Statement of Cash Flows

Learning Objectives

• LO1: Describe the cash flow activities reported on the statement of cash flows.

• LO2: Prepare the Cash Flows from (used for) Operating Activities section of the statement of cash flows using the indirect method.

• LO3: Prepare the Cash Flows from (used for) Investing Activities section of the statement of cash flows.

• LO4: Prepare the Cash Flows from (used for) Financing Activities section of the statement of cash flows.

• LO5: Prepare a statement of cash flows.

• LO6: Describe and illustrate the use of free cash flow in evaluating a company’s cash floww

Reporting Cash Flows

• The statement of cash flows reports a company’s cash inflows and outflows for a period.

• The Statement of Cash Flows provides information regarding a company’s ability to:

  • Generate cash from operations

  • Maintain and expand its operating capacity

  • Meet its financial obligations

  • Pay dividends

• The statement of cash flows is used by managers in evaluating past operations and in planning future investing and financing activities.

• It is also used by external users such as investors and creditors to assess a company’s profit potential and ability to pay its debt and pay dividends.

• Statement of cash flows categories:

  • Cash flows from (used for) operating activities

    • Cash flows from transactions that affect the net income of a company

    • Example: Purchase and sale of merchandise by a retailer

  • Cash flows from (used for) investing activities

    • Cash flows received from or used for transactions that affect investments in the noncurrent assets of the company

    • Example: Purchase and sale of fixed assets, such as equipment and buildings

  • Cash flows from (used for) financing activities

    • Cash flows received from or used for transactions that affect the debt and equity of the company

    • Example: Issuing or retiring equity and debt securities

• The ending cash on the statement of cash flows equals the cash reported on the company’s balance sheet at the end of the year.

Sources and Uses of Cash

• Cash Inflows

  • OPERATING

    • From the sale of products

    • From providing services

  • INVESTING

    • From sale of property, plant, and equipment

    • From sale of investments

  • FINANCING

    • From issuing long-term liabilities

    • From issuing stock

• Cash Outflows

  • OPERATING

    • To purchase inventory

    • To pay employees

    • To pay taxes

  • INVESTING

    • To buy property, plant, and equipment

    • To purchase investments

  • FINANCING

    • To pay dividends to shareholders

    • To repurchase common stock (treasury stock)

    • To repay long-term liabilities

Cash Flows from Operating Activities

• Cash flows from operating activities report the cash inflows and outflows from a company’s day-to-day operations.

• Companies may select one of two alternative methods for reporting cash flows from operating activities in the statement of cash flows:

  • The direct method

  • The indirect method

• Both methods result in the same amount of cash flow from operating activities. They differ in the way they report cash flows from operating activities.

The Direct Method

• Reports operating cash inflows (receipts) and cash outflows (payments) as follows:

  • The primary operating cash inflow is cash received from customers.

  • The primary operating cash outflows are cash payments for merchandise, operating expenses, interest, and income tax payments.

  • The cash received from operating activities less the cash payments for operating activities is the net cash flow from operating activities.

• Primary advantage

  • Directly reports cash receipts and cash payments in the statement of cash flows

• Primary disadvantage

  • Normally more costly to prepare as data related to cash receipts and cash payments may not be readily available; used infrequently in practice

The Indirect Method

• Reports cash flows from operating activities by beginning with net income (loss) and adjusting it for revenues and expenses that do not involve the receipt of cash or payment of cash.

  • The adjustments to reconcile net income to net cash flow from operating activities include such items as depreciation and gains or losses on fixed assets.

  • Changes in current operating assets and liabilities such as accounts receivable or accounts payable are also added or deducted, depending on their effect on cash flows.

• Primary advantage

  • Reconciles the differences between net income and net cash flows from operations

• Other advantage

  • Less costly to prepare than the direct method as data are readily available; most commonly used in practice

Direct and Indirect Methods-NetSolutions

• Direct Method

  • Cash flows from (used for) operating activities:

    • Cash received from customers…. $7,500$

    • Cash paid for expenses and paid to creditors…… $(4,600)$

    • Net cash flows from operating activities…… $2,900$

• Indirect Method

  • Cash flows from (used for) operating activities:

    • Net income.. $3,050$

    • Increase in accounts payable.. $400$

    • Increase in supplies …… $(550)$

    • Net cash flows from operating activities….. $2,900$

  • Result should be the same across both methods

Cash Flows from Investing Activities

• Show the cash inflows and outflows related to changes in a company’s long-term assets.

