FSA Ch.3: Understanding the Statement of Cash Flows

Statemnet of Cash Flows

The primary purpose of the statement of cash flows is to provide financial statement users with information about a firm’s cash receipts and cash expenditures that cause the change in the cash balance on the balance sheet.

Indirect Method

he indirect method of preparing the statement of cash flows, which reconciles net income with the net change in cash during the period. Thus, the statement of cash flows links net income on the income statement to the change in cash on the balance sheet. Net income is an important performance measure because it captures changes in all assets and liabilities from transactions with non-owners; the change in cash measures only the change in one asset (cash) and is also affected by transactions with owners. As we will learn in the sections that follow, the reconciling items are changes in non-cash assets and liabilities and net cash flows from transactions with owners (e.g., dividends and share issues).

Operating Activities

Operating activities include all activities directly involving the production and delivery of goods or services; examples include cash received from customers and cash used to purchase raw materials and to compensate employees.

Investing Activities

The investing activities section chronicles expenditures for and proceeds from dispositions of assets, such as plant and equipment and investments in securities, that are intended to be used to generate cash flows.

Financing Activities

financing activities includes cash received from and paid to capital providers such as banks, other lending institutions, and shareholders.

Product Life Cycle

Individual products (like goods or services) move through four phases: (1) introduction, (2) growth, (3) maturity, and (4) decline. Firms also evolve through these phases

The introduction stage includes nascent firms seeking to establish productive operations in the markets in which they seek to compete and among the customers they hope to serve. If firms are successful in the introduction stage, they progress to the growth stage, during which they seek to substantially expand the scale of productive capacity and operations, and grow their customer base and sales volume. Firms that are successful in the growth stage then progress into a mature stage as they more fully develop their growth opportunities. Mature firms are characterized by well-established competitive positions in the markets they serve, with stable customer bases, productive capacity and operations. Firms that successfully reach the mature stage strive to remain in that stage for as long as possible.

Cash Flow Patterns

Start-up firms typically have net losses, negative cash flows from operations, negative cash flows for investing activities, but positive cash flows from financing activities.

Growth firms typically have increasing profits or decreasing losses, positive cash flows from operations, negative cash flows for investing activities, and positive cash flows from financing activities.

Mature firms typically have large positive profits, large positive cash flows from operations, stable cash flows from investing activities, and negative cash flows from financing activities.

Decline firms typically have decreasing profits or increasing losses, declining cash flows from operations, low or positive cash flows for investing activities, and negative cash flows from financing activities.

Indirect Method

indirect method does not list cash flows directly, but instead reconciles reported net income to cash flows from operations by “unraveling” noncash (i.e., accrual) components of earnings.

• Under the indirect method, firms begin with net income to calculate cash flows from operations. The assumption implicit in starting with net income is that revenues increase cash and expenses decrease cash. However, remember that under accrual accounting, recognition of revenues and expenses does not necessarily coincide with the actual timing of cash receipts or payments. For example, sales to customers on credit trigger recognition of revenues, but this also triggers an increase in accounts receivable because customers have been extended credit and can pay later. Because of differences in the timing of cash flows and income statement recognition, net income must be reconciled to cash flows by adjusting for noncash effects.

Non-Articulation

When adjustments on the statement of cash flows rarely match the actual changes in the corresponding line items on the balance sheet

• 4 Reasons:

  1. Acquisitions and divestures

  2. Noncash transactions

  3. Changes in contra accounts

  4. Foreign Currency translation