Analysis of Cash Flow Statement

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Basic Concepts

• Reports the entity’s cash flows (cash receipts and cash payments) during the period

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Purposes of the Statementof Cash Flows

1. Predict future cash flows2. Evaluate management decisions3. Determine the ability to pay dividends

to stockholders’ and payments to creditors

4. Show the relationship of net income to the business’s cash flows

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What is Cash?

• Cash on hand• Cash in the bank• Cash equivalents - highly liquid, short-

term investments that can be converted into cash with little delay–Money-market investments–U.S. Government Treasury bills

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Statement of Cash FlowsSections

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Operating, Investing, and Financing Activities

• Operating activities create revenues, expenses, gains, and losses.

• Investing activities increase and decrease long-term assets.

• Financing activities obtain cash from investors and creditors.

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Two Formats forOperating Activities

• Indirect method reconciles from net income to net cash provided by operating activities

• Direct method reports all cash receipts and cash payments from operating activities

• The two methods have no effect on investing or financing activities.

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Two Formats forOperating Activities

Indirect MethodNet income $XXXAdjustments:Depreciation, etc. XXXNet income provided by operating activities $XXX

Direct MethodCollection from customers $XXXDeductions:Payment to suppliers, etc. XXXNet income provided by operating activities $XXX

The Indirect Operating Section

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Operating ActivitiesIndirect Method

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Cash flows from operating activities:Net income

Adjustments to reconcile net income to net cash provided by operating activities:+ Depreciation/amortization expense+ Loss on sale of long-term assets- Gain on sale of long-term assets- Increases in current assets other than cash+ Decreases in current assets other than cash+ Increases in current liabilities- Decreases in current liabilities

Net cash provided by operating activities

Investing Activities

Depreciation, Depletion, Amortization

Sales 10,000$ CGS 3500Gross Profit 6500

Depreciation 4000

Net Income 2,500$

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Depreciation, Depletion and Amortization are not Cash transactions, thusAre ADDED back to Net Income.

Gain or Loss fromLong-Term Assets

• Changes to Long-term Assets– Purchase or Sale

• Effect Cash (What’s the journal entry?)• They appear in the Investing Section• But... When Sold Are Reported on the Income

Statement– Thus, we need to reverse their effect

• Add back the Loss• Subtract out the Gain

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Long-Term AssetsSales 10,000$ CGS 3,500 Gross Profit 6,500

Loss on Sale of Equipment 575 Depreciation 4,000

Net Income 1,925$

Entry for Sale of Equipment:Debit Credit

Cash 4,500 A/D - Depreication 1,500 Loss on Sale 575 Equipment 6,575

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Operating Activities fromIndirect Method

• Changes in current assets and current liability accounts– Increase in another current asset decreases cash

• Purchase of Inventory for cash– Decrease in another current asset increases cash

• Collections of Accounts Receivable– Decrease in a current liability decreases cash

• Payment of Accounts Payable– Increase in a current liability increases cash

• Non-Cash Expense (Accrued Expense)

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Increase in Current AssetsDecreases Cash

Sales 10,000$ CGS 3,500 Gross Profit 6,500

Loss on Sale of Equipment 575 Depreciation 4,000

Net Income 1,925$

Sales Journal Entries:Debit Credit

Cash 7,500 Sales 7,500

Accounts Receivable 2,500 Sales 2500

• So $2,500 in Sales are NOT cash

• Any increase in Current Assets either uses cash– Increase Inventory– Decrease Cash

• Or is increased by a non-cash transaction– Accounts Receivable

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Decrease in Current AssetsIncreases Cash

• If A/R decreases that means we collected Cash– That cash needs to be added back to Net

Income• If Inventory, Supplies or other current assets

decrease that means we debited an expense but did not credit Cash– So we add back those decreases to Net Income

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Decrease in Current LiabilitiesDecreases Cash

• How is Accounts Payable decreased?– Debit Accounts Payable $1,000– Credit Cash $1,000

• Same for all other Payables

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Increase in Current LiabilitiesIncreases Cash

Sales 10,000$ CGS 3,500 Gross Profit 6,500

Salary Expense 1,000 Loss on Sale of Equipment 575 Depreciation 4,000

Net Income 925$

Salary Expense Journal Entries:Debit Credit

Salary Expense 875 Cash 875

Salary Expense 125 Salary Payable 125

• When Payables Increase– They create an

Expense– But the expense is

a non-cash expense

• So, Add back to Net Income

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The Indirect Method:Operating Activities

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Positive ItemsNet incomeDepreciation/amortizationLoss on sale of long-term assetsDecreases in current assets other than cashIncreases in current liabilities

Negative ItemsNet lossGain on sale of long-term assetsIncreases in current assets other than cashDecreases in current liabilities

The Indirect Method:Investing Activities

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Positive ItemsSale of plant assetsSale of investments that are not cash equivalentsCollections of loans receivable

