Reporting Cash Flows

Reporting Cash Flows

Learning Objectives

  • Distinguish between operating, investing, and financing activities, and describe how noncash investing and financing activities are disclosed.

  • Prepare a statement of cash flows applying the Indirect Method.

  • Determine cash flows from operating activities.

  • Determine cash flows from both investing and financing activities.

  • Analyze the statement of cash flows and apply the cash flow on total assets ratio.

Basics of Cash Flow Reporting

  • The purpose of a Statement of Cash Flows is to report all major cash receipts (inflows) and cash payments (outflows) during a period.

  • This report classifies cash flows into operating, investing, and financing activities.

  • The report answers important questions:

    • How does a company obtain its cash?

    • Where does the company spend its cash?

    • What explains the change in the cash balance?

    • How much is paid in cash dividends?

  • Information regarding cash flows is extremely important – it influences decision makers.

  • It is preferable for a company to pay expenses from cash generated from operations, as opposed to selling assets to pay bills.

  • We want a company that has enough cash to pay its debts.

Measurement of Cash Flows

  • Cash flows refers to both cash and cash equivalents.

  • Cash equivalents:

    • Is readily convertible to a known amount of cash.

    • Is sufficiently close to its maturity date so that its market value is unaffected by interest rate changes.

Format of the Statement of Cash Flows

The statement follows a standard format:

COMPANY NAME
Statement of Cash Flows
For period Ended date
Cash flows from operating activities
[List of individual inflows and outflows]
Net cash provided (used) by operating activities
$ #
Cash flows from investing activities
[List of individual inflows and outflows]
Net cash provided (used) by investing activities.
#
Cash flows from financing activities
[List of individual inflows and outflows]
Net cash provided (used) by financing activities.
Net increase (decrease) in cash
Cash (and equivalents) balance at prior period-end
$ #
#
$ #
Cash (and equivalents) balance at current period-end

  • A separate schedule or note disclosure of any "noncash investing and financing transactions” is required.

Classification of Cash Flows

The Statement of Cash Flows includes the following three sections:

  • Operating Activities – transactions and events that determine net income (with some exceptions, such as unusual gains and losses) ‐ examples

  • Investing Activities – transactions and events that affect long‐term assets, namely the purchase and sale of these assets ‐ examples

  • Financing Activities – transactions and events that affect long‐term liabilities and equity – examples

Non‐cash Investing and Financing Activities

  • There are some activities that do not affect cash receipts or payments.

  • They are important.

  • The full disclosure principal mandates disclosure.

  • They are disclosed at the bottom of the statement of cash flows or in a note to the statement.

  • Examples

Preparing the Statement of Cash Flows

There are five main steps:

  1. Compute the net increase or decrease in cash.

    • This is computed from comparative balance sheets; take the current period’s cash balance minus the prior period’s cash balance.

    • This is the bottom‐line figure for the statement of cash flows, and is a check on its accuracy.

  2. Compute and report net cash provided (used) by operating activities.

  3. Compute and report net cash provided (used) by investing activities.

  4. Compute and report net cash provided (used) by financing activities.

  5. Compute net cash flow from all sources, and then prove it by adding it to the beginning cash balance to show that it equals the ending cash balance.

Sources of Information

There are three main sources of information for preparing the statement:

  1. Comparative balance sheets (current year and prior year).

  2. The current year income statement.

  3. Other information – typically derived from analyzing noncash balance sheet accounts: examples:

    • Noncurrent assets (property, plant and equipment, and notes receivable).

    • Noncurrent liabilities (notes payable (including current notes payable), bonds payable).

    • Equity accounts (paid‐in capital accounts and retained earnings).

Cash Flows from Operating Activities

  • There are two methods of reporting cash flows from operating activities – the direct method and the indirect method.

  • The direct method - separately lists each major item of operating cash receipts and each major item of operating cash payments.

    • Cash payments are subtracted from cash receipts to determine the net cash provided (used) by operating activities.

  • The indirect method – reports net income and then adjusts it for items necessary to obtain net cash provided (used) by operating activities.

  • NOTE: Under both methods, the net cash provided (used) by operating activities is identical.

  • We will focus on the indirect method for reporting cash flows from operating activities.

Applying the indirect method

Requires adjusting net income for two types of items in order to get cash provided (used) by operating activities:

  1. Adjust for income statement items that do not affect cash.

    • Add back to net income non‐cash expenses ‐ examples:

      • Depreciation expense.

      • Depletion expense.

      • Amortization expense.

    • Subtract non‐cash gains from net income ‐ examples:

      • Gain on sale of plant assets.

      • Gain on retirement of debt.

    • Add back non‐cash losses to net income ‐ examples:

      • Loss on disposal of plant assets.

      • Loss from retirement of debt.

  2. Adjust for changes in current assets (other than cash), and current liabilities.

    • Add to net income:

      • Decreases in non‐cash current assets.

      • Increases in current liabilities.

    • Subtract from net income:

      • Increases in non‐cash current assets.

      • Decreases in current liabilities.

  • The Statement of Cash Flows – indirect method summary example of the two types of adjustment items

Cash Flows from Investing Activities

  • Reporting of investing activities is identical under the direct and indirect methods.

  • The three steps of analysis needed to determine cash provided (used) by investing activities:

    1. Identify changes in investing‐related accounts (all non‐current assets, and the current accounts for both notes receivable and investments in securities—excluding trading securities).

    2. Explain these changes to identify their cash flows effects using reconstruction analysis – reconstruct the journal entries that recorded the transactions to specifically identify the debit to cash (for cash amounts received) and the credits to cash (for cash paid).

    3. Report their cash flow effects.

Cash Flows from Financing Activities

  • Cash flows from financing activities is identical under the direct and indirect methods.

  • The three steps of analysis needed to determine cash provided (used) by investing activities:

    1. Identify changes in financing‐related accounts (all non‐current liabilities—including current portion of any notes and bonds, and the equity accounts).

    2. Explain these changes to identify their cash flows effects using reconstruction analysis – reconstruct the journal entries to identify the debits to cash (cash receipts) and credits to cash (cash payments).

    3. Report their cash flow effects.

Proving Cash Balances

The last step in preparing the statement is to the beginning and ending cash balances and prove that the net change in cash is by the operating, investing and financing cash flows.

Decision Analysis – Cash Flow Analysis

  • Analyzing Cash Sources and Uses.

  • Business managers stress that understanding and predicting cash flows is critical for making informed business decisions.

  • Creditors and investors decisions are also heavily based on a company’s cash flow evaluations and its cash flow projections.

  • Operating cash flows are the most significant: is the company’s ongoing operations generating cash?

Decision Analysis – Cash Flow on Total Assets

  • Cash Flow on Total Assets – similar to return on total assets.

    • Cash Flow on Total Assets=Net Cash from Operating ActivitiesAverage Total Assets\text{Cash Flow on Total Assets} = \frac{\text{Net Cash from Operating Activities}}{\text{Average Total Assets}}

  • However, the return is analyzed based on operating cash flows rather than net income.

  • Used to assess company performance.

  • Is there adequate cash flow to meet obligations, expand operations, and obtain financing?

  • How much operating cash is being generated by the company’s assets?