Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

UNDERSTANDING FINANCIAL STATEMENTS

STATEMENT OF CASH FLOWS

Chapter 4

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

The Cash Flow Statement

• Required by SFAS #95

• Replaced the Statement of Changes in Financial Position in 1988

• One of the required MAJOR statements

• Can be developed from Balance Sheet and Income Statement data

• Provides very RELEVANT information!

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Why is it important???

“A positive net income on the income statement is ultimately insignificant unless a company can translate its earnings into cash, and the only source in financial statement data for learning about the generation of cash from operations is the statement of cash flows”

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Segregation of Cash Flows• From OPERATING ACTIVITIES

• From INVESTING ACTIVITIES

• From FINANCING ACTIVITIES

• Which do you think is most important in assessing the firm’s prospects? Why?

• Defining these activities may help answer the question...

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Operating Activities include:

• Delivering or producing goods for sale and providing services

• The cash effects of transactions and other events that enter into the determination of income

• Examples: cash flows resulting from sales of goods, purchase of inventories, payment of operating expenses

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Investing Activities include

• Acquiring/disposing of securities that are not cash equivalents

• Acquiring/disposing of productive assets

• Lending money/collecting on loans

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Financing Activities include

• Borrowing from creditors/repaying the principal

• Obtaining resources from owners

• Providing owners with a return on investment

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Which is the most important?

• All sources and uses of cash represent important information

• But, only cash flows from operating activities represent cash generated internally

• In order to SURVIVE, a firm needs to generate positive cash flows internally, i.e. from “what it does for a living”...

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Basics of Preparing Statement

• Look at changes in balance sheet accounts from beginning to end of accounting period

• Classify changes in all accounts except cash as resulting from (1) operating, (2) investing or (3) financing activity(ies)

• The summary of all these changes EXPLAINS the change in cash!

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Preparing Operating Section

• Some folks like the DIRECT approach

• Others like the INDIRECT approach

• Both methods provide the information necessary for financial analysis

• Either method is acceptable but FASB prefers DIRECT approach

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

The Direct Method• Shows cash collections from customers,

interest and dividends collected, other operating cash receipts, cash paid to suppliers and employees, interest paid, taxes paid and other operating cash payments

• Translates each item on the accrual-based income statement to a cash revenue or expense item

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

The Indirect Method

• Starts with net income (accrual-based) and adjusts for deferrals, accruals, noncash items such as depreciation and amortization and nonoperating items such as gains and losses on asset sales

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Direct vs. Indirect• Keep in mind -- either method will get you

to the same place, i.e. operating cash flows will not look “better” using one method as opposed to the other -- it’s a matter of format

• Regardless of the method chosen to present operating cash flows, the rest of the Statement of Cash Flows looks the same…

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Preparing Other Sections

• Investing and Financing sections are pretty straight-forward -- the method chosen (direct or indirect) to present the Operations section does not affect the presentation of this information

• Focus primarily on changes in non-current assets and liabilities

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Analysis of the Statement of Cash Flows Indicates:

• Firm’s ability to generate cash flows in the future

• Firm’s capacity to meet cash obligations• Firm’s future external financing needs• Firm’s success in productively managing

investing activities• Firm’s effectiveness in implementing

financing and investing strategies

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

What does it all mean?

• BIG DIFFERENCE between overall increase or decrease in cash and increase or decrease in cash from operating activities

• Overall decrease in cash may be a positive sign

• Net cash outflow from operating activities is NOT desired...

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

FLASH!

A COMPANY CAN BE HIGHLY PROFITABLE AND BE IN TROUBLE

HOW CAN THIS BE???

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Profitable, yet in Trouble?

• A firm is defined as “profitable if it has a positive net income

• A positive net income results from accrual-based revenues exceeding accrual-based expenses

• A firm may have a positive net income, but this does not guarantee that the firm has the CASH to meet its obligations!

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

Think about the following:• How long would you sell to a company that

didn’t pay your bills (in CASH)?• How long would you sit still if you had

loaned money to a firm (bought their bonds) and didn’t get your interest (in CASH)?

• Would you loan more money to a firm who didn’t pay your last loan (in CASH)? Et cetera, et cetera

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

SCF Analysis Concerns:• Is the firm generating sufficient cash

from operations?• What are underlying causes of positive

or negative operating cash flow?• How large is the positive or negative

operating cash flow?• Have operating cash flows fluctuated

over time or are they stable?

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

SUMMARY

• Examination of the cash flow statement will help assess a firm’s financial health

• Major focus is on operating cash flows but there is important information in the other categories as well

• The information provided on the cash flow statement is REALLY necessary!

Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing

“Coming Attractions”

• NEXT ON THE AGENDA:

• THE ANALYSIS OF FINANCIAL STATEMENTS