Chapter 4: Reporting and Analyzing Cash Flows

Purpose of the Statement of Cash Flows

• Provides insights into how a company generates and utilizes cash.

• Assists investors and creditors in:

  • Evaluating a company's ability to settle liabilities and pay dividends.

  • Determining the need for external financing.

  • Observing and assessing management's investment and financing strategies.

Cash and Cash Equivalents

• Definition: Short-term, highly liquid investments that are:

  • Easily convertible into a known amount of cash.

  This means the investment is so close to its end date that changes in interest rates won't significantly affect its value.

• Maturity: Typically three months or less.

• Examples:

  • Money market accounts

  • Treasury bills

  • Commercial paper

• On the statement of cash flows:

  • Cash equivalents are combined with cash.

  • Cash with restrictions is also included.

  • Treated as a single sum.

  • Rationale: Purchase and sale of cash equivalents are part of cash management, not a source or use of cash.

  • Managers often refer to cash and cash equivalents as ‘cash’.

Framework for the Statement of Cash Flows

• Cash receipts and payments are categorized into:

  • Operating Activities

  • Investing Activities

  • Financing Activities

• The statement explains the change in cash and cash equivalents.

Operating Activities

• Focus: Selling goods or rendering services.

• Broad Definition: Includes any cash receipts or payments not classified as investing or financing.

• Reporting:

  • Income Statement: Accrual Basis

  • Statement of Cash Flows: Cash Basis

• Examples: Cash received and paid related to selling goods and rendering services directly related to the company’s primary day-to-day business activities.

Investing Activities

• Cash flows involving:

  • Acquiring and disposing of property, plant, and equipment (PP&E) and intangible assets. (copyrights, patents, and trademarks are examples of intangible assets that companies may acquire or sell as part of their investing activities.

  • Purchasing and selling government securities and other companies’ stocks, bonds, and non-cash-equivalent securities.

  • Lending and subsequent collection of money.

Financing Activities

• Cash flows involving:

  • Receiving cash from shareholders.

  • Returning cash to shareholders.

  • Borrowing from creditors.

  • Repaying amounts borrowed from creditors.

Preparing the Operating Section of the Statement of Cash Flows

• The difference between a revenue or an expense reported in the income statement and a related cash receipt or expenditure reported in the statement of cash flows will be reflected as a change in one or more balance sheet accounts.

• Convert revenue and expenses to cash flows from operating activities with the following adjustments:

  • Convert sales revenues to cash receipts from customers.

  • Convert cost of goods sold to cash paid for merchandise purchased.

  • Convert wages expense to cash paid to employees.

  • Convert rent expense and advertising expense to cash paid amounts.

  • Convert other adjusting entries to cash flows.

  • Eliminate depreciation expense and other noncash operating expenses.

1. Convert Sales Revenues to Cash Received from Customers

• Formula: $Cash flow = Net income - (Revenue) accounts receivable + Change in unearned revenue$

2. Convert Cost of Goods Sold to Cash Paid for Merchandise Purchased

• Formula: $Cash flow = Net income + (COGS expense) - inventory - Change in accounts payable$

3. Convert Wages Expense to Cash Paid to Employees

• The relationship can be rewritten as follows:

4. Convert Rent and Advertising Expenses to Cash Paid Amounts

• For these items, the cash amount paid is exactly equal to the amount recorded as an expense, so no adjustment is necessary.

5. Other Adjustments: Convert Insurance Expense to Cash Paid for Insurance

• The relationship can be rewritten as follows:

6. Other Adjustments: Convert Interest Expense to Cash Paid for Interest

• The relationship can be rewritten as follows:

7. Other Adjustments: Convert Interest Income to Cash Received for Interest

• The relationship can be rewritten as follows:

8. Other Adjustments: Convert Interest Income to Cash Received for Interest

• The relationship can be rewritten as follows:

9. Other Adjustments: Eliminate Depreciation and Noncash Operating Expenses

• The relationship can be rewritten as follows: Therefore, depreciation is a noncash item. Cash paid for depreciation is always $0.

10. Other Adjustments: Eliminate Non-Operating Gains and Losses

• Omit any gains and losses related to investing and financing activities.

  • Removed because

    • Not related to operating activities

    • Not cash flow amounts

  • Examples

    • Gains and losses due to sale of plant assets

    • Gains and losses from the retirement of bonds payable

Direct vs. Indirect Methods

• Differ only in the operating activities format.

• Both report the same cash flows from operating activities.

• Companies that use the direct method are required to present a supplemental disclosure showing the reconciliation of net income to cash from operations.

Cash Flows from Investing Activities

• Cause changes in noncash asset accounts, typically,

  • Noncurrent operating assets—property, plant, and equipment

  • Investing assets—marketable securities, long-term financial assets and acquisitions

• Analyze changes in all noncash asset accounts not used in computing net cash flow from operating activities

  • Cash flows decrease due to: An increase in assets

  • Cash flows increase due to: A decrease in assets

Cash Flows from Financing Activities

• Cause changes financing liabilities and stockholders’ equity accounts

  • Long-term liabilities and some short-term notes payable

  • Stockholders’ equity

• Analyze changes in all liability and stockholders’ equity accounts not used in computing net cash flow from operating activities

  • Cash flows increase due to: An increase in liabilities or stockholders’ equity

  • Cash flows decrease due to: A decrease in liabilities or stockholders’ equity

Gains and Losses

• FASB requires that financing and investing items be included at gross cash amounts in the statement of cash flows

  • Gains

    • Result when plant assets or financial assets are sold for more than their book value

    • Are special revenue accounts

  • Losses

    • Result when plant assets or financial assets are sold for less than their book value

    • Are special expense accounts

Noncash Investing and Financing Activities

• Not all significant investing and financing events affect current cash flows

  • Examples

    • Issue stock in exchange for land

    • Purchase a building by borrowing

• Noncash investing and financing transactions are supplemental to the statement of cash flows.

Supplemental Disclosures

• Three disclosures are required:

  • Cash paid for interest and for income taxes if the indirect method is used

  • A schedule of all noncash investing and financing activities

  • Policy for determining which highly liquid, short-term investments are treated as cash equivalents

Use a spreadsheet to construct the statement of cash flows.

• Step 1: Classify the Balance Sheet Accounts

• Step 2: Compute the Changes in Balance Sheet Accounts

• Step 3: Handle Accounts with Single Classifications

• Step 4: Enter the Effects of Investing and Financing Transactions that Do Not Involve Cash

• Step 5: Analyze the Changes in Retained Earnings

• Step 6: Analyze the Change in Plant Assets

• Step 7: Total the Columns

• Step 8: Prepare the Cash Flow Statement

Operating Cash Flow to Current Liabilities

• A measure of the ability to liquidate current liabilities.

Operating Cash Flow to Capital Expenditures & Free Cash Flow

• Helps assess if a firm is able to replace, and expand property, plant, and equipment.