The Cash Flow Statement

I. Introduction
Components and Relationships Between the Financial Statements
It is important to understand that the income statement, balance sheet and cash
flow statement are all interrelated.
The income statement is a description of how the assets and liabilities were utilized
in the stated accounting period. The cash flow statement explains cash inflows and
outflows, and will ultimately reveal the amount of cash the company has on hand;
this is reported in the balance sheet as well.
We will not explain the components of the balance sheet and the income statement
here since they were previously reviewed.
Figure 6.13: The Relationship between the Financial Statements

Statement of Cash Flow

The statement of cash flow reports the impact of a firm's operating, investing and
financial activities on cash flows over an accounting period. The cash flow
statement is designed to convert the accrual basis of accounting used in the income
statement and balance sheet back to a cash basis.
The cash flow statement will reveal the following to analysts:

1. How the company obtains and spends cash

2. Why there may be differences between net income and cash flows
3. If the company generates enough cash from operation to sustain the business
4. If the company generates enough cash to pay off existing debts as they
mature
5. If the company has enough cash to take advantage of new investment
opportunities
Segregation of Cash Flows
The statement of cash flows is segregated into three sections:
1. Operating activities
2. Investing activities
3. Financing activities
1. Cash Flow from Operating Activities (CFO)
CFO is cash flow that arises from normal operations such as revenues and cash
operating expenses net of taxes.
This includes:

Cash inflow (+)

1. Revenue from sale of goods and services
2. Interest (from debt instruments of other entities)
3. Dividends (from equities of other entities)

Cash outflow (-)

1. Payments to suppliers
2. Payments to employees
3. Payments to government
4. Payments to lenders
5. Payments for other expenses

2. Cash Flow from Investing Activities (CFI)

CFI is cash flow that arises from investment activities such as the acquisition or
disposition of current and fixed assets.
This includes:

Cash inflow (+)

1. Sale of property, plant and equipment

2. Sale of debt or equity securities (other entities)

3. Collection of principal on loans to other entities

Cash outflow (-)

1. Purchase of property, plant and equipment
2. Purchase of debt or equity securities (other entities)
3. Lending to other entities

3. Cash flow from financing activities (CFF)

CFF is cash flow that arises from raising (or decreasing) cash through the issuance
(or retraction) of additional shares, short-term or long-term debt for the company's
operations. This includes:

Cash inflow (+)

1. Sale of equity securities
2. Issuance of debt securities

Cash outflow (-)

1. Dividends to shareholders
2. Redemption of long-term debt
3. Redemption of capital stock

Reporting Noncash Investing and Financing Transactions

Information for the preparation of the statement of cash flows is derived from three
sources:
1. Comparative balance sheets
2. Current income statements
3. Selected transaction data (footnotes)
Some investing and financing activities do not flow through the statement of cash
flow because they do not require the use of cash.
Examples Include:

Conversion of debt to equity

Conversion of preferred equity to common equity

Acquisition of assets through capital leases

Acquisition of long-term assets by issuing notes payable

Acquisition of non-cash assets (patents, licenses) in exchange for shares or

debt securities

Though these items are typically not included in the statement of cash flow, they
can be found as footnotes to the financial statements.

Under
U.S. and ISA GAAP, the statement of cash flow can be presented by means of two
ways:
1. The indirect method
2. The direct method
The Indirect Method
The indirect method is preferred by most firms because is shows a reconciliation
from reported net income to cash provided by operations.
Calculating Cash flow from Operations
Here are the steps for calculating the cash flow from operations using the indirect
method:
1. Start with net income.
2. Add back non-cash expenses.
o

(Such as depreciation and amortization)

3. Adjust for gains and losses on sales on assets.

o

Add back losses

Subtract out gains

4. Account for changes in all non-cash current assets.

5. Account for changes in all current assets and liabilities except notes payable
and dividends payable.
In general, candidates should utilize the following rules:

(Such as depreciation and amortization)

The following example illustrates a typical net cash flow from operating activities:

Cash Flow from Investment Activities

Cash Flow from investing activities includes purchasing and selling long-term assets
and marketable securities (other than cash equivalents), as well as making and
collecting on loans.
Here's the calculation of the cash flows from investing using the indirect method:

Add back losses

Subtract out gains

Cash from sale of

Land

5,000

Purchase of Plant &

Equipment

(50,00
0)

Net cash flow from

investing activities

(45,00
0)

Cash Flow from Financing Activities

Cash Flow from financing activities includes issuing and buying back capital stock,
as well as borrowing and repaying loans on a short- or long-term basis (issuing
bonds and notes). Dividends paid are also included in this category, but the
repayment of accounts payable or accrued liabilities is not.

