Chapter 12: Reporting Cash Flows

Chapter 12: Reporting Cash Flows

Learning Objectives

• Conceptual Objectives

  • C1: Distinguish between operating, investing, and financing activities, and describe how noncash investing and financing activities are disclosed.

• Analytical Objectives

  • A1: Analyze the statement of cash flows and apply the cash flow on total assets ratio.

• Procedural Objectives

  • P1: Prepare a statement of cash flows.

  • P2: Compute cash flows from operating activities using the indirect method.

  • P3: Determine cash flows from both investing and financing activities.

  • P4: Illustrate use of a spreadsheet to prepare a statement of cash flows.

  • P5: Compute cash flows from operating activities using the direct method.

Purpose of the Statement of Cash Flows

• Understanding of cash flows is essential as they provide insight into:

  • Cash Inflows and Outflows

  • How a company receives and spends cash.

  • Income vs. Cash Flows

  • Mismatches between reported income and actual cash flow.

  • Changes in Cash Balances

  • Explanation of changes in the cash balance.

Importance of Cash Flows

• Users benefit from cash flow information to:

  • Assess whether the company has sufficient cash to meet its debts.

  • Evaluate the company's potential for pursuing new opportunities.

  • Aid managers in planning daily operations.

  • Assist managers in making informed long-term investment decisions.

Measurement of Cash Flows

• Cash flows encompass cash and cash equivalents.

• Criteria for Cash Equivalents

  1. Must be readily convertible to cash.

  2. Must be close to maturity such that market value is unaffected by interest rate changes.

Classification of Cash Flows

• The Statement of Cash Flows is divided into three main sections:

  1. Operating Activities

  2. Investing Activities

  3. Financing Activities

Links to Balance Sheet

• Cash flow classifications have connections to the balance sheet:

  • Operating Activities

  • Affected by changes in current assets and current liabilities.

  • Investing Activities

  • Affected by changes in long-term assets.

  • Financing Activities

  • Affected by changes in long-term liabilities and equity.

Noncash Investing and Financing Activities

• Examples of noncash activities must be disclosed separately in financial statements.

Preparing a Statement of Cash Flows

• Format of the Statement:

  • The structure includes sections for operating, investing, and financing activities.

• Information Sources:

  • Comparative balance sheets, current income statements, and any additional information relevant to cash flows.

Cash Flows from Operating Activities

• Indirect Method

  • Utilizes net income and adjusts for noncash transactions:

  • Adjustments

    • Expenses and losses without cash outflows are added back to net income.

    • Revenues and gains without cash inflows are subtracted from net income.

• Changes in Current Assets and Liabilities

  • Increases in current assets are subtracted from net income.

  • Decreases in current assets are added to net income.

  • Increases in current liabilities are added to net income.

  • Decreases in current liabilities are subtracted from net income.

Summary of Adjustments for Indirect Method

• Common adjustments for computing net cash via indirect method involve analyzing changes in various accounts.

Cash Flows from Investing Activities

• Analytical Method

  1. Identify changes in accounts related to investing.

  2. Determine cash effects using T-accounts and reconstructed entries.

  3. Report cash flow effects.

• **Example Adjustments:

  • Plant asset purchases, depreciation, and sales of assets should be documented and analyzed for cash impact.**

Cash Flows from Financing Activities

• Follow a similar three-step analysis as investing activities:

  1. Identify changes in financing-related accounts.

  2. Determine cash effects using T-accounts and reconstructed entries.

  3. Report cash flow effects.

• Key Aspects

  • Track increases or decreases in notes payable, common stock transactions, and retained earnings.

Cash Flow on Total Assets Ratio

• Formula
  $ext{Cash Flow on Total Assets} = rac{ ext{Cash Flows from Operations}}{ ext{Average Total Assets}}$

• This ratio helps assess overall performance alongside income-based ratios.

Use of Spreadsheets

• Spreadsheets serve as a practical tool for organizing the preparation process of the statement of cash flows.

Direct Method of Reporting Operating Cash Flows

• Involves adjusting income statement accounts related to operational activities based on balance sheet changes.

  • Framework necessitates direct reporting of cash receipts and payments for detailed cash flow understanding.

Conclusion

• Understanding the statement of cash flows is crucial for analyzing a company's financial health and making informed decisions based on actual cash flows, rather than mere accounting profits.

  • Each section (operating, investing, financing) plays a pivotal role in providing a clear picture of cash movement within a business.