The Statement of Cash Flows pgb

Created by Patrick Badolato, Doctoral Student at Duke University’s Fuqua School of Business.

The Balance Sheet and Income Statement are based on accrual accounting.
The SCF provides additional information on cash inflows (receipts) and outflows (payments) during a period.
Accrual accounting records transactions in a legal/economic sense rather than when cash is exchanged.
Accruals are recorded entries reflecting economic events without cash impact.
The SCF aids in company valuation by comparing earnings with cash flow performance.
Valuation models often relate a firm's value to the net present value of cash flows.

The most common method for preparing the SCF in academics and corporate practice.
Less common is the Direct Method, which achieves similar results but differs in detail.
Focus moving forward will be on the Indirect Method.

Represents cash transactions from day-to-day business activities (e.g., cash received from customers, cash paid in expenses).
Reconciles net income (from accrual-based income statement) to cash received or paid for operations within the reporting period.

Cash transactions related to investments in non-current assets (e.g., acquiring or selling property).

Reflects cash transactions with creditors and owners (e.g., debt issuance, stock sales).

Increase in an Asset:
- Considered a USE OF CASH and SUBTRACTED in the SCF.
Decrease in an Asset:
- Considered a SOURCE OF CASH and ADDED in the SCF.
Example with Accounts Receivable (AR):
- Increase in AR means customers paid less cash, whereas a decrease means they paid more cash.

Decrease in a Liability:
- Considered a USE OF CASH and SUBTRACTED in the SCF.
Increase in a Liability:
- Considered a SOURCE OF CASH and ADDED in the SCF.
Example with Accounts Payable (AP):
- Increase in AP means less cash paid out to suppliers; decrease means more cash paid out.

Begin with NET INCOME.
Add non-cash expenses (e.g., depreciation, amortization).
Reverse out non-cash gains/losses from non-current assets sales.
Adjust changes in Working Capital Accounts (Type 2 entries)—current non-cash assets and liabilities.
DO NOT INCLUDE the change in cash from the balance sheet.

Add proceeds from the sale of investment-related assets.
Subtract purchase of investment-related assets.
Non-cash transactions should be excluded.
Net Property, Plant, and Equipment (PPE) reflects depreciation adjustments when calculating cash spent on PPE.

Add proceeds from the sale of stock or debt issuance (long and short term).
Subtract cash spent on purchasing treasury stock or redeeming debt.
Dividends paid are classified as financing activities and should be calculated using the formula:
- Dividends = Ending Retained Earnings – Net Income – Beginning Retained Earnings.

Cash Flows from Operating Activities:
1. Start with Net Income
2. Add Non-Cash Expenses
3. Adjust for Changes in Non-Cash Assets
4. Adjust for Changes in Current Liabilities
5. Total Cash Flows from Operating Activities
Cash Flows from Investing Activities:
- Adjust for changes in Non-Current Assets.
Cash Flows from Financing Activities:
- Adjust for changes in Liabilities and Owner's Equity.
Net Change in Cash for the Period is finalized at the end.

An example illustrates a balance sheet transition from one year to the next and highlights cash flow impacts from the various accounts (assets, liabilities, SE).

Ensure all balance sheet items are accounted for; omit cash changes as final checks.
Differentiate the working capital ratio from cash sources/uses in working capital accounts.
Be attentive to account nature to determine SCF placement.
Keep in mind non-cash transactions and consider drawing T-Accounts for precision in cash transaction assessments.