Negative ItemsAcquisition of plant assetsPurchase of investments that are not cash equivalentsMaking loans to others

The Indirect Method:Financing Activities

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Positive ItemsIssuing stockSelling treasury stockBorrowing money

Negative ItemsPayment of dividendsPurchase of treasury stockPayment of principal amounts of debts

Cash Flow StatementAn Example

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Comparative Balance Sheets

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AssetsCurrent: Cash Accounts receivable Interest receivable Inventory Prepaid expensesLong-term receivablePlant assets, net Total

$ 22 93 3 135 8 11 453$725

$ 42 80 1 138 7 – 219$487

$ (20) 13 2 (3) 1 11 234$238

(In thousands) 20x2 20x1 Inc/dec)Anchor Corporation – December 31

Comparative Balance Sheets

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LiabilitiesCurrent: Accounts payable Salary payable Accrued liabilitiesLong-term debtStockholders’ equityCommon stockRetained earnings Total

$ 91 34 1 160

359 110$725

$ 5763

77

258 86$487

$ 34 (2) (2) 83

101 24$238

(In thousands) 20x2 20x1 Inc/dec)Anchor Corporation – December 31

Income Statement

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Revenues and gains:Sales revenue $284Interest revenue 12Dividend revenue 9Gain on sale of plant assets 8Total revenues and gains $313

Anchor CorporationYear Ended December 31, 20x2

(In thousands)

Income Statement

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Expenses:Cost of goods sold $150Salary and wage expense 56Depreciation expense 18Other operating expense 17Interest expense 16Income tax expense 15Total expenses $272

Anchor CorporationYear Ended December 31, 20x2

(In thousands)

Income Statement

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Total revenues and gains $313Total expenses 272Net income $ 41

Anchor CorporationYear Ended December 31, 20x2

(In thousands)

Statement of Cash Flows:Operating Activities

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Statement of Cash Flows (Indirect Method)Year Ended December 31, 20x2 (In thousands)

Cash flows from operating activities:Net Income $41

Adjustments to reconcile net income tonet cash provided by operating activities:

A Depreciation 18B Gain on sale of plant (8)

Depreciation does not affect cash, but it decreases net income – add it back in.

Sales of long-term assets are investingActivities – remove gains from net income.

Statement of Cash Flows: Operating Activities

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C Increase in accounts receivable (13)C Increase in interest receivable (2)C Decrease in inventory 3C Increase in prepaid expenses (1)C Increase in accounts payable 34C Decrease is salary payable (2)C Decrease in accrued liabilities (2) 27Net cash provided by operating activities $68

Statement of Cash Flows (Indirect Method)Year Ended December 31, 20x2 (In thousands)

Changes in Current Asset and Current Liability Accounts – C

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1. An increase in a current asset other than cash indicates a decrease in cash.

2. A decrease in a current asset other than cash indicates an increase in cash.

3. A decrease in a current liability indicates a decrease in cash.

4. An increase in a current liability indicates an increase in cash.

Statement of Cash Flows:Investing Activities

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Cash flows from investing activities:Acquisition of plant assets $(306)Loan to another company (11)Proceeds from sale of plant assets 62 Net cash used for investing activities $(255)

Statement of Cash Flows (Indirect Method)Year Ended December 31, 20x2 (In thousands)

Statement of Cash Flows:Financing Activities

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Cash flows from financing activities:Proceeds from issuance of common stock $101Proceeds from issuance of long-term debt 94Payment of long-term debt (11)Payment of dividends (17) Net cash provided by financing activities $167

Statement of Cash Flows (Indirect Method)Year Ended December 31, 20x2 (In thousands)

Statement of Cash Flows

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Net cash provided by operating activities $ 68Net cash used for investing activities (255)Net cash provided by financing activities 167Net decrease in cash $ (20)Cash balance, December 31, 20x1 42Cash balance, December 31, 20x2 $ 22

Statement of Cash Flows (Indirect Method)Year Ended December 31, 20x2 (In thousands)

Noncash Investing andFinancing Activities

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Suppose Anchor Corporation issued Common stock valued at $300,000

to acquire a warehouse.

Warehouse Building 300,000Common Stock 300,000

Noncash Investing andFinancing Activities

Noncash Investing and Financing Activities:Acquisition of building by issuing common

stock $300Acquisition of land by issuing note payable 70Payment of long-term debt by issuing

common stock 100Total noncash investing and financing

activities $470

Analysis of Cash Flows

• In evaluating sources and uses of cash, the analyst should focus on questions like: Are asset replacements financed from internal or external

funds? What are the financing sources of expansion and business

acquisitions? Is the company dependent on external financing? What are the company’s investing demands and opportunities? What are the requirements and types of financing? Are managerial policies (such as dividends) highly sensitive to

cash flows?

Quick quiz• Analyze the following CFS.

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