8/15/2016

Measuring Cash Flows

A. Profit Versus Cash Flows

1. Profits and cash flows are not the same
thing.
2. Without adequate cash flow, even a
profitable business can go bankrupt.
3. An income statement is not a measure of
cash flows because it is on an accrual
basis rather than a cash basis

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Two Approaches in Measuring Cash Flows

1. Statement of Cash Flows
2. Free Cash Flows and Financing Cash
Flows

Statement of Cash Flows

Method of presenting cash flows focuses on
identifying the sources and uses of cash
Explains the changes in a firms cash
balance reported in balance sheet

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Statement of Cash Flows

Sources of Cash
Decrease in an asset
Increase in a liability or
equity

Uses of Cash
Increase in an asset
Decrease in a liability or
equity

3 Key Activities
1. Generating cash flows from day-to-day
business operations
2. Investing in fixed assets and other longterm investments
3. Financing the business

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Cash Flow Activity 1:

Cash Flows from
Day-to-Day Operations
Net income
Plus depreciation expense
Less an increase in accounts receivable or plus a
decrease in accounts receivable.
Less an increase in inventories or plus a decrease
in inventories.
Less an increase in other current assets or plus a
decrease in other current assets.
Plus an increase in accounts payable and accrued
liabilities or less a decrease in accounts payable
and accrued liabilities

Cash Flow Activity 2:

Investing in Long-Term Assets
( + ) increase in gross fixed assets (cash outflow)
OR
( - )decrease in gross fixed assets and other long-term
assets (cash inflow)

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Cash Flow Activity 3:

Financing the Business
( + ) increase in interest-bearing debt (cash inflow)
OR
( - ) decrease in interest-bearing debt (cash outflow)
( + ) increase in common stock (cash inflow)
OR
( - ) decrease in common stock (cash outflow)
( - ) dividend payments (cash outflow)

Basic Format of a
Statement of Cash Flows
Cash flows from operations
+/- cash flows from investing activities
+/- cash flows from financing activities
=
change in cash
+
beginning cash
=
ending cash

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Study Problem 3-9

Given the following information,
prepare a statement of cash flows.
Increase in accounts receivable
Increase in inventories
Operating Income
Interest Expense
Increase in accounts payable
Dividends
Increase in common stock
Increase in net fixed assets
Depreciation Expense
Income taxes
Beginning cash

$25
30
75
25
25
15
20
23
12
17
20

FIRST, you need to get the NET INCOME.

Operating Income
Less: Interest Expense
Earnings Before Taxes
Less: Income Tax
Net Income

$75
25
$50
17
$33

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Cash Flows from Operating Activities

*Net Income
Adjustments:
Depreciation
Increase in accounts receivable
Increase in inventories
Increase in account payable

12
(25)
(30)
25

Net Cash provided by operating activates

$15

$33

Cash Flows from Investing Activities

**Increase in gross fixed assets

($35)

Cash Flows from Financing Activities

Increase in common stock
Dividends

$20
($15)

Net cash provided by financing activities

Decrease in Cash
Beginning Cash
Ending cash

$5
($15)
20
$5

* Net Income = operating income interest expense income taxes

** The change in gross fixed assets is equal to the change in net fixed assets ($23) plus the
depreciation expense for the year of $12, resulting in a
change in gross fixed assets of $35.

GAAP and IFRS

Generally Accepted Accounting Principles, (GAAP)
is rule-based and sets out rules that accountants
must follow when preparing financial statements.
International Financing Reporting Standards, (IFRS)
is principle-based and sets out general principles.
IFRS leaves more room for discretion than GAAP
does, permitting managers to exercise their own
judgment when deciding what to report in their
financial statements, as long as they follow the spirit
of the standards.

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Income Taxes and Finance

A. Computing Taxable Income
1. Taxable income is basically determined as
income less allowable exclusions and tax-deductible
expenses.
2. Interest expense is a tax deductible expense;
however, dividends paid by a corporation to its
stockholders are not a tax

Income Taxes and Finance

Two Basic Components of Taxable Income
1. Operating Income is gross profit less
operating expenses
2. Capital Gains/Loss when a firms sells a
capital asset, which is not part of its
ordinary operations.
example: land

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B. Computing the Taxes Owed

Corporate rate structure:
Rate

Income

15%
25%
34%
35%

$0 - $50,000
$50,001 - $75,000
$75,001 - $10,000,000
over $10,000,000

There is an additional surtax of 5 percent for income

between $100,000 and $335,000.
There is also an additional surtax of 3 percent on income
between $15 million and $18.3 million.

Accounting Malpractice and

Limitations of Financial
Statements

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Free Cash Flows

paid all operating expenses and made all its
investments, the remaining cash flows are free to be
distributed to the firms creditors and shareholders.
Results from 2 activities:
1. After-tax cash flows from operations
2. Asset investments

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