• Cash flows from investing activities are reported on the statement of cash flows as follows:

  • Cash inflows from investing activities normally arise from selling fixed assets, investments, and intangible assets.

  • Cash outflows normally include payments to purchase fixed assets, investments, and intangible assets.

Cash Flows from Financing Activities

• Show the cash inflows and outflows related to changes in a company’s long-term liabilities and stockholders’ equity.

• Cash flows from financing activities are reported on the statement of cash flows as follows:

  • Cash inflows from financing activities normally arise from issuing long-term debt or equity securities.

    • For example, issuing bonds, notes payable, preferred stock, and common stock creates cash inflows from financing activities.

  • Cash outflows from financing activities normally include paying cash dividends, repaying long-term debt, and acquiring treasury stock.

Noncash Investing and Financing Activities

• A company may enter into transactions involving investing and financing activities that do not directly affect cash.

• For example, a company may issue common stock to retire long-term debt.

• Because such transactions indirectly affect cash flows, they are reported in a separate section that usually appears at the bottom of the statement of cash flows.

Format of the Statement of Cash Flows

• COMPANY NAME

• Statement of Cash Flows

• For the Year Ended XXXX

  • Cash flows from (used for) operating activities:

    • (List of individual items)

    • Net cash flows from (used for) operating activities… $XXX$

  • Cash flows from (used for) investing activities:

    • (List of individual items)

    • Net cash flows from (used for) investing activities. $XXX$

  • Cash flows from (used for) financing activities:

    • (List of individual items)

    • Net cash flows from (used for) financing activities $XXX$

  • Net increase (decrease) in cash …… $XXX$

  • Cash at the beginning of the period…. $XXX$

  • Cash at the end of the period $XXX$

  • Noncash investing and financing activities.

Cash Flow per Share

• Sometimes reported in the financial press

• Normally computed as net cash flows from operating activities divided by the number of common shares outstanding

• However, such reporting may be misleading because of the:

  • Users may misinterpret cash flow per share as the per-share amount available for dividends

  • Users may misinterpret cash flow per share as equivalent to (or better than) earnings per share

Classifying Cash Flows

• Identify whether each of the following would be reported as an operating, investing, or financing activity in the statement of cash flows:

  • Purchase of patent

  • Payment of cash dividend

  • Disposal of equipment

  • Cash sales

  • Purchase of treasury stock

  • Payment of wages expense

Cash Flows from Operating Activities Section

• The indirect method of reporting cash flows from operating activities uses the logic that a change in any balance sheet account (including cash) can be analyzed in terms of changes in other balance sheet accounts:

• Thus, any change in the cash account can be determined by analyzing changes in the liability, stockholders’ equity, and noncash asset accounts

• Under the indirect method, there is no order in which the balance sheet accounts must be analyzed.

• However, net income (or net loss) is the first amount reported on the statement of cash flows.

• Because net income (or net loss) is a component of any change in Retained Earnings, the first account normally analyzed is Retained Earnings.

Income Statement and Comparative Balance Sheet

• Rundell Inc.

• Income Statement

• For the Year Ended December 31, 20Y8

  • Sales $1,180,000$

  • Cost of merchandise sold $790,000$

  • Gross profit $390,000$

  • Operating expenses:

    • Depreciation expense $12,000$

    • Other operating expenses $196,000$

    • Total operating expenses $203,000$

  • Income from operations $187,000$

  • Other revenue and expense:

    • Gain on sale of land $12,000$

    • Interest expense $(8,000)$

  • Income before income tax $191,000$

  • Income tax expense $83,000$

  • Net income $108,000$

• Rundell Inc.

• Comparative Balance Sheet

• December 31, 20Y8 and 20Y7

  • Assets

    • Cash:

      • 20Y8: $97,500$

      • 20Y7: $26,000$

      • Increase (Decrease): $71,500$

    • Accounts receivable (net):

      • 20Y8: $74,000$

      • 20Y7: $65,000$

      • Increase (Decrease): $9,000$

    • Inventories:

      • 20Y8: $172,000$

      • 20Y7: $180,000$

      • Increase (Decrease): $(8,000)$

    • Land:

      • 20Y8: $80,000$

      • 20Y7: $125,000$

      • Increase (Decrease): $(45,000)$

    • Building:

