Module 8, Statement of Cash Flows

Profitable businesses can be short of cash due to…

Large amounts of inventory or accounts receivable.

• Without cash, a company cannot succeed.

Statement of Cash Flows

Used to identify the sources (inflows) and uses (outflows) of cash during an accounting period.

• These inflows and outflows are grouped into operating, investing and financing activities.

• The sum of these three groups explains the difference between the opening and closing cash balance for the accounting period.

Use of the Statement of Cash Flows by Management

To inform the following decisions…

• Can the company afford to buy equipment or expand its operations?

• Does the company have enough cash to retire some of its long-term debt that is due?

• Is there enough cash to pay dividends to the shareholders as a return on their investment (shares)?

• Can the company survive these adverse economic conditions?

Use of the Statement of Cash Flows by Potential Creditors and Investors

To make decisions about a corporation’s financial performance.

• Reported cash flows can sometimes be an indicator of future cash flows though there are some risks, since the data is strictly historical, not prospective.

Cash and Cash Equivalents

Represent the sum of the assets that are not subject to significant risk, and can be quickly converted into known amounts of cash.

• Includes cash, petty cash, short-term investments three months or less from the date of acquisition.

• Management judgement is required for what is or is not included, and this basis is to be disclosed in the SCF or notes.

Cash balance in the statement of cash flows must be equal to that in the…

Balance sheet.

Indirect Method of Formatting a Statement of Cash Flows

In which there are four sections, including…

• Cash flows from operating expenses.

• Cash flows from investing expenses.

• Cash flows from financing expenses.

• Cash flows from reconciliation (i.e., cash at the beginning of the year).

Preparing a Statement of Cash Flows, Step 1

• Set up a cash flow table (or work with the existing income statement and balance sheet).

• Calculate the change between current year (CY) and prior year (PY) for all accounts.

Preparing a Statement of Cash Flows, Step 2

Calculate the net change in cash.

Preparing a Statement of Cash Flows, Step 3

Analyze and calculate the changes in retained earnings (R/E) and dividends payable.

Closing Retained Earnings

Opening retained earnings + net income - dividends declared.

Closing Dividends Payable

Opening dividend payable + dividend declared - cash dividend paid.

Preparing a Statement of Cash Flows, Step 4

Report on cash flows from operating activities (i.e., from the principal business operations).

• Begins with net income/loss from the income statement.

• Adjustments are made to restate net income/loss from an accrual basis to a cash basis.

  • i.e., Depreciation, gains, losses.

• Increase or decrease in each non-cash working capital account (i.e., current assets and current liabilities) is identified, excluding current portion of long-term debt and dividends payable, which are incorporated elsewhere.

• The operating activities section is sub-totaled and reported.

Preparing a Statement of Cash Flows, Step 5

Report on cash flows from investing activities (i.e., from long-term assets).

• Requires analysis of each long-term asset account to determine reasons for changes.

• Each increase and/or decrease in each long-term asset account is identified and reported separately.

• The investing activities section is sub-totaled and reported.

Preparing a Statement of Cash Flows, Step 6

Report on cash flows from financing activities (i.e., from long-term liabilities, share capital and cash dividends paid).

• Requires analysis of each long-term liability account and the share capital account to determine reasons for any changes.

• Each increase and/or decrease in each account is identified and reported separately.

• The financing activities section is sub-totaled and reported.

Preparing a Statement of Cash Flows, Step 7

Reconciliation of cash balances.

• Identify and report the net increase/decrease in cash.

• Add the opening balance for cash below and calculate the sum of the two amounts.

• Ending cash balance should be equal to the ending cash balance in the balance sheet.

Quality of earnings is often measured by…

The significance of the accruals.

• Users have more confidence in the company’s financial statements if there is a high correlation between cash provided by operations and net income (e.g., $80 net income compared to $70 net cash inflow from operations).

• Inventory increased by $450, which is significant and will tie up working capital.

Ratio is calculated by (cash flows from operations) / (net income).

Operating Section of Statement of Cash Flows

Includes current assets, current liabilities, revenues, expenses, gains, losses.

Investing Section of Statement of Cash Flows

Includes long-term assets.

Financing Section of Statement of Cash Flows

Includes long-term liabilities and shareholder’s equity.