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Statement of Cash FlowsChapter 14

14-2

External Reports

Income Income StatementStatement

Balance Balance SheetSheet

Statement of Statement of Cash FlowsCash Flows

The statement of cash flows highlights the major activities that impact cash flows and hence, affect the overall cash

balance.

14-3

Purpose of the Statement of Cash Flows

Are cash flows sufficient to

support ongoing operations?

Are cash flows sufficient to

support ongoing operations?

Can we pay debts?

Can we pay debts?

Can we pay dividends?

Can we pay dividends?

Why is there a difference

between net income and net

cash flow?

Why is there a difference

between net income and net

cash flow?

Will the company have to borrow money to make

needed investments?

Will the company have to borrow money to make

needed investments?

14-4

A Fundamental Principle

Cash Balance = Noncash Balance Sheet Accounts

This principle ensures that properly analyzing the changes in all noncash

balance sheet accounts always quantifies the cash inflows and

outflows that explain the change in the cash balance.

14-5

A Review of Basic Equations

Basic Equation for Asset Accounts

Beginning balance + Debits – Credits = Ending balance

Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts

Beginning balance – Debits + Credits = Ending balance

14-6

Statement of Cash Flows: Key Concepts

The term cash on the statement of cash flows refers broadly to both currency and cash equivalents.

Currency and Bank Accounts

Cash

Treasury Bills

Money Market Funds

Commercial Paper

Cash Equivalents

14-7

Learning Objective 1

Classify cash inflows and outflows as relating to operating, investing, or financing activities.

14-8

Organizing a Statement of Cash Flows

Operating Operating ActivitiesActivities

Revenue and expense Revenue and expense transactions that affect transactions that affect

net income. net income.

Investing Activities

Acquiring or disposing of noncurrent assets.

Financing Activities

Borrowing from and repaying principal to

creditors and transactions with stockholders.

14-9

Organizing a Statement of Cash Flows

14-10

Operating Activities: Direct or Indirect Method?

Reconstructs the income statement on a cash basis

from top to bottom

Direct Method

Accrual net income is adjusted

to a cash basis; Used by 99%

Indirect Method

Both methods result in the exact same amount of cash provided by operating activities.

14-11

The Indirect Method: A Three-Step Process Step 1

Step 2

Step 3

14-12

Step 1: Add Depreciation Charges

Accumulated Depreciation is a noncash balance sheet account and we must adjust net income for all of the changes in the noncash balance sheet accounts that

have occurred during the period.

Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts

Beginning balance – Debits + Credits = Ending balance

14-13

Step 1: Add Depreciation Charges

Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts

Beginning balance – Debits + Credits = Ending balance $300 – $70 + Credits = $500

Credits = $500 – $300 + $70Credits = $270

Account Activity for Accumulated Depreciation

Beginning balance $300

Ending balance $500

Accumulated depreciation of equipment sold

$70

14-14

Step 2: Analyze Net Changes in Noncash Balance Sheet Accounts

14-15

Step 3: Adjust for Gains and Losses

Under U.S. GAAP and IFRS rules, gains and losses must be included in the investing activities section of the

statement of cash flows.

Gains and losses must be removed from net income in

the operating activities section before they can be

shown in the investing activities section:

– Gains + Losses

14-16

Investing and Financing Activities: Gross Cash Flows

U.S. GAAP and IFRS require that the investing and financing sections of the statement of cash flows disclose

gross cash flows.

14-17

Property, Plant, and Equipment

Basic Equation for Asset Accounts

Beginning balance + Debits – Credits = Ending balance $1,000 + Debits – $100 = $1,800

Debits = $1,800 – $1,000 + $100 Debits = $900 (cash outflow)

Report $40 Report $40 cash inflow.cash inflow.

Report $900 Report $900 cash outflow.cash outflow.

