Statement of Cash Flows

1. Statement of Cash Flows Chapter 14

2. External Reports Income Statement Balance Sheet Statement of Cash Flows The statement of cash flows highlights the major activities that impact cash flows and hence, affect the overall cash balance.

3. Purpose of the Statement of Cash Flows Why is there a difference between net income and net cash flow? Are cash flows sufficient to support ongoing operations? Can we pay debts? Will the company have to borrow money to make needed investments? Can we pay dividends?

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.

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

6. The term cash on the statement of cash flows refers broadly to both currency and cash equivalents. Statement of Cash Flows: Key Concepts Cash Currency and Bank Accounts Cash Equivalents Treasury Bills Commercial Paper Money Market Funds

7. Learning Objective 1 Classify cash inflows and outflows as relating to operating, investing, or financing activities.

8. Organizing a Statement of Cash Flows Operating Activities Revenue and expense transactions that affect net income. Investing Activities Acquiring or disposing of noncurrent assets. Financing Activities Borrowing from and repaying principal to creditors and transactions with stockholders.

9. Organizing a Statement of Cash Flows

10. Direct Method Indirect Method Reconstructs the income statement on a cash basis from top to bottom Accrual net income is adjusted to a cash basis; Used by 99% Operating Activities: Direct or Indirect Method? Both methods result in the exact same amount of cash provided by operating activities.

11. The Indirect Method: A Three-Step Process Step 1 Step 2 Step 3

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

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 + $70 Credits = $270

14. Step 2: Analyze Net Changes in Noncash Balance Sheet Accounts

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

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.

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 cash inflow. Report $900 cash outflow.

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 income in Operating Activities. Report $200 dividends paid in Financing Activities.

19. Summary of Key Concepts

20. Summary of Key Concepts

21. Learning Objective 2 Prepare a statement of cash flows using the indirect method to determine the net cash provided by operating activities.

22. Apparel, Inc. Financial Statements

23. Apparel, Inc. Financial Statements

24. An Example of a Statement of Cash Flows In addition to the financial statements provided, assume the following: 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. The company did not issue any new bonds during the year. The company did not repurchase any of its own common stock during the year. The company paid a cash dividend during the year.

25. Operating Activities: Step 1 The first step in computing Apparel’s net cash provided by operating activities is to add depreciation to net income. 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

26. Operating Activities: Step 2 The 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.

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.

28. Operating Activities

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 $8 million cash inflow. Report $138 million cash outflow.

30. 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)

31. Statement of Cash Flows

32. Seeing the Big Picture

33. Interpreting the Statement of Cash Flows A statement of cash flows should be evaluated in the context of a company’s specific circumstances. Useful information can also be derived by examining the relationships among numbers.

34. Learning Objective 3 Compute free cash flow.

35. Free Cash Flows Free cash flow measures a company’s ability to fund its capital expenditures and dividends from its net cash provided by operating activities.

36. Free Cash Flows Free cash flow measures a company’s ability to fund its capital expenditures and dividends from its net cash provided by operating activities.

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