Chapter 21 - Statement Of Cash Flows

Purpose and Usefulness of the Statement of Cash Flows (SCF)

The Statement of Cash Flows (SCF) is a fundamental financial document providing information about the cash receipts and cash payments of an entity during a specific period. It assists investors and creditors in making meaningful projections of a company's future profitability and risk.

  • Decision Makers' Perspective: Investors and creditors use the SCF to answer critical questions:

    • In what types of activities is the company investing?
    • Are activities financed with debt, equity, or cash generated from operations?
    • Are facilities being acquired for future expansion?
    • How does cash from operations compare with net income over time?
    • Why isn't the increase in retained earnings reflected as an increase in dividends?
    • What happened to cash received from asset sales?
    • By what means is debt being retired?

  • Case Studies in SCF Importance:

    • W. T. Grant (1970s): This retailer appeared healthy on a working capital basis (46 million46\,\text{million} in 19721972), but the SCF would have revealed negative operating cash flows of −10 million-10\,\text{million}, which grew to a deficiency of −114 million-114\,\text{million} by 19731973. The company eventually filed for bankruptcy despite appearing profitable on an accrual basis.
    • Toys R Us: In its final three years (2014−20162014-2016), positive operating cash flow was dwarfed by massive cash outflows for debt repayments following a leveraged buyout (LBO).
    • Amazon.com: Amazon survived a decade of losses because it raised significant cash through selling stock (financing activities), which funded expansion until it became one of the world's largest companies with positive operating cash flows.

Classification of Cash Flow Activities

Cash flows are categorized into three primary types of activities:

  • Operating Activities: Transactions related to the normal operations and the production of net income. This involves day-to-day functions such as:

    • Inflows: Cash received from customers for goods/services; interest and dividend income on investments.
    • Outflows: Cash paid to employees; cash paid for inventory/supplies; payments for utilities, insurance, rent, marketing; interest paid on debts; income taxes paid.

  • Investing Activities: Transactions involving the acquisition and disposition of long-term assets and other investments (excluding cash equivalents and trading securities).

    • Inflows: Selling property, plant, and equipment (PPE); selling investments in securities of other firms; collecting the principal amount on loans made to others.
    • Outflows: Buying PPE (land, buildings, equipment); purchasing stocks or bonds of other companies; lending money to other entities.

  • Financing Activities: External financing transactions between the firm and its owners/creditors.

    • Inflows: Selling the company’s own stock (common or preferred); borrowing money through the issuance of bonds, notes, or other debt securities.
    • Outflows: Repurchasing the company's own stock (treasury stock or retirement); repaying the principal on debt; paying cash dividends to shareholders.

Cash, Cash Equivalents, and Restricted Cash

For the purposes of the SCF, "Cash" refers to the total of cash, cash equivalents, and restricted cash.

  • Cash Equivalents: Short-term, highly liquid investments that are readily convertible to cash with little risk of loss.

    • Criteria: To be a cash equivalent, an investment must have a maturity date no longer than three months (90 days) from the date of purchase.
    • Examples: Money market funds, Treasury bills (T-bills), and commercial paper.
    • Reporting: Companies must disclose their policy regarding cash equivalents in the notes. Transfers between the cash account and cash equivalents (e.g., buying a 100,000100,000 T-bill with cash) are not reported on the SCF as they do not change the total cash balance.

  • Restricted Cash: Cash set aside for specific purposes (e.g., debt repayment, workers' compensation claims) is included as part of the total cash balance reported on the SCF.

Operating Activities: Direct vs. Indirect Methods

GAAP allows two methods for reporting Operating Activities. Both result in the same net cash flow total.

  • Direct Method: Directly reports the specific nature of cash receipts and payments (e.g., "Cash received from customers," "Cash paid to employees").

    • FASB Preference: The FASB strongly encourages the direct method because it is more transparent and easier for users to interpret.
    • Requirement: If the direct method is used, the company must also provide a reconciliation of net income to operating cash flows (which is effectively the indirect method) in a separate schedule.

  • Indirect Method: Starts with Net Income and works backward to convert it to a cash basis by adjusting for non-cash items and changes in current assets/liabilities.

    • Prevalence: The vast majority of companies use this method because it is easier to prepare and keeps certain operational details from competitors.
    • Mechanism: Adjustments include adding back non-cash expenses (depreciation) and adjusting for the "Opposite" direction of Current Assets and the "Same" direction of Current Liabilities.

Preparation of the Statement of Cash Flows

To prepare an SCF, three sources are required: the current year's Income Statement, comparative Balance Sheets (current and prior year), and additional transaction data.

  • The Roadmap for Analysis:

    • Operating: Income Statement + Current Assets + Current Liabilities.
    • Investing: Non-current (Long-term) Assets.
    • Financing: Non-current Liabilities + Equity.

  • Reconciliation of Total Cash: A mandatory final step is verifying that the sum of the three sections equals the actual change in the cash balance from the start of the year (Jan 1) to the end (Dec 31).

In-Depth Account Analysis and Journal Entries (Direct Method)

1. Cash Received from Customers

Determine using Sales Revenue and the change in Accounts Receivable (AR). Beginning AR+Sales Revenue−Cash Received=Ending AR\text{Beginning AR} + \text{Sales Revenue} - \text{Cash Received} = \text{Ending AR}

  • Example: Beginning AR was 30 M30\,\text{M}, Sales were 100 M100\,\text{M}, and Ending AR was 32 M32\,\text{M}.
    • 30+100−X=32  ⟹  X=98 M30 + 100 - X = 32 \implies X = 98\,\text{M}.
2. Cash Paid to Suppliers (The Most Complex Calculation)

This requires a two-step process involving Cost of Goods Sold (COGS), Inventory, and Accounts Payable (AP).

