CHAPTER 12

STATEMENT OF CASH FLOWS

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin

Copyright 2014 by The McGraw-Hill Companies, Inc. All

UNDERSTANDING THE BUSINESS

Positive cash flows permit a company to . . .
Pay
dividends to
owners.
Take advantage
of market
opportunities.

Expand its
operations
.
Replace
needed assets.

Wall
Wall Street
Street analysts
analysts consider
consider cash
cash flow
flow an
an
important
important indicator
indicator of
of aa companys
companys
financial
financial health.
health.
12-2

CLASSIFICATIONS OF THE
STATEMENT OF CASH FLOWS
Cash
Equivalents

Cash
Cash

Currency

Short-term,
Short-term,highly
highlyliquid
liquid investments.
investments.

Readily convertible into cash.

Readily convertible into cash.

So
Sonear
nearmaturity
maturitythat
that market
market value
valueis
is unaffected
unaffectedby
by
interest
interestrate
ratechanges
changes(i.e.,
(i.e.,original
originalmaturities
maturitiesof
of less
less
than
than33months).
months).
12-3

CLASSIFICATIONS OF THE
STATEMENT OF CASH FLOWS
Operating
Activities

Cash inflows and outflows

directly related to earnings
from normal operations.

Investing
Activities

Cash inflows and outflows related to

the acquisition or sale of productive
facilities and investments in the
securities of other companies.

Financing
Activities

Cash inflows and outflows related to

external sources of financing
(owners and creditors) for the
enterprise.
12-4

CASH INFLOWS
Operating Activities
Cash received
from revenues

Investing Activities
Sale of operational assets
Sale of investments
Collections of loans

Financing Activities
Issuance of stock
Issuance of bonds
and notes

Business
Cash paid for
expenses

Purchase of operational
assets
Purchase of investments
Loans to others

Payment of dividends
Repurchase of stock
Repayment of debt

CASH OUTFLOWS
12-5

This ending cash

balance should
agree with the
balance sheet.

12-6

DIRECT METHOD VS. INDIRECT

METHOD
Two Formats for Reporting Operating Activities
Direct Method

Indirect Method

Reports the
cash effects of
each operating
activity

Starts with
accrual net
income and
converts to
cash basis

Note that no matter which format is used, the same

amount of net cash flows from operating activities is
generated.
12-7

CASH FLOWS FROM OPERATING

ACTIVITIES
Inflows
Inflows
Cash
Cash received
received from:
from:

Customers
Customers

Dividends
Dividends and
andinterest
interest on
on
investments
investments
Outflows
Outflows
Cash
Cashpaid
paidfor:
for:

Purchase
Purchaseof
of goods
goodsfor
for resale
resale
and
andservices
services (electricity,
(electricity,etc.)
etc.)

Salaries
Salaries and
andwages
wages

Income
Incometaxes
taxes

Interest
Intereston
onliabilities
liabilities

+
_

Cash
Cash
Flows
Flows
from
from
Operating
Operating
Activities
Activities

12-8

CASH FLOWS FROM INVESTING

ACTIVITIES
Inflows
Inflows
Cash
Cash received
receivedfrom:
from:

Sale
Saleor
or disposal
disposalof
of property,
property,
plant
plant and
andequipment
equipment

Sale
Saleor
or maturity
maturityof
ofinvestments
investments
in
insecurities
securities
Outflows
Outflows
Cash
Cashpaid
paidfor:
for:

Purchase
Purchaseof
ofproperty,
property,plant
plantand
and
equipment
equipment

Purchase
Purchaseof
ofinvestments
investmentsin
in
securities
securities

+
_

Cash
Cash
Flows
Flows
from
from
Investing
Investing
Activities
Activities

12-9

CASH FLOWS FROM FINANCING

ACTIVITIES
Inflows
Inflows
Cash
Cash received
received from:
from:

Borrowings
Borrowingson
onnotes,
notes, mortgages,
mortgages,
bonds,
bonds, etc.
etc. from
from creditors
creditors

Issuing
Issuingstock
stock to
toowners
owners
Outflows
Outflows
Cash
Cashpaid
paidfor:
for:

Repayment
Repaymentof
of principal
principalto
to
creditors
creditors (excluding
(excluding interest,
interest,
which
whichisis an
anoperating
operating activity)
activity)

Repurchasing
Repurchasingstock
stockfrom
from owners
owners

Dividends
Dividendsto
toowners
owners

+
_

Cash
Cash
Flows
Flows
from
from
Financing
Financing
Activities
Activities

12-10

RELATIONSHIPS TO THE BALANCE

SHEET AND THE INCOME STATEMENT
Information
Information needed
needed to
to prepare
prepare aa
statement
statement of
of cash
cash flows:
flows:

Comparative
Comparative Balance
Balance Sheets.
Sheets.

