McGraw-Hill/IrwinChapter 11

The Statement of Cash FlowsCopyright 2011. The McGraw-Hill Companies. All Rights Reserved.*11-*Statement of Cash FlowsThird required financial statement.Does not affect the way transactions are recorded (i.e., information for statement is derived from data reported in other financial statements).

*11-*Income Statement vs. Statement of Cash FlowsIncome statement.Accrual basis results of entitys operating activities during a period.Revenue recognition, matching of expenses.Statement of Cash Flows.Cash flows associated with an entitys operating, investing, and financing activities during a period.Reconciles changes in cash account on balance sheet (i.e., beginning balance to ending balance).

*11-*Benefits of theStatement of Cash FlowsNumbers on cash flow statement are objective (i.e., cash is cash).Eliminates judgments and estimates involved with accrual accounting as on income statement and balance sheet.Useful information for users dependent upon a healthy cash flow from entity (e.g., employees, suppliers, lenders).But in some instances, balance sheet and income statement may provide better information about financial status and operating performance.

*11-*Statement of Cash Flows:Categories of ActivitiesSources.Activities that generate cash.Uses.Activities that involve spending cash.*11-*Cash SourcesOperations.New borrowings.New stock issues.Sale of property, plant, and equipment.Sale of other non-current assets.

*11-*Cash UsesCash dividends.Repayment of borrowings.Repurchase of stock.Purchase of property, plant, and equipment.Purchase of non-current assets.

*11-*Definition of CashCash.Cash equivalents.Short-term investments.Highly liquid.Convertible to known amounts of cash.Mature in no more than 90 days (GAAP).Subject to insignificant risk of changes in value (IASB).

*11-*Organization of theStatement of Cash FlowsOperating activitiesInvesting activities.Financing activities.*11-*Operating ActivitiesAll transactions that are not investing or financing activity.Cash inflows associated with sales revenues.Cash outflows associated with operating activities (e.g., payments to suppliers, employees, taxes, interest on loans).

*11-*Investing ActivitiesOutflows:Acquiring long-lived assets (e.g., property, plant, equipment).Making investments in securities (i.e., other than cash equivalents).Lending money.*11-*Investing ActivitiesInflows:Disposing of long-lived assets (e.g., property, plant, equipment).Disposing of investments in securities (i.e., other than cash equivalents).Collecting loans.*Financing ActivitiesInflows:Borrowing of cash.Issuance of equity securities.Outflows:Repaying loans.Retiring equity securities.Payment of dividends.

11-**11-*Interest and DividendsFASB.Interest received or paid: operating activity.Dividends received: operating activity.Dividends paid: financing activity.IASB.Can be classified in any activity category as long as done in a consistent manner.

*11-*Significant Noncash TransactionsSignificant investing and financing activities that did not involve cash.E.g., conversion of a convertible bond into stock, purchase of a building with a notes payable.Not reported in body of statement of cash flows; narrative statement or supplemental disclosure.*11-*Operating Activities:Approaches to PresentationDirect method.Inflows (i.e. cash provided by operating activities).Outflows (i.e. cash disbursed for operating activities).Net cash flow (i.e. inflows - outflows).Encouraged by FASB.Indirect method.Reconciliation of periods net income and the periods net cash flow from operations.More difficult to understand.Note: Cash flow from operating activities will be the same under either method.*11-*Supplemental DisclosureIf direct method is used, FASB requires supplemental disclosure of reconciliation between net income and operating cash flows.In effect, if direct method is used, indirect method is also required.

*11-*Operating Activities Cash FlowCollections from customers.Sales (End AR Beg AR).Payments to suppliers.Cost of goods sold + (End Inventory Beg Inventory) (End AP Beg AP).Interest paid.Interest expense (End Int. Pay Beg Int. Pay).*11-*Indirect Method ofPresenting Operating ActivitiesStart with net income.Adjust for noncash items included in net income (i.e., adjustment of accrual based earnings).Depreciation and amortization (add back). Difference between sales and cash collected (i.e., the change in accounts receivable).Differences between expenses and cash payments (i.e., Changes in accounts payable, inventory, prepaid expenses).*11-*Indirect Method ofPresenting Operating ActivitiesAdditions to net income.Depreciation expense.Decreases in:Accounts receivable.Inventories.Prepaid Expenses. Increases in:Accounts payable.Wages payable.Interest payable.Taxes payable.Deferred taxes.Loss on disposal.*11-*Indirect Method ofPresenting Operating ActivitiesSubtractions from net income.Increases in:Accounts receivable.Inventories.Prepaid Expenses. Decreases in:Accounts payable.Wages payable.Interest payable.Taxes payable.Deferred taxes.Gain on disposal.*11-*Indirect Method ofPresenting Operating ActivitiesDepreciation.Cash paid for property, plant, or equipment is a cash outflow.Allocation of this amount to expense (via depreciation) is not a cash flow.Therefore, must be subtracted out (added back) in operating activities section.Gains and losses.Cash proceeds from the sale of property, plant, or equipment is a cash inflow.Recorded gain (loss) is not the cash flow.Therefore, must be subtracted out (added back) in operating activities section.*11-*Summary ofCash Flow Statement Cash flow from operating activities+ Cash flow from investing activities+ Cash flow from financing activities= Increase (decrease) in cash and cash equivalents+ Cash and cash equivalents at beginning of year= Cash and cash equivalents at end of year*11-*Cash Flow RatiosCash realization ratio (i.e., quality of earnings).Cash generated by operations Net income.Coverage ratios.Use cash flow as numerator in Chapter 8 coverage ratios (i.e., times interest earned, fixed charges coverage).Source and use percentages.Reorganize data into sources and uses format; then show each item as percent of total sources.Ratio of cash generated by operations to total debt.*11-*Cash Flow ProjectionsFree Cash Flow.Cash from operations less:Fixed asset replacements necessary to maintain existing capacity.Scheduled debt repayments.Normal dividend payments.*11-*Cash Flow ProjectionsProjected cash flow statement.Useful to project amount, timing, and character of new financing.For management: anticipate future cash needs.For potential lenders: indicate ability to repay debt.Cash budget.Useful for shorter-term financial planning (e.g., seasonal needs, when excess cash is available to invest in short-term securities).*