FA 4

FINANCIAL ACCOUNTING

Session 4 - Chapter 4

Reporting and Analyzing Cash Flows

Purpose of the Statement of Cash Flows

Provides information about how a company generates cash and how it uses cash.
Enables investors and creditors:
- To better assess a firm’s ability to settle its liabilities and pay dividends.
- To determine a company’s need for external financing.
- To provide cash-basis information about the company’s operating, investing, and financing activities.

Usefulness of the Statement of Cash Flows

Provides information to help assess:

Entity’s ability to generate future cash flows.
Entity’s ability to pay dividends and obligations.
Reasons for difference between net income and net cash flow from operating activities.
Cash and noncash investing and financing transactions.

Classification of Cash Flows

Income Statement Items
- Operating Activities: Generally includes long-term asset items.
- Investing Activities: Generally includes long-term liability and equity items.
- Financing Activities: Generally includes debt and equity transactions.
The term “Cash” is understood to mean cash and cash equivalents.

Format of the Statement of Cash Flows

Order of Presentation:

Operating Activities
Investing Activities
Financing Activities

Report inflows and outflows from investing and financing activities separately.
Direct Method
Indirect Method

General Format of the Statement of Cash Flows

The 3 activities—operating, investing, and financing—plus the significant noncash investing and financing activities constitute the general format of the SCF.

Cash Equivalents

Cash equivalents are short-term, highly liquid investments that are both:
- Readily convertible to known amounts of cash.
- So near their maturity that they present insignificant risk of changes in interest rates.
Generally, only investments with original maturities of three months or less qualify as cash equivalents.
Examples of cash equivalents:
- Treasury bills
- Commercial paper
- Money market funds

Classification of Cash Flows

Typical Inflows and Outflows

Operating

Cash inflows:
- From sales of goods or services.
- From returns on loans (interest) and on equity securities (dividends).
Cash outflows:
- To suppliers for inventory.
- To employees for services.
- To government for taxes.
- To lenders for interest.
- To others for expenses.

Investing

Cash inflows:
- From sale of property, plant, and equipment.
- From sale of debt or equity securities of other entities.
- From collection of principal on loans to other entities.
Cash outflows:
- To purchase property, plant, and equipment.
- To purchase debt or equity securities of other entities.
- To make loans to other entities.

Financing

Cash inflows:
- From issuing debt or equity.
Cash outflows:
- To buy back stock.
- To pay dividends.
- To repay debt.
Interest expense is recorded as an income statement item and is classified under operating cash flow.
Dividends declared are part of retained earnings items and classified under financing cash flow.

Significant Noncash Activities

Not all of a company’s significant activities involve cash.

Examples of significant noncash activities include:

Issuance of common stock to purchase assets.
Conversion of bonds into common stock.
Issuance of debt to purchase assets.
Exchange of plant assets.
Significant financing and investing activities that do not affect cash are not reported in the body of the SCF but must be disclosed either:
- In a separate schedule at the bottom of the SCF or
- In a separate note or supplementary included in the financial statements.

Exercise: Classification of Transactions

Classify the following items as:

Operating—add to net income
Operating—deduct from net income
Investing
Financing
Significant noncash investing and financing activities

Transactions to classify:

a. Purchase of equipment.
b. Redemption of bonds payable.
c. Sale of building.
d. Depreciation.
e. Exchange of equipment for furniture.
f. Issuance of capital stock.
g. Amortization of intangible assets.
h. Purchase of treasury stock.
i. Issuance of bonds for land.
j. Payment of dividends.
k. Increase in interest receivable on notes receivable.
l. Pension expense exceeds amount funded.

Company Product Life Cycle & Cash Flows

Cash Flow

Positive and Negative Cash Flow areas during various phases:

Introductory Phase
Growth Phase
Maturity Phase
Decline Phase

Usefulness of the Statement of Cash Flows

Financial Flexibility

Provides information useful in evaluating a firm’s financial flexibility.
Includes an evaluation of a firm’s ability to survive an unexpected drop in demand, assessed by reviewing its past cash flows from operations.
Larger cash flows equate to greater ability to adjust to adverse economic changes.

Quality of Earnings

Some users relate cash flow from operations to net income to measure earnings quality; higher ratios indicate higher quality income.

Sources of Cash Flow

Understanding sources of cash flow changes, such as:
- What the sources are and if they are transitory.
- If they are mainly from operations, and how the company allocates cash to essential areas or stakeholders.

Home Depot 2022 Annual Report - Cash Flows

Cash Flows from Operating Activities:

Net earnings:
- Fiscal 2022: $17,105 million
Reconciliation of net earnings to net cash provided by operating activities:
- Depreciation and amortization
- Changes in receivables, net
- Changes in merchandise inventories
- Changes in other current assets
- Changes in accounts payable and accrued expenses
- Changes in deferred revenue
- Changes in income taxes payable
- Changes in deferred income taxes
- Other operating activities
- Net cash provided by operating activities: (sum above)

Cash Flows from Investing Activities

Includes capital expenditures and payments for businesses acquired.
Net cash used in investing activities (total of activities).

Cash Flows from Financing Activities

Involves proceeds from debt issuance, repayments of long-term debt, and cash dividends.
Net cash used in financing activities (sum of activities).

Changes in Cash and Cash Equivalents

Lists beginning of year and end of year cash balances as well as adjustments from exchange rate changes.

Supplemental Disclosures

Cash paid for income taxes
Cash paid for interest, net of interest capitalized
Non-cash capital expenditures

Balance Sheet Information

Home Depot 2022 Consolidated Balance Sheets

Assets (in millions)

Total current assets:
- Cash and cash equivalents: $2,757
- Receivables, net: $3,317
- Merchandise inventories: $24,886
- Other current assets: $3,426
- Total assets: $76,445

Liabilities & Stockholders' Equity

Current liabilities:
- Short-term debt: $1,035
- Total liabilities: $74,883
- Total stockholders' equity: $76,445

Income Statement

Home Depot 2022 Consolidated Statements of Earnings (in millions)

Net sales: $157,403
Cost of sales: $104,625
Operating income: $52,778
Net earnings: $17,105
Diluted earnings per share:
- $16.74 for fiscal 2022
Basic weighted average common shares:
- 1,025 for fiscal 2022

Cash Flow Ratios

Operating Cash Flow to Current Liabilities

Helps assess a company's liquidity to liquidate current liabilities.

Operating Cash Flow to Capital Expenditures

Assesses if a firm can replace and expand property, plant, and equipment.

Cash from Operations to Total Debt

Measures ability to generate cash to cover debt payments.

Free Cash Flow

Defined as:
$ext{Free Cash Flow} = ext{Cash Flow From Operations} - ext{Capital Expenditures}$

Special Issues in Statement Preparation

Adjustments for noncash items such as amortization of intangibles, changes in current assets and liabilities.

Exercises

Operating Activities—Indirect Method

Preparing a statement section by identifying adjustments affecting cash flows based on comparative balance sheet information and the statement of earnings.