Statement of Cash Flows and Cash Flow Analysis

Purposes of the Statement of Cash Flows

• Investors and creditors focus on cash flows along with net income.
• Investors want to assess the firm’s ability to pay dividends and maximize firm value, reflected in stock price.
• Creditors are interested in the firm’s ability to pay interest and repay debt.

Cash Flows vs. Net Income

• Understanding the difference between net income and net cash flows is crucial.
• Higher net income is generally seen as positive. However, this is only valuable if it eventually leads to increased cash.
• In the long term, net income and net cash flows will converge.
• In the short term, net income and net cash flows can differ.

Example: Period 1

• A firm bills customers 100 for services rendered.
• Journal entry:
  • Accounts Receivable: 100
  • Sales Revenue: 100
• Net income increases by 100, but cash flows remain unchanged.

Example: Period 2

• The customer pays the 100 bill.
• Journal entry:
  • Cash: 100
  • Accounts Receivable: 100
• Cash flow increases by 100, while net income remains unchanged.

Summary Table

• Net income and net cash flows differ in periods 1 and 2 but equate over the combined periods.

Statement of Cash Flows Overview

• Cash is typically the first asset listed on the balance sheet.
• The change in cash from the previous year to the current year represents the net cash flows for the current year.
• The statement presents all cash inflows and outflows for the current year.
• The change in cash on the balance sheet corresponds to the net cash flows reported on the statement of cash flows.
• Cash transactions are categorized into operating, investing, and financing activities.

Statement Structure

• Operating Activities:
  • Inflows: XXX
  • Outflows: (XXX)
  • Net operating cash flows
• Investing Activities:
  • Inflows: XXX
  • Outflows: (XXX)
  • Net investing cash flows
• Financing Activities:
  • Inflows: XXX
  • Outflows: (XXX)
  • Net financing cash flows
• Net Cash Flows

Operating Activities Methods

• There are two methods to present this section:
  1. Direct method
  2. Indirect method
• The direct method lists cash inflows and outflows directly.
• The indirect method reconciles accrual-basis net income to cash-basis net income. We will focus on the indirect method.

Indirect Method - Reconciliation Formula

Net Income + Depreciation Expense + Losses on sale of assets - Gains on sale of assets + Decreases in current operating assets - Increases in current operating assets + Increases in current operating liabilities - Decreases in current operating liabilities = Net Operating Cash Flows (Cash-Basis Net Income)

• This method eliminates accruals to reflect only the cash part of net income.

Explanation of Adjustments

• Depreciation Expense: Depreciation reduces net income but does not involve a cash outflow. To reconcile net income to cash flows, depreciation expense is added back.
• Gains and Losses on Asset Sales: Gains and losses affect net income but not operating cash flows. Gains are subtracted, and losses are added back to eliminate their impact on net income when calculating operating cash flows.

Example

• A company sells land for 12,000, originally purchased for 10,000. The journal entry includes:
  • Cash: 12,000
  • Land: 10,000
  • Gain: 2,000
• Net income increases by 2,000. However, the 12,000 is classified as an investing cash flow, not an operating cash flow.

Adjustments for Changes in Current Assets and Liabilities

• Accounts Receivable: If accounts receivable increase, the company has less cash compared to net income. The increase in accounts receivable is subtracted from net income to arrive at operating cash flows.

Example

• A company has 100 sale on account.
  • Accounts Receivable: 100
  • Sales Revenue: 100
• Later, the company collects 70 from the customer.
  • Cash: 70
  • Accounts Receivable: 70
• Operating cash flows are 70 and net income is 100. The increase in accounts receivable (30) is subtracted from net income to calculate operating cash flows.
• Wages Payable: If current operating liabilities like wages payable increase, the company has more cash compared to net income. The increase is added to net income to calculate operating cash flows.

Example

• Workers earn 100 but are not paid.
  • Wages Expense: 100
  • Wages Payable: 100
• Later, the company pays workers 70 of wages owed.
  • Wages Payable: 70
  • Cash: 70
• Operating cash flows are (70) and net income is (100). The increase in wages payable (30) is added to net income to calculate operating cash flows.

Quick Check

• Gain on sale of asset: Subtract
• Decrease in Accounts Receivable: Add
• Decrease in Wages Payable: Subtract
• Depreciation expense: Add
• Increase in Prepaid Rent: Subtract
• Loss on sale of asset: Add
• Increase in Accounts Payable: Add
• Increase in Inventory: Subtract

Comprehensive Example

Income Statement

• Sales: 80,000
• Expenses:
  • COGS: (50,000)
  • Depreciation: (7,000)
  • Salaries: (11,000)
• Net Income: 12,000

Partial Balance Sheet

Operating Section (Indirect Method)

• Net income: 12,000
• Depreciation Expense: 7,000
• Accounts Receivable Increase: (4,000)
• Inventory Decrease: 8,000
• Salaries Payable Increase: 500
• Net cash from operating activities: 23,500

Accrual vs. Cash Basis Example

Consider these transactions:

1. Sold goods on account, 100
2. Purchased office supplies with cash, 20
3. Incurred but did not pay wages, 40

Operating Cash Flow Calculation

Net Income - \text{Increase in Accounts Receivable} - \text{Increase in Office Supplies} + \text{Increase in Wages Payable} = \text{Operating Cash Flow}
60 - 100 - 20 + 40 = -20

Investing Activities

• Lending money and collecting loans.
• Buying and selling long-term assets.
• Buying and selling investments not classified as cash equivalents.
• Focus on cash transactions dealing with long-term assets and short-term investments.

Financing Activities

• Borrowing money and repaying debt.
• Obtaining resources from owners (issuing stock).
• Paying dividends.
• Focus on cash transactions dealing with long-term liabilities and equities.

Relationship Between Statement of Cash Flows and Balance Sheet

Investing or Financing? Inflow or Outflow?

Final Points

• Borrowing cash is a financing activity.
• Paying interest on borrowed cash is an operating activity.
• Purchasing another company’s stock is an investing activity.
• Receiving dividends on stock owned is an operating activity.
• Issuing stock is a financing activity.
• Paying dividends on stock issued is a financing activity.
• Interest paid and dividends received are classified as operating activities because they affect net income, unlike dividends paid, which only affect Retained Earnings.

Example: Investing & Financing Activities

1. Net Income: 4,135
2. Purchase of PPE: 871
3. Borrowings from bank: 1,417
4. Proceeds from stock issuance: 11
5. Cash from customers: 29,164
6. Payments to long-term debt: 46
7. Sale of marketable securities: 134
8. Proceeds from sale of PPE: 6,594
9. Dividends paid: 277
10. Interest paid: 90
11. Purchase of treasury stock: 1,583

Investing Activities:

• #2: (871)
• #7: 134
• #8: 6,594
• Total: 5,857

Financing Activities:

• #3: 1,417
• #4: 11
• #6: (46)
• #9: (277)
• #11: (1,583)
• Total: (478)