Chapter 14: Statement of Cash Flows

Statement of Cash FlowsChapter 14External ReportsIncome StatementBalance SheetStatement of Cash FlowsThe statement of cash flows highlights the major activities that impact cash flows and hence, affect the overall cash balance.Purpose of the Statement of Cash FlowsAre cash flows sufficient to support ongoing operations?Can we pay debts?Can we pay dividends?Why is there a difference between net income and net cash flow?Will the company have to borrow money to make needed investments?A Fundamental Principle Cash Balance =  Noncash Balance Sheet AccountsThis 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. A Review of Basic EquationsBasic Equation for Asset AccountsBeginning balance + Debits – Credits = Ending balanceBasic Equation for Contra-Asset, Liability, and Stockholders’ Equity AccountsBeginning balance – Debits + Credits = Ending balanceStatement of Cash Flows: Key ConceptsThe term cash on the statement of cash flows refers broadly to both currency and cash equivalents.Currency and Bank AccountsCashTreasury BillsMoney Market FundsCommercial PaperCash EquivalentsOrganizing a Statement of Cash FlowsOperating ActivitiesRevenue and expense transactions that affect net income. Investing ActivitiesAcquiring or disposing of noncurrent assets. Financing ActivitiesBorrowing from and repaying principal to creditors and transactions with stockholders. Organizing a Statement of Cash FlowsOperating Activities: Direct or Indirect Method?Reconstructs the income statement on a cash basis from top to bottomDirect MethodAccrual net income is adjusted to a cash basis; Used by 99%Indirect MethodBoth methods result in the exact same amount of cash provided by operating activities.The Indirect Method: A Three-Step ProcessStep 1Step 2Step 3Step 1: Add Depreciation ChargesAccumulated 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 AccountsBeginning balance – Debits + Credits = Ending balanceStep 2: Analyze Net Changes in Noncash Balance Sheet AccountsStep 3: Adjust for Gains and LossesUnder 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 Investing and Financing Activities: Gross Cash FlowsU.S. GAAP and IFRS require that the investing and financing sections of the statement of cash flows disclose gross cash flows. Summary of Key ConceptsSummary of Key ConceptsApparel, Inc. Financial StatementsApparel, Inc. Financial StatementsAn Example of a Statement of Cash FlowsIn 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. Operating Activities: Step 1Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity AccountsBeginning 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. 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. Operating Activities: Step 3The third step in computing Apparel’s net cash provided by operating activities is to adjust for gains and losses included in net income.Operating ActivitiesInvesting ActivitiesBasic Equation for Asset AccountsBeginning 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.Financing ActivitiesBasic Equation for Contra-Asset, Liability, and Stockholders’ Equity AccountsBeginning 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)Statement of Cash FlowsSeeing the Big PictureInterpreting the Statement of Cash FlowsA 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.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. Earnings QualityManagers 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. End of Chapter 14