Chapter 5- Statement of Cash Flow

How is “cash” defined in accounting?

• Cash includes currency, coins, demand deposits (checking accounts)

• highly liquid investments with maturities of 3 months or less

• readily convertible to known amounts of cash

Why is the statement of cash flows significant to users?

It shows liquidity, ability to meet short-term obligations, pay dividends, invest, and assess the quality of earnings.

How does the cash flow statement differ from the income statement?

The income statement reports accrual-based revenues and expenses (profitability), while the cash flow statement reports actual cash inflows and outflows (liquidity).

What is the direct method of cash flows?

Reports specific cash receipts and payments (cash from customers, cash to suppliers, wages paid).

What is the indirect method of cash flows?

Starts with net income and adjusts for non-cash items and changes in working capital.

Working capital rules for current assets & current liabilities?

• Assets: Increase → subtract (cash outflow), Decrease → add (cash inflow)

• Liabilities: Increase → add (cash inflow), Decrease → subtract (cash outflow)

How is investing cash flow calculated?

Cash paid or received for long-term asset purchases or sales.

How is financing cash flow calculated?

Cash received from issuing debt/equity - repayments and dividends paid.

How are interest and dividends classified?

• Interest paid/received and dividends received usually operating (policy may vary)

• dividends paid are financing

What do cash flow patterns reveal?

Whether the company funds itself through operations or relies on external financing.

How to assess ability to cover current liabilities?

Compare operating cash flow to current liabilities (higher ratio = stronger liquidity).

Why might a company have positive net income but low operating cash flow?

Revenue recorded but not collected (↑ AR), inventory increases, or other accrual timing differences.

How can management use the cash flow statement?

Identify cash shortages, plan investments, manage debt, and decide on dividends.

Mnemonic: CASH

C = Customers (operating cash); A = Assets (investing); S = Shares/debt (financing); H = How we adjust net income (indirect method)

Mnemonic: Working Capital Rule

Assets move opposite cash; liabilities move in the same direction as cash.

What are Capital Expenditures (CapEx)?

Capital expenditures = Purchase of PPE (long-term assets). It is an Investing cash outflow.

How are non-cash investing and financing activities reported?

They are NOT included in Operating, Investing, or Financing sections. They are disclosed separately below the statement or in the notes.

What is the Cash Flow to Current Liabilities ratio?

Cash Flow to Current Liabilities = Operating Cash Flow ÷ Current Liabilities. Measures ability to cover short-term obligations.

What is Step 1 of the Indirect Method (Operating Activities)?

Start with Net Income.

What is Step 2 of the Indirect Method (Operating Activities)?

Adjust for non-cash and non-operating items: add back depreciation/amortization, add back losses, subtract gains.

What is Step 3 of the Indirect Method (Operating Activities)?

Adjust for changes in working capital (current assets and current liabilities, excluding cash).

Why is a gain/loss on sale of equipment subtracted/added in the indirect method?

• Gain: Subtracted from net income because the gain increases net income but does not generate operating cash

• Loss: Added back to net income in operating activities since it is non-cash, while proceeds are included in investing activities

Why is depreciation added back under operating activities?

It reduced net income but did not use cash.

What working capital accounts are included in Step 3 of the indirect method?

Current assets and current liabilities, excluding cash and short-term debt.

If inventory increases, what happens to operating cash flow?

Decrease (cash outflow).

If wages payable increases, what happens to operating cash flow?

Increase (cash inflow).

Why does an increase in Accounts Receivable reduce cash collected?

Revenue was recorded but not yet collected in cash.

Purchase of equipment with cash is classified as what?

Investing outflow.

Purchase of equipment by issuing shares is classified as what?

Non-cash investing and financing activity (disclosed separately).

Payment of notes payable (long-term) is classified as what?

Financing outflow.

Increase in notes payable is classified as what?

Financing inflow.

Interest paid is classified as what under GAAP?

Operating activity.

Dividends paid are classified as what?

Financing activity.

Proceeds from sale of land are classified as what?

Investing inflow.

What is the full Free Cash Flow formula?

Operating Cash Flow - Capital Expenditures - Dividends Paid.

Why is Free Cash Flow important?

It shows cash available for debt repayment, expansion, or dividends.

After calculating net increase (decrease) in cash, what must be done?

Add beginning cash to determine ending cash.

What must ending cash equal?

The cash balance reported on the balance sheet.

The period of time between when cash is disbursed for the purchase of inventory and when cash is received from selling the inventory and collecting the accounts receivable.

Cash-to-cash cycle

Cash that is not available to meet short-term cash needs due to restrictions placed on it, normally by creditors.

Restricted cash

The net change in cash that occurs from the beginning of an accounting period to the end of the period.

Cash flows

The direction (positive or negative) of cash flows in three categories: operating, investing, and financing.

Cash flow pattern

A company's activities that involve raising funds to support other activities or that represent a return of these funds.

