Statement of Cash Flows (Indirect Method) – Comprehensive Study Notes

Overview: Statement of Cash Flows

  • Covers a period (e.g., 1 year); reconciles beginning cash balance → ending cash balance.

  • Answers three core questions:

    • How was cash generated or used?

    • Does the firm generate enough cash to pay dividends & meet obligations?

    • Is cash from normal operations positive, indicating future ability to create cash?

  • Broken into three sections (always appear in this order on the finished statement):

    1. Operating Activities (OA) – cash from core business/income-statement items.

    2. Investing Activities (IA) – cash related to long-term assets & investments.

    3. Financing Activities (FA) – cash from/for long-term liabilities & equity.

  • Two preparation approaches:

    • Indirect method (required, easier, most common, focus of course).

    • Direct method (shown for illustration only, rarely used, more complex).

Usefulness & Decision-Making

  • Investors/creditors study cash flows to judge:

    • Dividend-paying capacity.

    • Liquidity & solvency (ability to meet due dates).

    • Future cash-flow potential.

  • Example comparisons (Income vs Cash-flow):

    • Apple: NI=$55B→NCFOp=$69B\text{NI}=\$55\text{B} \rightarrow \text{NCF}_\text{Op}=\$69\text{B} (\$14 B higher).

    • Retail sample (Kohl’s, Walmart, Target, etc.): cash from ops differs widely from accrual profit.

Core Categories in Detail

1. Operating Activities (OA)

  • Inflows:

    • Cash collections from customers (sales).

    • Interest & dividend income on investments.

  • Outflows:

    • Payments to suppliers, employees, tax authorities, lenders (interest), etc.

  • Indirect method starts with Net Income (accrual) and adjusts for:

    • Non-cash expenses – add back depreciation, amortization.

    • Gains/Losses on asset sales – subtract gains, add losses (actual cash goes to IA).

    • Changes in current assets/liabilities:

    • ↑Current Asset⇒Subtract\uparrow \text{Current Asset} \Rightarrow \text{Subtract}

    • ↓Current Asset⇒Add\downarrow \text{Current Asset} \Rightarrow \text{Add}

    • ↑Current Liability⇒Add\uparrow \text{Current Liability} \Rightarrow \text{Add}

    • ↓Current Liability⇒Subtract\downarrow \text{Current Liability} \Rightarrow \text{Subtract}

    • Memory aid: Balance the equation Assets=Liabilities+Equity\text{Assets}=\text{Liabilities}+\text{Equity} by solving for the change in Cash.

2. Investing Activities (IA)

  • Cash outflows:

    • Purchase of property, plant & equipment (PP&E), intangibles.

    • Purchase of debt/equity securities of other entities.

    • Making loans (notes receivable).

  • Cash inflows:

    • Sale of PP&E or intangibles.

    • Sale/collection of investments or notes receivable.

3. Financing Activities (FA)

  • Cash inflows:

    • Issuing common/preferred stock.

    • Issuing bonds or notes; new bank borrowing.

  • Cash outflows:

    • Dividend payments.

    • Repayment of principal on debt.

    • Treasury-stock purchases.

  • Interest expense is NOT FA (it’s OA → income-statement item).

4. Non-cash Investing & Financing (NCIF)

  • Significant exchanges with zero immediate cash (disclosed separately):

    • Land acquired by issuing stock.

    • Bonds converted to equity.

    • Asset swaps (building for building).

    • PP&E purchased via long-term note.

Preparation Requirements & Steps (Indirect Method)

  1. Gather:

    • Comparative balance sheets (current & prior year).

    • Current income statement.

    • Supplemental data (e.g., asset sale details, depreciation breakdown, dividend declarations).

  2. Compute OA section:

    • Start with Net Incomeaccrual\text{Net Income}_{\text{accrual}}.

    • Add back non-cash charges.

    • Reverse gains/losses on asset sales.

    • Adjust for changes in working-capital accounts.

  3. Determine IA from changes in long-term assets & supplemental info.

  4. Determine FA from changes in long-term debt & equity accounts.

  5. Reconcile: Change in Cash=NCF<em>Op+NCF</em>Inv+NCFFin\text{Change in Cash}=\text{NCF}<em>\text{Op}+\text{NCF}</em>\text{Inv}+\text{NCF}_\text{Fin}.

  6. Verify: Beg. Cash+Change=End Cash (Balance Sheet)\text{Beg. Cash}+\text{Change}=\text{End Cash (Balance Sheet)}.

Comprehensive Classroom Example – Computer Services Co.

Data Snapshot

  • Net income: $145,000\$145{,}000 (accrual).

  • Depreciation expense: $9,000\$9{,}000.

  • Loss on equipment sale: $3,000\$3{,}000.

  • Working-capital changes (12/31/18 → 12/31/19):

    • Accounts receivable: 30k→20k30\text{k} \rightarrow 20\text{k} (↓ 10k10\text{k}).

    • Inventory: 10k→15k10\text{k} \rightarrow 15\text{k} (↑ 5k5\text{k}).