      • 20Y8: $260,000$

      • 20Y7: $200,000$

      • Increase (Decrease): $60,000$

    • Accumulated depreciation-building:

      • 20Y8: $(65,300)$

      • 20Y7: $(58,300)$

      • Increase (Decrease): $(7,000)$

    • Total assets:

      • 20Y8: $618,200$

      • 20Y7: $537,700$

      • Increase (Decrease): $80,500$

  • Liabilities

    • Accounts payable (merchandise creditors):

      • 20Y8: $43,500$

      • 20Y7: $46,700$

      • Increase (Decrease): $(3,200)$

    • Accrued expenses payable (operating expenses):

      • 20Y8: $26,500$

      • 20Y7: $24,300$

      • Increase (Decrease): $2,200$

    • Income taxes payable:

      • 20Y8: $7,900$

      • 20Y7: $8,400$

      • Increase (Decrease): $(500)$

    • Dividends payable:

      • 20Y8: $14,000$

      • 20Y7: $10,000$

      • Increase (Decrease): $4,000$

    • Bonds payable:

      • 20Y8: $100,000$

      • 20Y7: $150,000$

      • Increase (Decrease): $(50,000)$

    • Total liabilities:

      • 20Y8: $191,900$

      • 20Y7: $239,400$

      • Increase (Decrease): $(47,500)$

  • Stockholders' Equity

    • Common stock ($2 par):</p><ul><li><p>20Y8:$24,000$</p></li><li><p>20Y7:$16,000$</p></li><li><p>Increase (Decrease):$8,000$</p></li></ul></li><li><p>Paid-in capital in excess of par:</p><ul><li><p>20Y8:$120,000$</p></li><li><p>20Y7:$80,000$</p></li><li><p>Increase (Decrease):$40,000$</p></li></ul></li><li><p>Retained earnings:</p><ul><li><p>20Y8:$282,300$</p></li><li><p>20Y7:$202,300$</p></li><li><p>Increase (Decrease):$80,000$</p></li></ul></li><li><p>Total stockholders' equity:</p><ul><li><p>20Y8:$426,300$</p></li><li><p>20Y7:$298,300$</p></li><li><p>Increase (Decrease):$128,000$</p></li></ul></li><li><p>Total liabilities and stockholders' equity:</p><ul><li><p>20Y8:$618,200$</p></li><li><p>20Y7:$537,700$</p></li><li><p>Increase (Decrease):$80,500$</p></li></ul></li></ul></li></ul></li></ul><h3 id="e093beb0-f7fc-4c60-b2ce-49ce693420aa" data-toc-id="e093beb0-f7fc-4c60-b2ce-49ce693420aa" collapsed="false" seolevelmigrated="true">Net Income</h3><ul><li><p>Rundell Inc.’s net income for 20Y8 is$108,000$, as shown on the income statement.</p></li><li><p>Since net income is closed to Retained Earnings, net income also helps explain the change in retained earnings during the year.</p></li><li><p>The retained earnings account indicates that the$80,000 ($108,000 –$28,000)$ change resulted from net income of $108,000$ and cash dividends of $28,000$.

    • The net income of $108,000$ is the first amount reported in the Cash flows from operating activities section.

    • The impact of the dividends of $28,000$ on cash flows will be included as part of financing activities.

    Adjustments to Net Income

    • The net income of $108,000$ reported by Rundell Inc. does not equal the cash flows from operating activities for the period.

    • This is because net income is determined using the accrual method of accounting.

    • Under the accrual method of accounting, revenues and expenses are recorded at different times from when cash is received or paid.

    • Thus, under the indirect method, adjustments to net income must be made to determine cash flows from operating activities.

    • Net income is normally adjusted to cash flows from operating activities, using the following steps:

      • Step 1. Expenses that do not affect cash are added. Such expenses decrease net income but do not involve cash payments and, thus, are added to net income.

      • Step 2. Losses on the disposal of assets are added and gains on the disposal of assets are deducted.

      • Step 3. Changes in current operating assets and liabilities are added or deducted as follows:

        • Increases in noncash current operating assets are deducted.

        • Decrease in noncash current operating assets are added.

        • Increases in current operating liabilities are added.

        • Decreases in current operating liabilities are deducted.