Financing activities

A ratio that is calculated by dividing cash flows from operating activities by current liabilities.

Operating cash flow ratio

The amount of cash that a company generates from its operations that is in excess of the cash required to maintain the company's productive capacity.

Free cash flow

Company activities involving long-term investments, primarily investments in property, plant, and equipment, and in the shares of other companies.

Investing activities

An arrangement with a financial institution that allows a company to overdraw its bank account.

Bank overdraft facility

The cash flow generated from a company's operating activities that would be available to the company's common shareholders.

Net free cash flow

Financial statement that summarizes the cash flows of a company during the accounting period, categorized into operating, investing, and financing activities.

Statement of cash flows

A pre-arranged short-term loan that a company can draw upon as required.

Line of credit

The activities of a company that are related to developing, producing, marketing, and selling the company's goods and/or services to customers, and other basic day-to-day activities related to operating the business.

Operating activities

How do you classify cash flows from issuing bonds, repaying debt, and issuing shares?

Financing activities — inflows from issuance of debt or equity, outflows for repayment of long-term debt

What type of activity involves investing resources over long periods in long-term assets?

Investing activities (IA)

Which activities cause an inflow of cash in operating activities?

Examples include:

• a loss on sale of a capital asset

• collections from customers

• receipt of dividends/interest (depending on policy)

Which section of the cash flow statement should a banker focus on to determine loan repayment ability?

Operating activities (OA), because they show cash generated from core operations

What accounts are typically included in financing activities?

Long-term liabilities and shareholders' equity (e.g., issuing shares, repaying loans, paying dividends)

Do non-cash expenses reduce operating cash flow?

No — false. Non-cash expenses like depreciation reduce net income but are added back in the indirect method

Which transactions are NOT reflected in the cash flow statement?

Non-cash investing/financing activities, such as purchasing land by issuing shares

How are cash inflows and outflows from investing activities identified?

Inflows: proceeds from sale of equipment or investments. Outflows: purchase of long-term assets

What is indicated by positive operating cash flow and negative investing cash flow?

A healthy company generating cash from operations and investing in growth

What is indicated by negative operating cash flow and positive financing cash flow?

The company is relying on external financing or borrowing to fund operations

How are proceeds from issuing shares or bonds classified?

Financing inflow

How are repayment of long-term debt or dividends classified?

Financing outflow

How do you calculate net cash from operating activities (indirect method)?

Net Income + non-cash expenses + losses − gains ± changes in working capital

How is cash flow from customers calculated (direct method)?

Sales revenue ± change in accounts receivable

How is cash flow to suppliers calculated (direct method)?

COGS ± change in inventory − change in accounts payable

What are the three main categories of cash flow and their definitions?

• Operating activities (OA) include day-to-day cash flows from core business operations, like cash received from customers and cash paid to suppliers or employees

• Investing activities (IA) involve long-term asset transactions, such as purchase or sale of property, plant, equipment, or investments

• Financing activities (FA) involve raising or returning capital, including issuing/repaying debt, issuing shares, or paying dividends.

How to calculate profit?

Revenue - COGS - operating expenses

Why profit does not equal cash flow

Accrual accounting: revenues may not be collected in cash, expenses may not be paid in cash

Cash collected from customers (direct method)

Sales revenue − increase in Accounts Receivable (or + decrease in A/R)

Cash paid to suppliers (direct method)

COGS + increase in inventory − increase in Accounts Payable

Cash paid for operating expenses

Operating expense − increase in accrued liabilities (or + decrease in payables)

Operating cash inflows (examples)

Cash from customers; interest/dividends received; other day-to-day operations

Investing cash inflows/outflows (examples)

Purchase/sale of property, plant, equipment; purchase/sale of long-term investments

Financing cash inflows/outflows (examples)

Issuing/repaying debt; issuing shares; paying dividends

Effect of gain/loss on sale of assets (indirect method)

Gain: subtract from net income; Loss: add back to net income

Non-cash investing/financing activities

Buying assets by issuing shares or debt; disclosed separately, not in main cash flow sections

Dividends declared vs paid

Declared: no cash impact; Paid: financing cash outflow

Positive operating, negative investing cash flow

Company generating cash and investing in growth (healthy)

Negative operating, positive financing cash flow

Company relying on external financing to fund operations

Why depreciation is added back (indirect method)

Non-cash expense that reduced net income but did not use cash

How to adjust net income for changes in working capital

Subtract increases in current assets; add decreases; add increases in current liabilities; subtract decreases

Indirect method minimum info needed

Statement of income for period + beginning & ending balance sheets

Difference between direct and indirect method

Direct: reports actual cash receipts/payments; Indirect: adjusts net income for non-cash items & WC changes

Items NOT included in cash flow statement

Non-cash investing/financing transactions like issuing shares for equipment

Free cash flow formula

Operating Cash Flow − Capital Expenditures − Dividends Paid

Operating cash flow ratio

Operating Cash Flow ÷ Current Liabilities