    • Prepaid expenses: 1k→5k1\text{k} \rightarrow 5\text{k} (↑ 4k4\text{k}).

    • Accounts payable: 12k→28k12\text{k} \rightarrow 28\text{k} (↑ 16k16\text{k}).

    • Income taxes payable: 8k→6k8\text{k} \rightarrow 6\text{k} (↓ 2k2\text{k}).

  • Non-cash exchange: issued $110,000\$110{,}000 bonds for land.

  • Other IA / FA events:

    • Bought building $120,000\$120{,}000 cash.

    • Bought equipment $25,000\$25{,}000 cash.

    • Sold equipment (cost $8,000\$8{,}000, accum. dep. $1,000\$1{,}000) for $4,000\$4{,}000.

    • Issued common stock $20,000\$20{,}000 cash.

    • Dividends paid $29,000\$29{,}000.

OA Section (Indirect)

Adjustment

Logic

Effect

Start NI 145k145\text{k}

accrual base

—

+ Depreciation 9k9\text{k}

non-cash

+

+ Loss on sale 3k3\text{k}

remove from OA

+

+ Decrease A/R 10k10\text{k}

collected > sales

+

– Increase Inventory 5k5\text{k}

bought > COGS

–

– Increase Prepaids 4k4\text{k}

more cash spent

–

+ Increase A/P 16k16\text{k}

paid < expenses

+

– Decrease Tax Payable 2k2\text{k}

paid > expense

–

Net OA cash

$172,000\$172{,}000

IA Section

  • Purchase building (cash out): −$120,000−\$120{,}000.

  • Purchase equipment (cash out): −$25,000−\$25{,}000.

  • Proceeds from equipment sale (cash in): +$4,000+\$4{,}000.

  • Net IA cash: −$141,000−\$141{,}000.

FA Section

  • Issue common stock (cash in): +$20,000+\$20{,}000.

  • Dividends paid (cash out): −$29,000−\$29{,}000.

  • Net FA cash: −$9,000−\$9{,}000.

Overall Reconciliation

NCF<em>Op=+172k\text{NCF}<em>\text{Op}=+172\text{k} NCF</em>Inv=−141k\text{NCF}</em>\text{Inv}=−141\text{k}
NCFFin=−9k\text{NCF}_\text{Fin}=−9\text{k}
ΔCash=+22k\Delta\text{Cash}=+22\text{k}
Beg. cash 33k→33\text{k} \rightarrow End cash 55k55\text{k} (matches balance sheet).

NCIF Disclosure (footnote / schedule)

  • Issued $110,000\$110{,}000 bonds in direct exchange for land (no cash).

Analytical Metrics

Free Cash Flow (FCF)

FCF=Net Cash from OA−Capital Expenditures−Dividends\displaystyle \text{FCF}=\text{Net Cash from OA} - \text{Capital Expenditures} - \text{Dividends}

  • Microsoft 2015 example:

    • NCFOp=$29.1B\text{NCF}_\text{Op}=\$29.1\text{B}.

    • CapEx=$5.9B\text{CapEx}=\$5.9\text{B}.

    • Dividends=$9.8B\text{Dividends}=\$9.8\text{B}.

    • FCF=$13.4B\text{FCF}=\$13.4\text{B} free for other uses.

Lending Example (ABC vs XYZ)

  • Both end cash $130k\$130k, but:

    • ABC: +150k150k cash from ops → funded IA (−25k−25k) & repaid FA (−25k−25k).

    • XYZ: −100k−100k cash from ops → had to raise +125k+125k financing & liquidate +75k+75k investments.

  • Banker’s choice = ABC (stronger operating cash, less reliance on external funds).

Key Rules & Formulas

  • Accounting equation: Assets=Liabilities+Equity\text{Assets}=\text{Liabilities}+\text{Equity} guides sign of adjustments.

  • OA indirect adjustment cheat-sheet:

    • Non-cash expenses → add.

    • Gain\text{Gain} → subtract; Loss\text{Loss} → add.

    • Current asset ↑ → subtract; ↓ → add.

    • Current liability ↑ → add; ↓ → subtract.

  • Ending cash check: Beg. Cash+NCF<em>Op+NCF</em>Inv+NCFFin=End Cash\text{Beg. Cash}+\text{NCF}<em>{\text{Op}}+\text{NCF}</em>{\text{Inv}}+\text{NCF}_{\text{Fin}}=\text{End Cash}.

Ethical & Practical Implications

  • Positive net income does not guarantee liquidity; cash analysis prevents misinterpretation.

  • Disclosing NCIF transactions maintains transparency (avoids hiding leverage or asset swaps).

  • Analysts penalize firms with chronic negative OA cash despite reported profits.

Study Tips & Connections

  • Link OA adjustments to accrual vs cash timing differences.

  • Remember depreciation: expense on I/S, never a cash flow.

  • Cross-reference to chapters on receivables, inventory, PP&E, bonds, equity for journal-entry logic.

  • Practice by reconstructing T-accounts (ledger) to visualize debits/credits → cash effects.

  • Use the free-cash-flow metric to connect cash-flow statements to valuation discussions in finance courses.