STATEMENT

OF
CASH FLOWS

12-1

Statement
Statement of
of Cash
Cash Flows
Flows

The Statement of
Cash Flows:
Usefulness and
Format

Preparing the
Statement of Cash
FlowsIndirect
Method

Usefulness
Classifications

Step 1: Operating
activities
Step 2: Investing
activities
Step 3: Financing
activities

Significant noncash
activities
Format
Corporate life cycle
Preparation
Indirect and direct
methods
12-2

Using Cash Flows to

Evaluate a Company
Free cash flow
Assessing liquidity
and solvency

Usefulness
Usefulness and
and Format
Format
Usefulness of the Statement of Cash Flows
Provides information to help assess:
1. Entitys ability to generate future cash flows.
2. Entitys ability to pay dividends and obligations.
3. Reasons for difference between net income and net
cash provided (used) by operating activities.
4. Cash investing and financing transactions during the
period.

12-3

Usefulness
Usefulness and
and Format
Format
Classification of Cash Flows
Operating

Investing

Financing

Activities

Activities

Activities

Income

Changes in
Investments
and Long-Term
Asset Items

Changes in
Long-Term
Liabilities and
Stockholders
Equity

Statement Items

12-4

OPERATING ACTIVITIES

Include
Cash

effects of transactions that create

revenues and expenses and
Enter into determination of net profit
(loss)

12-5

Balance Sheet: Current Assets

and Current Liabilities; Income
Statement Items

INVESTING ACTIVITIES

Include
Purchasing

and disposing of investments

and productive long-lived assets using
cash
Lending money and collecting loans
Interest received and Dividend received

12-6

Balance Sheet: Investment and

Long-Term Asset Items

FINANCING ACTIVITIES

Include
Obtaining

cash through issuing shares

and Debentures
Buying back shares and Debentures
Payment of interest and dividends

Balance Sheet: Long-Term

Liability and Equity Items
12-7

PREPARING
THE CASH FLOW STATEMENT
The cash flow statement is prepared differently
from the three other basic financial statements.
1. It is not prepared from the adjusted trial
balance.
2. The cash flow statement deals with cash
receipts and payments, so the accrual concept is
not used in the preparation of this statement.
The information to prepare this statement usually
comes from three sources:
1. Comparative balance sheet
2. Current income statement
3. Additional information
12-8

Usefulness
Usefulness and
and Format
Format
Format of the Statement of Cash Flows
Order of Presentation:
1.

12-9

Operating activities.

2.

Investing activities.

3.

Financing activities.

Direct Method
Indirect Method

INDIRECT AND DIRECT METHODS

Both

methods arrive at the same total

amount of cash provided (used) by operating
activities
Methods differ in disclosing the items that
make up the total amount
Choice of methods affects only the operating
activities section; the investing and financing
activities sections are the same

12-10

NET INCOME VS. NET CASH PROVIDED BY

OPERATING ACTIVITIES
The indirect method starts with net income and converts it to
net cash provided by operating activities . In other words, it
adjusts net income for items that affect reported net income but
do not affect cash, as shown below.
Accrual Basis of Accounting

Eliminate noncash revenues

Earned
Revenues

Net Income

12-11

Incurred
Expenses

Cash Basis of Accounting

Net Cash Provided

(Used) by Operating
Activities

Eliminate noncash expenses

NET INCOME TO NET CASH PROVIDED (USED) BY

OPERATING ACTIVITIES
(I/S: Noncash Items)
Adjustments to Convert Net
Income to Net Cash Provided
(Used) by Operating Activities

Noncash Items on Income Statement

Depreciation (of capital assets)
Loss on sale of asset
Interest expense
Interest Income
Gain on sale of asset
Income from long-term equity investment

12-12

Add
Add
Add
Deduct
Deduct
Deduct

NET INCOME TO NET CASH PROVIDED (USED) BY

OPERATING ACTIVITIES
(B/S: Noncash Current Assets and Current Liabilities)

