Statement of Cash Flows - Notes

Financial Accounting for Undergraduates 5E

Statement of Cash Flows

• Classifies cash receipts (inflows) and cash payments (outflows) into three key activities.
• Reconciles the net increase or decrease in cash during the period with the beginning and ending cash on the balance sheet.

Cash and Cash Equivalents

• Cash equivalents are investments easily convertible into cash and close to maturity (typically within three months).
• Examples: US treasury bills, certificates of deposit, commercial paper, money market funds.
• Companies must disclose their policy for determining which investments are considered cash equivalents.
• Cash and cash equivalents are added together and treated as a single amount on the statement of cash flows.

Noncash Investing & Financing Activities

• Some significant investing and financing activities do not affect current cash flows but generally affect future cash flows.
• Examples include:
  • Issuance of stock or bonds for long-term assets
  • Exchange of long-term assets for other long-term assets
  • Conversion of long-term debt into common stock
• Companies must disclose information regarding material noncash investing and financial activities immediately following the statement of cash flows or in a financial statement note.

Cash Flow from Operating Activities

• Two presentation formats:
  • Indirect method: Starts with net income (accrual basis) and makes adjustments to derive cash flow from operating activities (cash flow basis).
  • Direct method: Shows individual operating cash inflows and outflows, which are summed to calculate cash flow from operating activities.
• Cash flow from investing activities and cash flow from financing activities are presented the same way with both formats.

Change in Cash

• The change in cash can be computed from changes in all other balance sheet accounts.
• Assets (A) = Liabilities (L) + Stockholders’ Equity (SE)
  A = L + SE
• Separate assets into cash and non-cash assets (NCA):
  Cash + NCA = L + SE
• Rewrite the elements as changes (∆):
  ∆Cash + ∆NCA = ∆L + ∆SE
• Rearrange to show that the change in cash (cash flow) is explained by changes in all other balance sheet accounts:
  ∆Cash = ∆L – ∆NCA + ∆SE

Change in Cash (Detailed)

• Separate non-cash assets and liabilities into short-term (ST) and long-term (LTA) categories and rearrange by type of activity: ∆Cash = ∆L – ∆NCA + ∆SE ∆Cash = [∆STL – ∆STA] – ∆LTA + [∆LTL + ∆SE]
  • Operating Activities: [∆STL – ∆STA]
  • Investing Activities: - ∆LTA
  • Financing Activities: [∆LTL + ∆SE]

Operating Activities - Indirect Method

• Indirect method—starts with net income (accrual basis) and makes adjustments to determine operating cash flows (cash flow basis).
• To prepare the operating section of the statement of cash flows, the following information is needed:
  • Balance sheets for the current and prior year
  • Income statement
  • Additional data from the company's financial records (possibly)

Five Steps to Cash Flow - Step 1

• Calculate the change in each balance sheet account by subtracting the beginning balance from the ending balance.
• Calculate the change in the PP&E account net of accumulated depreciation.
• Verify that the net change in assets equals the net change in liabilities plus stockholders’ equity.

Five Steps to Cash Flow - Step 2

• Classify each of the changes in balance sheet accounts as operating, investing, or financing: ∆Cash = [∆STL – ∆STA] – ∆LTA + [∆LTL + ∆SE]
  • Operating Activities
  • Investing Activities
  • Financing Activities

Five Steps to Cash Flow - Step 3

• Prepare a preliminary statement of cash flows.
• Organize the changes in account balances by type (operating, investing, financing).
• List the amounts following the equation for ∆Cash: ∆Cash = ∆L – ∆NCA + ∆SE
  • Add changes in liabilities and stockholders’ equity accounts
  • Subtract changes in noncash asset accounts

Five Steps to Cash Flow - Step 4

• Integrate income statement data.
• Replace the change in retained earnings with net income (operating) and dividends paid (financing).
• Add back noncash expenses to net income and subtract from investing.
  • Depreciation expense
  • Amortization expense

Five Steps to Cash Flow - Step 5

• Remove the effects of any nonrecurring or nonoperating transactions from net income.
• For example, gains or losses on disposal of long-term assets
  • Loss from disposal of long-term assets
    • Add back loss to net income
    • Include cash received as investing cash inflow
  • Gain from disposal of long-term assets
    • Subtract gain from net income
    • Include cash received as investing cash inflow

Free Cash Flow

• Indicates the amount of cash flow generated beyond what is needed to operate the business at its current productive capacity.
• Free cash flow is available for capital expansion, paying dividends, repaying debt, or other purposes.
  Free cash flow = Cash flow from operating activities – Capital expenditures

Operating Cash Flow to Current Liabilities Ratio

• Measures a company’s ability to pay its current liabilities using operating cash flows.
• Similar in nature to the current ratio and the quick ratio.
  Operating cash flow to current liabilities ratio = \frac{Cash flow from operating activities}{Average current liabilities}

Operating Cash Flow to Capital Expenditures Ratio

• Measures a company’s ability to finance its capital expenditures from operating cash flow.
• A ratio > 1.0 indicates that current operating activities are generating sufficient cash to fund capital investment.
• Firms in a growth phase of their life cycle will likely have a lower ratio than firms in a mature phase.
  Operating cash flow to capital expenditures ratio = \frac{Cash flow from operating activities}{Annual net capital expenditures}

Direct Method

• Direct method cash flow from operations can be prepared from the information in the company’s general ledger cash account.
• This information is not available to external users.
• The adjustments in the indirect method to convert net income to operating cash flows can be used to convert revenues/expenses (accrual basis) to cash inflows/outflows (cash basis).
• Replace net income with the individual income statement line items.
• Adjust the income statement line items by the related amounts from the indirect method.

Direct Method Conversion

Direct Method Conversion Schedule: Adjustments to Convert Income Statement Items to Operating Activity Cash Flows