Income
Income Statement.
Statement.

Additional
Additional details
details concerning
concerning
selected
selected accounts.
accounts.

12-11

RELATIONSHIPS TO THE BALANCE

SHEET AND THE INCOME STATEMENT
Cash
Cash == Liabilities
Liabilities Stockholders
Stockholders
Equity
Equity Noncash
Noncash Assets
Assets
Derives from . . .

Assets
Assets == Liabilities
Liabilities Stockholders
Stockholders Equity
Equity
12-12

RELATIONSHIPS TO THE BALANCE

SHEET AND THE INCOME STATEMENT

12-13

REPORTING AND INTERPRETING CASH

FLOWS FROM OPERATING ACTIVITIES
The
Theindirect
indirect method
methodadjusts
adjustsnet
netincome
incomeby
byeliminating
eliminating
noncash
noncash items.
items.
+/+/-Changes
Changesin
incurrent
current
assets
assetsand
andcurrent
current
liabilities.
liabilities.

Net
Net
Income
Income
++Losses
Lossesand
and
--Gains
Gains

Cash
Cash Flows
Flows
from
from Operating
Operating
Activities:
Activities:
Indirect
IndirectMethod
Method

++Noncash
Noncash
expenses
expensessuch
suchas
as
depreciation
depreciationand
and
amortization.
amortization.
12-14

REPORTING AND INTERPRETING CASH

FLOWS FROM OPERATING ACTIVITIES

Current
Assets
Current
Liabilities

Change in Account Balance During Year

Increase
Decrease
Subtract from net
Add to net income.
income.
Add to net income.
Subtract from net
income.

Use this table when adjusting Net Income

to Operating Cash Flows using the
indirect method.
12-15

ADJUSTMENT FOR GAINS AND

LOSSES
Transactions that cause gains and losses should be
classified on the statement of cash flows as operating,
investing, or financing activities, depending on their
dominate characteristics. For example, if the sale of
equipment produced a gain, it would be classified as an
investing activity.

Gains

Gains must be subtracted from net

income to avoid double counting the
gain.

Losses

Losses must be added to net income

to avoid double counting the loss.
12-16

12-17

The Statement of Cash Flows will begin with

net income from the Income Statement.
12-18

Step
Step 11
Adjust
Adjust net
net income
income for
for depreciation
depreciation and
and
amortization
amortization expense.
expense.
12-19

Step
Step 22
Adjust
Adjust net
net income
income for
for changes
changes in
in
current
current assets
assets and
and current
current liabilities.
liabilities.

12-20

Current
Assets
Current
Liabilities

Change in Account Balance During Year

Increase
Decrease
Subtract from net
Add to net income.
income.
Add to net income.
Subtract from net
income.

12-21

INTERPRETING CASH FLOWS FROM

OPERATING ACTIVITIES
A common rule of thumb followed by financial and credit
analysts is to avoid firms with rising net income but
falling cash flow from operations.
Investors will not invest in a company if they do
not believe that cash generated from operations
will be available to pay them dividends or expand
the company.

Creditors will not lend money if they do not believe

that cash generated from operations will be
available to pay back the loan.
12-22

INTERNATIONAL PERSPECTIVEIFRS
CLASSIFICATION OF INTEREST ON THE CASH FLOW STATEMENT

U.S. GAAP and IFRS differ in the cash flow statement

treatment of interest received and interest paid.

These differences are currently on the agenda of

the joint FASB/IASB financial statement
presentation project.
12-23

QUALITY OF INCOME RATIO

Quality of =
Income Ratio

Cash Flow from Operating Activities

Net Income

In general, this ratio measures the portion of

income that was generated in cash. All other
things equal, a higher quality of income ratio
indicates greater ability to finance operating
and other cash needs from
operating cash inflows.