Adjustments to Convert Net Income

to Net Cash Provided (Used) by
Operating Activities
Add*
Deduct*
Change in Current Asset Account Balance
Accounts receivable
Decrease
Inventory
Decrease
Other current assets
Decrease

Increase
Increase
Increase

Change in Current Liability Account Balance

Accounts payable
Increase
Accrued expenses payable
Increase
Other current liabilities
Increase

Decrease
Decrease
Decrease

* Add (deduct) change in account balance to net income

12-13

Format
Format of
of the
the Statement
Statement of
of Cash
Cash Flows
Flows
Illustration: Classify each of these
transactions by type of cash flow activity.
1. Issued 100,000 shares of $5 par value
common stock for $500,000 cash.
2. Borrowed $200,000, signing a 5-year note
bearing 8% interest.
3. Purchased two semi-trailer trucks for $170,000
cash.
4. Paid employees $12,000 for salaries and
wages.
5. Collected $20,000 cash for services provided.
12-14

Usefulness
Usefulness and
and Format
Format
Preparing the Statement of Cash Flows
Three Sources of Information:
1. Comparative balance sheets
2. Current income statement
3. Additional information

12-15

Usefulness
Usefulness and
and Format
Format
Indirect and Direct Methods
Companies favor the indirect
method for two reasons:
1. Easier and less costly to
prepare.
2. Focuses on differences
between net income and net
cash flow from operating
activities.

12-16

Preparing
Preparing the
the Statement
Statement of
of Cash
Cash Flows
Flows
Illustration Indirect Method

12-17

Preparing
Preparing the
the Statement
Statement of
of Cash
Cash Flows
Flows

12-18

Preparing
Preparing the
the Statement
Statement of
of Cash
Cash Flows
Flows

Additional information for 2012:

1. Depreciation expense was comprised of $6,000 for building and $3,000 for equipment.
2. The company sold equipment with a book value of $7,000 (cost $8,000, less accumulated
depreciation $1,000) for $4,000 cash.
3. Issued $110,000 of long-term bonds in direct exchange for land.
4. A building costing $120,000 was purchased for cash. Equipment costing $25,000 was also
purchased for cash.
5. Issued common stock for $20,000 cash.
6. The company declared and paid a $29,000 cash dividend.
12-19

Preparation
Preparation of
of the
the Statement
Statement of
of Cash
Cash Flows
Flows
Indirect
Indirect Method
Method
Step 1: Operating Activities
Determine net cash provided/used by operating activities by
converting net income from accrual basis to cash basis.

Common adjustments to Net Income (Loss):

12-20

Add back non-cash expenses (depreciation).

Deduct gains and add losses.

Changes in current assets and current liabilities.

Step
Step 1:
1: Operating
Operating Activities
Activities
Depreciation Expense
Although depreciation expense reduces net income, it does
not reduce cash. The company must add it back to net
income.

12-21

Operating
Operating Activities
Activities
Loss on Sale of Equipment
Companies report as a source of cash in the investing
activities section the actual amount of cash received from
the sale.

12-22

Any loss on sale is added to net income in the

operating section.

Any gain on sale is deducted from net income in the

operating section.

Operating Activities
Interest paid
Companies

report interest paid as expense in the Income

statement and deduct it from the Net income. But, it is an
expense relating to Financing Activity. Hence, it should be
added back to Net income and deducted from the Cash Flow
from Financing Activities.

12-23

Operating
Operating Activities
Activities
Loss on Sale of Equipment

12-24

Operating
Operating Activities
Activities
Changes to Current Asset Accounts
When the Accounts Receivable balance decreases, cash
receipts are higher than revenue earned under the accrual
basis.
Accounts Receivable
1/1/012

Balance
Revenues

12/31/12 Balance

30,000
507,000

Receipts from customers 517,000

20,000

Company adds to net income the amount of the decrease in

accounts receivable.
12-25

Operating
Operating Activities
Activities
Changes to Noncash Current Asset Accounts

12-26

Operating
Operating Activities
Activities
Changes to Noncash Current Asset Accounts
When the Inventory balance increases, the cost of
merchandise purchased exceeds the cost of goods sold.
Inventory
1/1/12

