Assignment for Cash Flow Analysis

1. What is the function of cash flow statement in company analysis? And what is the uniqueness of
this statement compared to other financial statements?

 The function of cash flow statement is to show where an entitites cash is being generated
(cash inflows), and where its cash is being spent (cash outflows), over a specific period of
time (usually quarterly and annually), it is important for analyzing the liquidity and long term
solvency of a company. And the uniqueness of this statement it’s because a cash flow
statement is a financial statement that summarizes the amount of cash and cash equivalents
entering and leaving a company. The cash flow statement measures how well a company
manages its cash position, meaning how well the company generates cash to pay its debt
obligations and fund its operating expenses

2. There are 3 types of activities covered in the cash flow statement. Explain it and add examples
for each.

 Operating activities include cash activities related to net income. For example, cash
generated from the sale of goods (revenue) and cash paid for merchandise (expense) are
operating activities because revenues and expenses are included in net income.
 Investing activities include cash activities related to noncurrent assets. Noncurrent assets
include (1) long-term investments; (2) property, plant, and equipment; and (3) the principal
amount of loans made to other entities. For example, cash generated from the sale of land
and cash paid for an investment in another company are included in this category. (Note
that interest received from loans is included in operating activities.)
 Financing activities include cash activities related to noncurrent liabilities and owners’
equity. Noncurrent liabilities and owners’ equity items include (1) the principal amount of
long-term debt, (2) stock sales and repurchases, and (3) dividend payments. (Note that
interest paid on long-term debt is included in operating activities.)

3. How to arrange cash flow statement using indirect and direct method? Explain in detail.

Prepare the Statement of Cash Flows Using the Indirect Method

 The statement of cash flows is prepared by following these steps:

1. Determine Net Cash Flows from Operating Activities

Using the indirect method, operating net cash flow is calculated as follows:

 Begin with net income from the income statement.

 Add back noncash expenses, such as depreciation, amortization, and depletion.
 Remove the effect of gains and/or losses from disposal of long-term assets, a cash
from the disposal of long-term assets is shown under investing cash flows.
  Adjust for changes in current assets and liabilities to remove accruals from
operating activities.

2. Determine Net Cash Flows from Investing Activities

Investing net cash flow includes cash received and cash paid relating to long-term
assets.

3 . Present Net Cash Flows from Financing Activities

Financing net cash flow includes cash received and cash paid relating to long-term
liabilities and equity.

4 . Reconcile Total Net Cash Flows to Change in Cash Balance during the Period

To reconcile beginning and ending cash balances:

 The net cash flows from the first three steps are combined to be total net cash
flow.
 The beginning cash balance is presented from the prior year balance sheet.
 Total net cash flow added to the beginning cash balance equals the ending cash
balance.

5 . Present Noncash Investing and Financing Transactions

Transactions that do not affect cash but do affect long-term assets, long-term debt,
and/or equity are disclosed, either as a notation at the bottom of the statement of cash
flow, or in the notes to the financial statements.

Prepare a Statement of Cash Flows Using the Direct Method

 The direct method of developing the cash flow statement lists operating cash receipts
(e.g., receipt from customers) and cash payments (e.g., payments to employees,
suppliers, operations, etc.) in the operating activities section. In this section, any
interest paid on outstanding debt is also reported along with all income taxes paid.
Using the direct method, the result is cash receipts minus cash disbursements, and the
final figure is net cash flows from operations.
 Issue With the Direct Method

One of the problems with the direct method is the level of complexity involved in
preparing the cash flows statement. If your business is small, then listing your cash
receipts and cash payments is simple. As a business grows, imagine all of the cash
receipts and cash payments from different sources that would have to be listed. The
direct method becomes very complex, which is why the majority of companies use
the indirect method of developing a cash flow statement.
 Another problem with the complexity of the direct method is that all accounting
transactions affect two accounts. In addition to all the cash transactions to contend
with, each cash transaction affects another account, such as inventory or accounts
receivable, and you have to consider those accounts when developing the statement of
cash flows.
 Operating Section format

The direct method is also called the income statement method. The simplest format of
the direct method looks something like this:

Cash Flow from Revenue - Cash Payments for Expenses = Income Before Income
Taxes - Cash Payment for Income Taxes = Net Cash Flow From Operating Activities.

The first two line items, cash flow from revenue and cash payments from expenses,
are subject to the problems of complexity discussed above

4. What is the relation of these following special circumstance toward cash flow statement?
a. Equity method investments :
The equity method is an accounting technique used by a company to record the profits
earned through its investment in another company.

b. Acquisition of companies with stock:

A stock-for-stock merger occurs when shares of one company are traded for another during
an acquisition. When, and if, the transaction is approved, shareholders can trade the shares
of the target company for shares in the acquiring firm's company.

c. Postretirement benefit costs:

Other post-retirement benefits are benefits, other than pension distributions, paid to
employees during their retirement years. Post-retirement benefits may include life
insurance and medical plans, or premiums for such benefits, as well as deferred-
compensation arrangements.

d. Securitization of accounts receivable:

A larger organization can convert its accounts receivable into cash at once by securitizing the
receivables. This means that individual receivables are aggregated into a new security,
which is then sold as an investment instrument.

5. What is the limitation of cash flow statement?

 Fails to Present Net Profit: Cash flow statement fails to present the net income of a firm for
period as it ignores non-cash items which is considered by Profit and Loss Statement.

6. How the could you relate between cash flow and income statement?
  The cash flow statement and the income statement are integral parts of a corporate balance
sheet. The cash flow statement or statement of cash flows measures the sources of a
company's cash and its uses of cash over a specific time period. The income statement
measures a company's financial performance, such as revenues, expenses, profits, or losses
over a specific time period. This financial document is sometimes called a statement of
financial performance. An income statement shows whether a company made a profit, and
a cash flow statement shows whether a company generated cash.

7. Based on your understanding, what does the meaning of free cash flow and how to compute it?

 Free cash flow is important because it allows a company to pursue opportunities that
enhance shareholder value. Without cash, it's tough to develop new products, make
acquisitions, pay dividends and reduce debt.

8. Please do exercise 7-3.