Account Activity for Property, Plant, and Equipment

Beginning balance $1,000 Original cost of equipment sold

$100

Ending balance $1,800 Accumulated depreciation of equipment sold

$70

Cash proceeds from sale of equipment

$40 Gain on the sale of equipment (included in net income)

$10

14-18

Retained Earnings

Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts

Beginning balance – Debits + Credits = Ending balance $2,000 – Debits + $1,200 = $3,000

$3,200 = $3,000 + Debits Debits = $200 (cash outflow)

Report $1,200 net Report $1,200 net income in Operating income in Operating

Activities.Activities.

Report $200 Report $200 dividends paid in dividends paid in

Financing Activities.Financing Activities.

Account Activity for Retained Earnings

Beginning balance $2,000

Ending balance $3,000

Net income $1,200

14-19

Summary of Key Concepts

14-20

Summary of Key Concepts

14-21

Learning Objective 2

Prepare a statement of cash flows using the indirect method to

determine the net cash provided by operating

activities.

14-22

Apparel, Inc. Financial Statements

14-23

Apparel, Inc. Financial Statements

14-24

An Example of a Statement of Cash Flows

In addition to the financial statements provided, assume the following:

1.The company sold a store that had an original cost of $15 million and accumulated depreciation of $10 million. The cash proceeds from the sale were $8 million. The gain on the sale was $3 million.

2.The company did not issue any new bonds during the year.

3.The company did not repurchase any of its own common stock during the year.

4.The company paid a cash dividend during the year.

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Operating Activities: Step 1

Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts

Beginning balance – Debits + Credits = Ending balance$561 million – $10 million + Credits = $654 million Credits = $654 million – $561 million + $10 million Credits = $103 million

The first step in computing Apparel’s net cash provided by operating activities is to add

depreciation to net income.

14-26

Operating Activities: Step 2The second step in computing Apparel’s net cash provided by

operating activities is to analyze net changes in noncash balance sheet accounts that impact net income.

14-27

Operating Activities: Step 3

The third step in computing Apparel’s net cash provided by operating activities is to adjust for

gains and losses included in net income.

14-28

Operating Activities

14-29

Investing Activities

Basic Equation for Asset Accounts

Beginning balance + Debits – Credits = Ending balance$1,394 million + Debits – $15 million = $1,517 million Debits = $1,517 million – $1,394 million + $15 million Debits = $138 million (cash outflow)

Report Report $8 million $8 million

cash inflow.cash inflow.

Report Report $138 million $138 million cash outflow.cash outflow.

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Financing Activities

Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts

Beginning balance – Debits + Credits = Ending balance $897 million – Debits + $140 million = $1,009 million $1,037 million = $1,009 million + Debits Debits = $28 million (cash outflow)

14-31

Statement of Cash Flows

14-32

Seeing the Big Picture

14-33

Interpreting the Statement of Cash Flows

A statement of cash flows A statement of cash flows should be evaluated in the should be evaluated in the

context of a company’s context of a company’s specific circumstances.specific circumstances.

Useful information can also be Useful information can also be derived by examining the derived by examining the

relationships among numbers.relationships among numbers.

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Learning Objective 3

Compute free cash flow.

14-35

Free Cash Flows

Free Cash Flow =Net Cash Provided by Operating Activities

- Capital Expenditures

- Dividends

Free cash flow measures a company’s ability to fund its capital expenditures and dividends from

its net cash provided by operating activities.

14-36

Free Cash FlowsFree cash flow measures a company’s ability to fund its capital expenditures and dividends from

its net cash provided by operating activities.

Free Cash Flow =Net Cash Provided by Operating Activities

- Capital Expenditures

- Dividends

93$ = 259$ - 138$ - 28$

14-37

Earnings Quality

Managers generally perceive that earnings are of higher quality when the earnings: 1.are not unduly influenced by inflation, 2.are computed using conservative accounting principles and estimates, and 3.are correlated with net cash provided by operating activities.

14-38

End of Chapter 14