Reporting and Analyzing Cash Flows

1. 17 Reporting and Analyzing Cash Flows

2. Importance of Cash Flows How did the business fund its operations? Does the business have sufficient cash to pay its debts as they mature? Did the business make any dividend payments? Did the business borrow any funds or repay any loans?

3. Measuring Cash Flows Cash Cash Equivalents Currency • Short-term, highly liquid investments. • Readily convertible into cash. • So near maturity that market value is unaffected by interest rate changes.

4. Classifying Cash Flows The Statement of Cash Flows includes the following three sections: • Operating Activities • Investing Activities • Financing Activities

5. Operating Activities • Inflows • Receipts from customers. • Cash dividends received. • Interest from borrowers. • Other. • Outflows • Salaries and wages. • Payments to suppliers. • Taxes and fines. • Interest paid to lenders. • Other.

6. Investing Activities Inflows • Selling long-term productive assets. • Selling equity investments. • Collecting of principal on loans. • Other. + Cash Flows from Investing Activities • Outflows • Purchase long-term productive assets. • Purchase equity investments. • Purchase debt investments. • Make loans. _

7. Financing Activities Inflows • Issuing its own equity securities. • Issuing bonds and notes. • Issuing short-term and long-term liabilities. + Cash Flows from Financing Activities • Outflows • Pay dividends to stockholders. • Purchase treasury stock. • Repay cash loans. • Cover withdrawals by owners. _

8. Noncash Investing and Financing Items requiring separate disclosure include: • Retirement of debt by issuing equity securities. • Conversion of preferred stock to common stock. • Leasing of assets in a capital lease transaction.

9. Exh. 17.5

10. Exh. 17.5 There are two acceptable methods to determine Cash Flows from Operating Activities: Direct Method Indirect Method

11. Derives from . . . Assets = Liabilities + Stockholders’ Equity Analyzing Noncash Accounts The changes in cash can be determined by analyzing the noncash accounts on the balance sheet. D Cash = D Liabilities + D Stockholders’ Equity - D Noncash Assets

12. Let’s look at the Direct Method for preparing the Cash Flows from Operating Activities section.

13. { Cash received - Increase in A/R = Sales from customers + Decrease in A/R Exh. 17.12 Direct MethodCash Received from Customers Can be computed two ways: • Obtained from cash receipts journal. • Obtained from accrual sales information.

14. { + Increase in inventory Purchases = COGS - Decrease in inventory { Cash paid for + Decrease in A/P = Purchases merchandise - Increase in A/P Exh. 17.13 Direct MethodCash Paid for Merchandise • Step 1 • Step 2

15. Cash paid for Wages + Increase in + Decrease in wages and and other prepaid expenses accrued liabilities = other operating operating - Decrease in - Increase in expenses expenses prepaid expenses accrued liabilities Exh. 17.14 Direct MethodWages and Operating Expenses The cash paid for wages and other operating expenses is affected by (1) whether the expense was prepaid, and (2) whether the expense was accrued. { {

16. + Decrease in Cash paid Interest interest payable = for interest Expense - Increase in interest payable + Decrease in Cash paid Tax taxes payable = for taxes Expense - Increase in taxes payable Exh. 17.15 Direct MethodCash Paid for Interest and Taxes • Interest • Taxes { {

17. Direct MethodDepreciation Expense • Depreciation, Amortization, and Depletion Expenses • Operating cash flows are not involved. • They are not disclosed in the Statement of Cash Flows using the direct method.

18. Direct MethodGains and Losses Gains and losses do not appear on the Statement of Cash Flows using the Direct Method.

19. Let’s look at the Indirect Method for preparing the Cash Flows from Operating Activities section.

20. Cash Flows from Operating Activities Net Income Indirect Method of Reporting Operating Cash Flows Changes in current assets and current liabilities. + Losses and - Gains + Noncash expenses such as depreciation and amortization. 97.5% of all companies use the indirect method.

21. Change in Account Balance During Year Increase Decrease Current Subtract from net Add to net income. Assets income. Current Add to net income. Subtract from net Liabilities income. Indirect Method of Reporting Operating Cash Flows Use this table when adjusting Net Income to Operating Cash Flows.

22. Indirect MethodExample East, Inc. reports $125,000 net income for the year ended December 31, 2002. Accounts Receivable increased by $7,500 during the year and Accounts Payable increased by $10,000. During 2002, East reported $12,500 of Depreciation Expense. What is East, Inc.’s Operating Cash Flow for 2002?

23. Net income $ 125,000 Net income $ 125,000 Deduct: Increase in accounts Deduct: Increase in accounts receivable receivable Cash provided by operating Cash provided by operating activities activities Indirect MethodExample For the indirect method, start with net income.

24. Net income $ 125,000 Net income $ 125,000 Add: Depreciation expense 12,500 Add: Depreciation expense 12,500 Deduct: Increase in accounts Deduct: Increase in accounts receivable receivable Cash provided by operating Cash provided by operating activities activities Indirect MethodExample Add noncash expenses such as depreciation, depletion, amortization, or bad debt expense.

25. Net income $ 125,000 Net income $ 125,000 Add: Depreciation expense 12,500 Add: Depreciation expense 12,500 Deduct: Increase in accounts Deduct: Increase in accounts receivable (7,500) receivable (7,500) Cash provided by operating Change in Account Balance During Year Cash provided by operating Increase Decrease activities activities Current Subtract from net Add to net income. Assets income. Current Add to net income. Subtract from net Liabilities income. Indirect MethodExample

26. Net income $ 125,000 Net income $ 125,000 Add: Depreciation expense 12,500 Add: Depreciation expense 12,500 Deduct: Increase in accounts Deduct: Increase in accounts receivable (7,500) receivable (7,500) Add: Increase in accounts payable 10,000 Add: Increase in accounts payable 10,000 Cash provided by operating Cash provided by operating Change in Account Balance During Year activities activities Increase Decrease Current Subtract from net Add to net income. Assets income. Current Add to net income. Subtract from net Liabilities income. Indirect MethodExample

27. Net income $ 125,000 Net income $ 125,000 Add: Depreciation expense 12,500 Add: Depreciation expense 12,500 Deduct: Increase in accounts Deduct: Increase in accounts receivable (7,500) receivable (7,500) Add: Increase in accounts payable 10,000 Add: Increase in accounts payable 10,000 Cash provided by operating Cash provided by operating activities $ 140,000 activities $ 140,000 Indirect MethodExample If we used the Direct Method, we would get the same $140,000 for Cash Provided by Operating Activities.

28. Let’s do a complete Statement of Cash Flows using the Indirect Method.

29. Statement of Cash FlowsIndirect Method Prepare a Statement of Cash Flows for the period ending December 31, 2001 using the Indirect Method.Refer to the following information . . .

31. Additional Information for 2001: • Net income was $105,000. • Cash dividends declared and paid were $40,000. • Bonds payable of $50,000 were redeemed for $50,000 cash. • Common stock was issued for $35,000 cash.

32. Start with accrual-basis net income. Add noncash expenses and losses. Subtract noncash revenues and gains. Then, analyze the changes in current assets and current liabilities.

34. Now, let’s complete the investing section.

35. Now, let’s complete the financing section.

37. Exh. 17.19 Analyzing Cash Sources and Uses

38. Cash Flow on Operating cash flows = Total Assets Average total assets Exh. 17.20 Cash Flow on Total Assets Used, along with income-based ratios, to assess company performance.

39. End of Chapter 17