Here's the calculation of the cash flows from financing using the indirect method:

The Direct Method

The direct method is the preferred method under FASB 95 and presents cash flows
from activities through a summary of cash outflows and inflows. However, this is not
the method preferred by most firms as it requires more information to prepare.
Cash Flow from Operations
Under the direct method, (net) cash flows from operating activities are determined
by taking cash receipts from sales, adding interest and dividends, and deducting
cash payments for purchases, operating expenses, interest and income taxes. We'll
examine each of these components below:

Cash collections are the principle components of CFO. These are the actual
cash received during the accounting period from customers. They are defined
as:
Formula 6.7

s Receipts from Sales

ase (or - increase) in Accounts Receivable

Cash payment for purchases make up the most important cash outflow
component in CFO. It is the actual cash dispersed for purchases from
suppliers during the accounting period. It is defined as:
Formula 6.8

for purchases = cost of goods sold + increase (or - decrease) in inventory + decrease (or - increase

Cash payment for operating expenses is the cash outflow related to

selling general and administrative (SG&A), research and development (R&A)
and other liabilities such as wage payable and accounts payable. It is defined
as:
Formula 6.9

for operating expenses = operating expenses + increase (or - decrease) in prepaid expenses + dec
rued liabilities

Cash interest is the interest paid to debt holders in cash. It is defined as:
Formula 6.10

interest expense - increase (or + decrease) interest payable + amortization of bond premium (or

Cash payment for income taxes is the actual cash paid in the form of
taxes. It is defined as:
Formula 6.11

for income taxes

decrease (or - increase) in income taxes payable

w from investing and financing are computed the same way it was calculated under the indirect me
The diagram below demonstrates how net cash flow from operations is derived
using the direct method.

ust know the following:

he methods used differ, the results are always the same.

CFF are the same under both methods.

an inverse relationship between changes in assets and changes in cash flow.

Free Cash Flow (FCF)

Free cash flow (FCF) is the amount of cash that a company has left over after it has
paid all of its expenses, including net capital expenditures. Net capital expenditures
are what a company needs to spend annually to acquire or upgrade physical assets
such as buildings and machinery to keep operating.

Formula 6.12

ow from operating activities - net capital expenditures (total capital expenditure - after-tax procee
The FCF measure gives investors an idea of a company's ability to pay down debt,
increase savings and increase shareholder value, and FCF is used for valuation
purposes.
Free Cash Flow to the Firm (FCFF)
Free cash flow to the firm is the cash available to all investors, both equity and debt
holders. It can be calculated using Net Income or Cash Flow from Operations (CFO).
The calculation of FCFF using CFO is similar to the calculation of FCF. Because FCFF
is the cash flow allocated to all investors including debt holders, the interest
expense which is cash available to debt holders must be added back. The amount of
interest expense that is available is the after-tax portion, which is shown as the
interest expense multiplied by 1-tax rate [Int x (1-tax rate)]. .
This makes the calculation of FCFF using CFO equal to:
FCFF = CFO + [Int x (1-tax rate)] FCInv
Where:
CFO = Cash Flow from Operations
Int = Interest Expense
FCInv = Fixed Capital Investment (total capital expenditures)
This formula is different for firm's that follow IFRS. Firm's that follow IFRS would not
add back interest since it is recorded as part of financing activities. However, since
IFRS allows dividends paid to be part of CFO, the dividends paid would have to be
added back.
The calculation using Net Income is similar to the one using CFO except that it
includes the items that differentiate Net Income from CFO. To arrive at the right
FCFF, working capital investments must be subtracted and non-cash charges must
be added back to produce the following formula:
FCFF = NI + NCC + [Int x (1-tax rate)] FCInv WCInv
Where:
NI = Net Income
NCC = Non-cash Charges (depreciation and amortization)
Int = Interest Expense
FCInv = Fixed Capital Investment (total capital expenditures)
WCInv = Working Capital Investments
Free Cash Flow to Equity (FCFE), the cash available to stockholders can be derived
from FCFF. FCFE equals FCFF minus the after-tax interest plus any cash from taking
on debt (Net Borrowing). The formula equals:
FCFE = FCFF - [Int x (1-tax rate)] + Net Borrowing

