presentation of the operating activities will differ.
• These categories help users assess a company’s strategy and ability to generate a profit and stay in business by assessing how much a company relies on operating, investing, and financing activities to produce its cash flows.

Significant Noncash Activities

 Companies report noncash activities in either a separate schedule (bottom of the statement) or separate note to the financial statements

1. 1. Direct 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.

Prepare the Statement of Cash Flows Using the Indirect Method

Companies favor the indirect method for two reasons:

1. 1. Easier and less costly to prepare.
   2. Focuses on differences between net income and net cash flow from operating activities.

There are five steps:

• Step 1: Determine Net Cash Flows from Operating Activities
• Step 2: Determine Net Cash Flows from Investing Activities
• Step 3: Present Net Cash Flows from Financing Activities
• Step 4: Reconcile Total Net Cash Flows to Change in Cash Balance during the Period
• Step 5: Present Noncash Investing and Financing Transactions

Step 1: Operating Activities

Begin with net income from the income statement.

• Add back on non-cash expenses
• Deduct gains and add losses
• Add decreases in current assets
• Deduct increases in current assets
• Add increases in current liabilities
• Deduct decreases in current liabilities

Step 2: Investing Activities

Step 3: Financing Activities

Steps 4 and 5: Completing the Cash Flow Statement

Alternate Process to Prepare the Statement of Cash Flows Using the Indirect Method

Three sources of information:

1. 1. Comparative balance sheets
   2. Current income statement
   3. Additional information

Three Major Steps

1.    Determine net cash provided/used by operating activities by converting net income from accrual basis to cash basis.

• • • • Add back non-cash expenses (depreciation, amortization, or depletion expense).
      • Deduct gains and add losses.
      • Analyze changes in noncash current asset and current liability accounts.

2.    Analyze changes in noncurrent assets and liability accounts and record as investing and financing activities or disclose as noncash transactions.
3.    Compare the net change in cash account reported on the statement of cash flows with the change in the cash account reported on the balance sheet to make sure the amounts agree.

Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency

Cash flow ratio analysis allows financial statement users to see the company’s liquidity position from a clearer perspective.

The following ratios will be evaluated for Propensity Company:

• Free cash flow
• Cash flows to sales
• Cash flows to assets

Free cash flow: measure of cash remaining after the company pays for capital expenditures, operating expenses, and dividends

• The absence of free cash flow is an indicator of severe liquidity concern for Propensity Company and could be an early indicator that the company may not be able to continue operations.
• This could also be a one-time occurrence, in a year where a large capital investment was planned, to be financed with resources from the company’s capital reserves from previous years’ profits. In such a case, the negative free cash flow would not be an issue of concern.

Cash flows to sales: how much sales are contributing to free cash flow

Free Cash Flow ÷ Sales Revenue

• Since free cash flow for Prosperity Company was negative, this ratio cannot be calculated.

Cash flows to assets: how well assets are being utilized to generate free cash flow

Free Cash Flow ÷ Total Assets

• Since free cash flow for Prosperity Company was negative, this ratio cannot be calculated.

Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method

1. Compute net cash provided by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis.
2. Companies report only major classes of operating cash receipts and cash payments.
3. For these major classes, the difference between cash receipts  and cash payments is the net cash provided by operating activities.

• The statement of cash flows presents the sources and uses of cash.
• There are two approaches utilized to prepare the statement of cash flow: the indirect method and the direct method.
• Transactions must be segregated into the three types of activities presented on the statement of cash flows: operating, investing, and financing.
• Operating cash flows arise from the normal operations of producing income, such as cash receipts from revenue and cash disbursements to pay for expenses.
• Investing cash flows arise from a company investing in or disposing of long-term assets.
• Financing cash flows arise from a company raising funds through debt or equity and repaying debt.
• Company activities that reflect changes in long-term assets, long-term liabilities, or equity, but have no cash impact, require special reporting treatment, as noncash investing and financing transactions.
• Three cash flow rations to helps assess liquidity are free cash flow, cash flow to assets ratio, and cash flow to sales ratio.
• The direct method of preparing the statement of cash flows is identical to the indirect method except for the cash flows from the operating and financing sections.
• To complete the cash flows from operating activities, the direct method directly shows the cash collected from customers from revenue activities and the cash spent on operations, rather than reconciling net income to cash flows from operating activities as done using the indirect method.