Balance
Purchases

12/31/12 Balance

10,000
155,000

Cost of goods sold

150,000

15,000

Cost of goods sold does not reflect cash payments made for
merchandise. The company deducts from net income this
inventory increase.
12-27

Operating
Operating Activities
Activities
Changes to Noncash Current Asset Accounts

12-28

Operating
Operating Activities
Activities
Changes to Noncash Current Asset Accounts
When the Prepaid Expense balance increases, cash paid for
expenses is higher than expenses reported on an accrual
basis. The company deducts the decrease from net income
to arrive at net cash provided by operating activities.
If prepaid expenses decrease, reported expenses are higher
than the expenses paid.

12-29

Operating
Operating Activities
Activities
Changes in Current Asset Accounts

12-30

Operating
Operating Activities
Activities
Changes in Current Liability Accounts
When Accounts Payable increases, the company received more
in goods than it actually paid for. The increase is added to net
income to determine net cash provided by operating activities.
When Income Tax Payable decreases, the income tax expense
reported on the income statement was less than the amount of
taxes paid during the period. The decrease is subtracted from
net income to determine net cash provided by operating activities.

12-31

Operating
Operating Activities
Activities
Changes to Noncash Current Liability Accounts

12-32

NET CASH PROVIDED (USED) BY

INVESTING ACTIVITIES
Study the

balance sheet to determine changes

in investments and long-term assets
Changes in each short-term investment (unless
incorporated as part of cash definition) and
long-term account are analysed using selected
transaction data to determine the effect, if any,
the changes had on cash

12-33

NET CASH PROVIDED (USED) BY

FINANCING ACTIVITIES
Study the

balance sheet to determine

changes in noncurrent liabilities and
owners/shareholders equity
Changes in each noncurrent account are
analysed using selected transaction data to
determine the effect, if any, the changes had
on cash

12-34

Investing
Investing and
and Financing
Financing Activities
Activities
Partial statement

12-35

Statement
Statement
of
of Cash
Cash
Flows
Flows
Indirect
Method

12-36

USING CASH FLOWS TO EVALUATE

COMPANY
Liquidity
Cash

current debt coverage ratio

Profitability
Cash

return on sales ratio

Cash flow per share
Solvency
Cash

total debt coverage

These ratios are cash-based instead of

accrual-based
12-37

CASH CURRENT DEBT COVERAGE

Cash current debt coverage indicates the
amount of cash to pay off current debt that is
generated from operating activities.
The ratio provides a better picture of liquidity
than using the current ratio because it uses
cash provided by operating activities rather
than the year-end asset balance.

Cash
Provided by
Operating
Activities
12-38

Average
Current
Liabilities

Cash
Current
Debt
Coverage

CASH RETURN ON SALES

Cash

return on sales indicates how

quickly sales are turned into cash.
The company is efficient at turning
sales into cash when its cash return on
sales is greater than its accrual-based
counterpart, the profit margin.
Cash
Provided by
Operating
Activities
12-39

Net Sales

Cash Return
on Sales

CASH FLOW PER SHARE

Cash

flow per share indicates the cash

flow generated for each common share.

Cash Flow
from Operating,
Investing, and
Financing
Activities

12-40

Number of
Common Shares

Cash Flow per

Share

CASH TOTAL DEBT COVERAGE

Cash

total debt coverage indicates the

amount of cash to pay off total debt that
is generated from operating activities.
The ratio is the cash based counterpart
to the debt to total assets ratio.
Cash
Provided by
Operating
Activities

12-41

Average
Total
Liabilities

Cash Total
Debt
Coverage

Step
Step 3:
3: Net
Net Change
Change in
in Cash
Cash
Compare the net change in cash on the Statement of Cash
Flows with the change in the cash account reported on the
Balance Sheet to make sure the amounts agree.

12-42

Using
Using Cash
Cash Flows
Flows to
to Evaluate
Evaluate aa Company
Company
Free Cash Flow

Free cash flow describes the cash remaining from

operations after adjustment for capital expenditures and
dividends.

12-43