    Adjustments to Net Income (Loss) Using the Indirect Method

    • Net income (loss). $XXX$

    • Adjustments to reconcile net income (loss) to net cash flows from (used for) operating activities:

      • Depreciation of fixed assets XXX

      • Amortization of intangible assets XXX

      • Losses on disposal of assets XXX

      • Gains on disposal of assets (XXX)

      • Changes in current operating assets and liabilities:

        • Increases in noncash current operating assets (XXX)

        • Decreases in noncash current operating assets XXX

        • Increases in current operating liabilities XXX

        • Decreases in current operating liabilities. (XXX)

    • Net cash flows from (used for) operating activities. $XXX$

    • The next few slides will show how Rundell’s net income is converted to cash flows from operating activities of $100,500$.

      • Step 1: Add depreciation of $7,000$.

        • Analysis: The comparative balance sheet indicates that Accumulated Depreciation—Building increased by $7,000$. The following account indicates that depreciation for the year was $7,000$ for the building:

      • Step 2: Deduct the gain on the sale of land of $12,000$.

        • Analysis: The income statement reports a gain of $12,000$ from the sale of land. The proceeds, which include the gain, are reported in the Investing section of the statement of cash flows. Thus, the gain of $12,000$ is deducted from net income in determining cash flows from operating activities.

      • Step 3: Add and deduct changes in current operating assets and liabilities excluding cash.

        • Accounts receivable (net): The $9,000$ increase is deducted from net income.

          • This is because the $9,000$ increase in accounts receivable indicates that sales on account were $9,000$ more than the cash received from customers.

          • Thus, sales (and net income) includes $9,000$ that was not received in cash during the year.

      • Step 3: Add and deduct changes in current operating assets and liabilities excluding cash.

        • Inventories: The $8,000$ decrease is added to net income.

          • This is because the $8,000$ decrease in inventories indicates that the cost of merchandise sold exceeds the cost of merchandise purchased during the year by $8,000$.

          • In other words, the cost of merchandise sold includes $8,000$ of goods from inventory that were not purchased (used cash) during the year.

      • Step 3: Add and deduct changes in current operating assets and liabilities excluding cash.

        • Accounts payable (merchandise creditors): The $3,200$ decrease is deducted from net income.

          • This is because a decrease in accounts payable indicates that the cash payments to merchandise creditors exceed the merchandise purchased on account by $3,200$.

          • Therefore, the cost of merchandise sold is $3,200$ less than the cash paid to merchandise creditors during the year.

      • Step 3: Add and deduct changes in current operating assets and liabilities excluding cash.

        • Accrued expenses payable (operating expenses): The $2,200$ increase is added to net income.

          • This is because an increase in accrued expenses payable indicates that operating expenses exceed the cash payments for operating expenses by $2,200$.

          • In other words, operating expenses reported on the income statement include $2,200$ that did not require a cash outflow during the year.

      • Step 3: Add and deduct changes in current operating assets and liabilities excluding cash.

        • Income taxes payable: The $500$ decrease is deducted from net income.

          • This is because a decrease in income taxes payable indicates that taxes paid exceed the amount of taxes incurred during the year by $500$.

          • In other words, the amount reported on the income statement for income tax expense is less than the amount paid by $500$.

    Net Cash Flow From Operating Activities-Indirect Method

    • Cash flows from (used for) operating activities:

      • Net income $108,000$

      • Adjustments to reconcile net income to net cash flows from (used for) operating activities:

        • Depreciation $7,000$

        • Gain on sale of land $(12,000)$

        • Changes in current operating assets and liabilities:

          • Increase in accounts receivable $(9,000)$

          • Decrease in inventories $8,000$

          • Decrease in accounts payable $(3,200)$

          • Increase in accrued expenses payable $2,200$

          • Decrease in income taxes payable $(500)$

      • Net cash flows from operating activities $100,500$

    Cash Flows from Investing Activities Section

    • Reports the cash inflows and outflows related to changes in a company’s long- term assets.