12-24

12-25

We must report
individually the
cash used to
purchase
equipment and
the cash
proceeds
received from
the sale of
equipment.

12-26

Although shortterm
investments is
a current asset,
it is reported in
the investing
section on the
statement of
cash flows.

12-27

CAPITAL ACQUISITIONS RATIO

Capital
Acquisitions = Cash Flow from Operating Activities
Cash Paid for Property, Plant,
Ratio
and Equipment

In general, this ratio reflects the portion

of purchases of property, plant and
equipment financed from operating
activities. A high ratio indicates less
need for outside financing for current
and future expansions.

12-28

FREE CASH FLOW

Free Cash Flow = Cash Flow from Operating
Activities Dividends Capital Expenditures

In general, this measures a firms

ability to pursue long-term
investment opportunities.

12-29

REPORTING CASH FLOWS FROM

FINANCING ACTIVITIES

12-30

12-31

Cash used to
repay long-term
debt.

12-32

Cash proceeds
from the
issuance of
common stock
to employees.
12-33

Retained
earnings
decreased by
$65,560 due to
the combined
effect of
$40,754 of
income and
$106,314 in
dividends.

12-34

INTERPRETING CASH FLOWS FROM

FINANCING ACTIVITIES
The long-term growth of a company is normally
financed from three sources: internally
generated funds, the issuance of stock, and
money borrowed on a long-term basis.
The statement of cash flows shows how
management has elected to fund its growth. This
information is used by analysts who wish to
evaluate the capital structure and growth
potential of a business.
12-35

COMPLETING THE STATEMENT AND

ADDITIONAL DISCLOSURES
Three Required Disclosures
1.Reconciliation of net income to cash
flow from operations
2.Noncash investing and financing
activities
3.Cash paid for interest and income
taxes
12-36

SUPPLEMENT A: REPORTING CASH FLOWS

FROM OPERATING ACTIVITIESDIRECT
METHOD
Sales revenue
+ Decrease in accounts receivable
- Increase in accounts receivable
= Cash collected from customers
Interest/Dividend revenue
+ Decrease in interest/dividends
receivable
- Increase in interest/dividends
receivable
= Collections of interest/dividends
on investments
+
+
=

Cost of goods sold

Increase in inventory
Decrease in inventory
Increase in accounts payable
Decrease in accounts payable
Cash payments to suppliers

+
+
=

Other expenses
Increase in prepaid expenses
Decrease in prepaid expenses
Increase in accrued expenses
Decrease in accrued expenses
Cash paid for expenses

+
+
=

Income tax expense

Increase in prepaid income taxes
Decrease in prepaid income taxes
Increase in income taxes payable
Decrease in income taxes payable
Payments of income taxes

12-37

SUPPLEMENT A: REPORTING CASH FLOWS

FROM OPERATING ACTIVITIESDIRECT
METHOD

Remember that when we prepared the

operating section using the indirect method,
we also arrived at net cash inflow of $50,425.
12-38

SUPPLEMENT B: ADJUSTMENTS FOR GAINS

AND LOSSES ON SALE OF LONG-TERM
ASSETS: INDIRECT METHOD
Property, plant, and equipment with an original cost of
$10,000 and accumulated depreciation of $4,000 is sold
for $8,000 cash.

Because the gain was included in the computation of

income, it is necessary to remove (subtract) the $2,000
gain from the Operating Activities section of the
statement to avoid double counting.
12-39

SUPPLEMENT C: T-ACCOUNT
APPROACH (INDIRECT METHOD)
Based on the idea that changes in cash must equal the sum of
the changes in all other balance sheet accounts. we can use Taccounts to analyze cash flows as follows:
1. Prepare a single large T-account to represent the changes
that have taken place in cash, subdivided into the three
sections of the cash flow statement.
2. Prepare additional T-accounts for all noncash balance sheet
accounts, entering the beginning and ending balance in each
noncash balance sheet T-Account.
3. Enter the transactions affecting cash in each noncash
balance sheet T-account and in the proper section of the cash
T-account until all changes in noncash balance sheet
accounts have been account for.
12-40

SUPPLEMENT C: T-ACCOUNT
APPROACH (INDIRECT METHOD)

12-41

SUPPLEMENT C: T-ACCOUNT
APPROACH (INDIRECT METHOD)

12-42

END OF CHAPTER 12

12-43