  • Step A: Determine Purchases:Beginning Inventory+Purchases−COGS=Ending Inventory\text{Beginning Inventory} + \text{Purchases} - \text{COGS} = \text{Ending Inventory}
  • Step B: Determine Cash Paid:Beginning AP+Purchases−Cash Paid=Ending AP\text{Beginning AP} + \text{Purchases} - \text{Cash Paid} = \text{Ending AP}
  • Example: COGS 60 M60\,\text{M}, Inventory decreased by 4 M4\,\text{M} (50 M50\,\text{M} to 46 M46\,\text{M}), AP increased by 6 M6\,\text{M} (20 M20\,\text{M} to 26 M26\,\text{M}).
    • Step A: 50+X−60=46  ⟹  X=56 M50 + X - 60 = 46 \implies X = 56\,\text{M} (Purchases).
    • Step B: 20+56−Y=26  ⟹  Y=50 M20 + 56 - Y = 26 \implies Y = 50\,\text{M} (Cash Paid).
3. Cash Paid to Employees

Relate Salaries Expense to the change in Salaries Payable. Beginning Salaries Payable+Salaries Expense−Cash Paid=Ending Salaries Payable\text{Beginning Salaries Payable} + \text{Salaries Expense} - \text{Cash Paid} = \text{Ending Salaries Payable}

  • Example: Expense 13 M13\,\text{M}, Payable increased from 1 M1\,\text{M} to 3 M3\,\text{M}.
    • 1+13−X=3  ⟹  X=11 M1 + 13 - X = 3 \implies X = 11\,\text{M}.
4. Other Expenses (Insurance and Interest)
  • Insurance: Decrease in Prepaid Insurance indicates cash paid was less than the expense.
    • Expense−Decrease in Prepaid Asset=Cash Paid\text{Expense} - \text{Decrease in Prepaid Asset} = \text{Cash Paid}
  • Interest: Must account for bond discounts/premiums.
    • Interest Expense−Discount Amortization=Cash Paid to Bondholders\text{Interest Expense} - \text{Discount Amortization} = \text{Cash Paid to Bondholders}

Non-Cash Investing and Financing Activities

Significant transactions that affect assets, liabilities, or equity but do not involve cash must be disclosed in a separate schedule or note.

  • Examples:
    • Acquiring an asset by issuing a long-term note payable (e.g., buying 20 M20\,\text{M} of equipment with a 20 M20\,\text{M} note).
    • Acquiring an asset via a lease agreement.
    • Converting debt into common stock.
    • Exchanging non-cash assets.
  • Note: Stock dividends are NOT considered non-cash investing/financing activities because they do not affect assets or liabilities; they are mere transfers within shareholders' equity.

Adjustments for the Indirect Method

When using the indirect method, Net Income is adjusted as follows:

  • Adjustments for Non-Cash Effects:

    • Add back: Depreciation expense, Amortization expense, Losses on the sale of assets.
    • Deduct: Gains on the sale of assets.

  • Adjustments for Changes in Operating Assets and Liabilities:

    • Current Assets: Deduct an increase; Add a decrease (Opposite direction).
    • Current Liabilities: Add an increase; Deduct a decrease (Same direction).

US GAAP vs. IFRS Differences

  • Interest and Dividends:
    • US GAAP: Interest Expense, Interest Income, and Dividend Income must be in Operating Activities because they reflect items on the Income Statement. Dividends Paid is in Financing Activities.
    • IFRS: Offers more flexibility. Interest and Dividends Received are usually Investing Activities. Interest and Dividends Paid are usually Financing Activities.

Cash Flow Ratios

Analysts often substitute Cash Flow from Operations (CFFO) into traditional ratios to assess financial health.

Performance Ratios
  1. Cash Flow to Sales: CFFONet Sales\frac{\text{CFFO}}{\text{Net Sales}}
  2. Cash Return on Assets: CFFOAverage Total Assets\frac{\text{CFFO}}{\text{Average Total Assets}}
  3. Cash Return on Shareholders' Equity: CFFOAverage Shareholders’ Equity\frac{\text{CFFO}}{\text{Average Shareholders' Equity}}
  4. Cash to Income: CFFOIncome from Continuing Operations\frac{\text{CFFO}}{\text{Income from Continuing Operations}}
  5. Cash Flow per Share: CFFO−Preferred DividendsWeighted-Average Shares Outstanding\frac{\text{CFFO} - \text{Preferred Dividends}}{\text{Weighted-Average Shares Outstanding}} (Note: Prohibited from being reported on the face of the SCF).
Sufficiency Ratios
  1. Debt Coverage: Total LiabilitiesCFFO\frac{\text{Total Liabilities}}{\text{CFFO}}
  2. Interest Coverage: CFFO+Interest+TaxesInterest\frac{\text{CFFO} + \text{Interest} + \text{Taxes}}{\text{Interest}}
  3. Reinvestment: CFFOCash Outflow for Noncurrent Assets\frac{\text{CFFO}}{\text{Cash Outflow for Noncurrent Assets}}
  4. Dividend Payment: CFFOCash Outflow for Dividends\frac{\text{CFFO}}{\text{Cash Outflow for Dividends}}

Appendices: Methods of Preparation

  • Spreadsheet Method: Organized by entering beginning/ending balances of all non-cash accounts. Reconstructs journal entries in "changes" columns to ensure every account balance change is explained. If an entry involves cash, it is categorized into one of the three SCF sections.
  • T-Account Method: Similar to the spreadsheet but involves drawing T-accounts for every balance sheet and income statement item. A large Cash T-account is used to track Operating, Investing, and Financing flows. This is often