    • Similar to preparing the Cash Flows from (used for) Operating Activities section, the change in each long-term asset account is analyzed for its effect on cash flows from investing activities

    • Rundell Inc.’s comparative balance sheet lists land, building, and accumulated depreciation—building as long-term assets

    Land

    • The $45,000$ decline in the land account of Rundell Inc. was from two transactions, as follows:

    • The June 8 transaction is the sale of land with a cost of $60,000$ for $72,000$ in cash. The $72,000$ proceeds from the sale are reported in the Investing Activities section

    • The October 12 transaction is the purchase of land for cash of $15,000$. This transaction is reported as an outflow of cash in the Investing Activities section

    Building and Accumulated Depreciation—Building

    • The building account of Rundell Inc. increased by $60,000$, and the accumulated depreciation—building account increased by $7,000$

    • The purchase of a building for cash of $60,000$ is reported as an outflow of cash in the Investing Activities section

    Cash Flows from Financing Activities Section

    • Reports the cash inflows and outflows related to changes in a company’s long- term liabilities and stockholders’ equity

    • Rundell Inc.’s comparative balance sheet reports changes in bonds payable, common stock, and paid-in capital in excess of par

    • In addition, dividends payable has changed, which impacts retained earnings.

    • Each change must be analyzed to determine its effect on cash flows from financing activities.

    Bonds Payable

    • The Bonds Payable account of Rundell Inc. decreased by $50,000$

    • This decrease is from retiring the bonds by a cash payment for their face amount. This cash outflow is reported in the Financing Activities section

    Common Stock

    • The common stock account of Rundell Inc. increased by $8,000$, and the paid-in capital in excess of par—common stock account increased by $40,000$

    • These increases were from issuing 4,000 shares of common stock for $12$ per share. This cash inflow is reported in the Financing Activities section

    Dividends and Dividends Payable

    • The retained earnings account of Rundell Inc. indicates cash dividends of $28,000$ were declared during the year.

    • cash dividends paid during the year can also be computed by adjusting the dividends declared during the year for the change in the dividends payable account as follows:

    • Because dividend payments are a financing activity, the dividend payment of $24,000$ is reported in the Financing Activities section of the statement of cash flows

    Statement of Cash Flows-Indirect Method

    • Rundell Inc.

    • Statement of Cash Flows

    • For the Year Ended December 31, 20Y8

      • Cash flows from (used for) operating activities:

        • Net income $108,000$

        • Adjustments to reconcile net income to net cash flows from (used for) operating activities:

          • Depreciation $7,000$

          • Gain on sale of land $(12,000)$

          • Changes in current operating assets and liabilities:

            • Increase in accounts receivable $(9,000)$

            • Decrease in inventories $8,000$

            • Decrease in accounts payable $(3,200)$

            • Increase in accrued expenses payable $2,200$

            • Decrease in income taxes payable $(500)$

        • Net cash flows from operating activities $100,500$

      • Cash flows from (used for) investing activities:

        • Cash received from sale of land $72,000$

        • Cash paid for purchase of land $(15,000)$

        • Cash paid for purchase of building $(60,000)$

        • Net cash flows used for investing activities $(3,000)$

      • Cash flows from (used for) financing activities:

        • Cash received from issuing common stock $48,000$

        • Cash paid to retire bonds payable $(50,000)$

        • Cash dividends $(24,000)$

        • Net cash flows used for financing activities $(26,000)$

      • Net increase in cash $71,500$

      • Cash balance, January 1, 2018 $26,000$

      • Cash balance, December 31, 2018 $97,500$

    Financial Analysis and Interpretation: Free Cash Flow

    • Free cash flow measures the operating cash flow available to a company to use after purchasing the property, plant, and equipment (PP&E) necessary to maintain its current operations.

    • Since the investments in PP&E necessary to maintain current operations cannot often be determined from financial statements, analysts estimate this amount using the cash used to purchase PP&E, as shown in the statement of cash flows.

    • Free cash flow is computed as follows:

      • Free Cash Flow = Cash Flows from Operating Activities – Purchase of PP&E

      • The free cash flow can be expressed as a percentage of sales in order to provide a relative measure that can be compared over time or to other companies. This ratio is computed as follows:

      • $\text{Free Cash Flow as a percentage of sales} = \frac{\text{Free Cash Flow}}{\text{Sales}}$

    • Positive free cash flow is considered favorable.

    • A company that has free cash flow is able to fund growth and acquisitions, retire debt, purchase treasury stock, and pay dividends.

    • A company with no free cash flow may have limited financial flexibility, potentially leading to liquidity problems.

    Example Exercise: Free Cash Flow

    • Omnicron Inc. reported the following on the company’s cash flow statement in 20Y8 and 20Y7:

      • Seventy-five percent of the net cash flow used for investing activities was used to replace existing capacity.

      • Determine Omnicron’s free cash flow for both years.

      • Has Omnicron’s free cash flow improved or declined from 20Y7 to 20Y8?