The Auditor and Audit Opinion

The Auditor
An audit is a process for testing the accuracy and completeness of information
presented in an organization's financial statements. This testing process enables an
independent Certified Public Accountant (CPA) to issue what is referred to as "an
opinion" on how fairly a company's financial statements represent its financial
position and whether it has complied with generally accepted accounting principles.

Note: Only independent auditors (CPAs) can produce audited financial statements. That is, the com

members,
staff and their relatives their relationship with the company compromises their independence.
The audit report is addressed to the board of directors as the trustees of the
organization. The report usually includes the following:

a cover letter, signed by the auditor, stating the opinion.

the financial statements, including the balance sheet, income statement and
statement of cash flows

notes to the financial statements

In addition to the materials included in the audit report, the auditor often prepares
what is called a "management letter" or "management report" to the board of
directors. This report cites areas in the organization's internal accounting control
system that the auditor evaluates as weak.
What Does the Auditor Do?
The auditor will request information from individuals and institutions to confirm:

bank balances

contribution amounts

conditions and restrictions

contractual obligations

monies owed to and by the organization.

To ensure that all activities with significant financial implications is adequately

disclosed in the financial statements the auditor will review:

physical assets

journals and ledgers

board minutes

In addition, the auditor will also:

select a sample of financial transactions to determine whether there is proper

documentation and whether the transaction was posted correctly into the
books

interview key personnel and read the procedures manual, if one exists, to
determine whether the organization's internal accounting control system is
adequate

The auditor usually spends several days at the organization's office looking over
records and checking for completeness.

Auditor Responsibility
Auditors are not expected to guarantee that 100% of the transactions are recorded
correctly. They are required only to express an opinion as to whether the financial
statements, taken as a whole, give a fair representation of the organization's
financial picture. In addition, audits are not intended to discover embezzlements or
other illegal acts. Therefore, a "clean" or unqualified opinion should not be
interpreted as assurance that such problems do not exist.
The standard auditor's opinion contains three parts and states that:
the preparation of the financial statements are the responsibility of management,
and that the auditor has performed an independent review.
Generally accepted auditing procedures were followed, providing reasonable
assurance that the statements do not contain any material errors.
The auditor is satisfied that the statements were prepared in accordance with
accepted accounting procedures and that any assumptions or estimates used are
reasonable.
An unqualified opinion indicates that the auditor believes that the statements are
free from any material errors or omissions
The Qualified Opinion
A qualified opinion is issued when the accountant believes the financial statements
are, in a limited way, not in accordance with generally accepted accounting
principles. A qualified option may be issued if the auditor has concerns about the
going-concern assumption of the company, the valuation of certain items on the
balance sheet or some unreported pending contingent liabilities.
An adverse opinion is issued if the statements are not presented fairly or do not
conform to generally accepted accounting procedures.
Internal Controls
Under U.S. GAAP, the auditor must provide its judgment about the company's
internal controls, or the processes the company uses to ensure accurate financial
statements.
Under the Sarbanes-Oxley act, management is supposed to make a statement
about its internal controls including the following:
A statement declaring that the financial statements are presented fairly;
A statement declaring that management is responsible for maintaining and
executing effectual internal controls;
A description of the internal control system and how it is evaluated;
An analysis of how effective the internal controls have been over the last year;
A statement declaring that the auditors have review management's report on its
internal controls