Financial Statement Analysis: Charles H. Gibson

Financial Statement
Analysis
CHARLES H. GIBSON
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website for classroom use.
Chapter
10
Statement of Cash Flows
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
Primary Purpose
To provide relevant information about the
cash receipts and cash payments of an
enterprise during a period.
The statement provides answers to the
following questions:
1. Where did the cash come from?
2. What was the cash used for?
3. What was the change in the cash balance?
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for classroom use.
Basic Elements of the Statement
of Cash Flows
The statement of cash flows uses a concept of
Cash and Cash Equivalent focus
The category cash and cash equivalents includes
Cash on hand, Cash on deposit, and Investments
in Short-Term, Highly Liquid Investments
(Marketable Securities).
The cash flow statement explains the changes
in focus accounts by examining all the accounts
on the balance sheet other than the cash focus
accounts.
Uses of the statement of
cash flows
Internal users (management) may use the statement to:
• Determine dividend policy
• Evaluate cash generated by operations
• Review investing and financing policy
External users such as creditors and investors may use
the statement to:
• Determine a firm’s ability to increase dividends
• Determine a firm’s ability to pay debt from
operations
• Determine the percentage of cash from operations
in relation to the cash from financing
Preparation of the Statement of
Cash Flows
• The statement of cash flows classifies cash
receipts and cash payments into three activities:
Operating activities, Investing activities, and
Financing activities.
• The statement of cash flows presents cash flows
from operating activities first, followed by
investing activities and then financing activities.
• The operating activities section can be presented
using the direct method or the indirect method.
• The indirect method is sometimes referred to as
the reconciliation method.
Preparation of the Statement of
Cash Flows
Information obtained from several sources:
1. Comparative balance sheet
2. Current year income statement, and selected transaction data.
To prepare the statement, Determine:
1.Net cash provided by (or used in) operating activities.
2. Net cash provided by (or used in) investing and financing
activities.
3. Determine the change (increase or decrease) in cash during the
period.
4. Reconcile the change in cash with the beginning and the ending
cash balances.
Structure of the Statement of
Cash Flows
Cash Flows from Operating Activities
Add: Cash Flows from Investing Activities
Add: Cash Flows from Financing Activities
Change in Cash
Beginning Cash Balance

Add: Change in cash
Ending Cash Balance
Supplemental disclosure: Noncash investing

and financing activities
1st: Cash Flows Operating Activities
The excess of cash receipts over cash
payments from operating activities.
Operating activities include: revenues,
expenses, gains(sold items gain during
operation period), losses(sold items loss
during operation period, current assets, and
current liabilities.
This amount is determined by converting net
income on accrual basis to a cash basis as
follows:
• Net income x
+ noncash expenses such as: depreciation
expenses(because it was subtracted previously),
amortization expenses, loss on sale of assets or
investments,…… x
- gain on sale of assets (because it is included in
changing in current assets and to avoid double
calculation) x
+ decrease in current assets (except cash) x
- increase in current assets (except cash) x
+ Increase in current liabilities x
- decrease in current liabilities x
MCQ
During 2015 the DLD Company had a net income of
200,000. In addition, selected accounts showed the
following changes:
Accounts Receivable 12,000 increase
Accounts Payable 4,000 increase
Buildings 16,000 decrease
Depreciation Expense 6,000 increase
Bonds Payable 32,000 increase
What was the amount of cash provided by operating
activities?
a. 198,000 b. 200,000 c. 206,000 d.238,000
2nd: Cash Flows from Investing Activities
Investing activities include: sale or purchase

of long-term investments and property plant
and equipment PP&E
Cash flows from investing activities
+ selling price of PP&E and investments for
cash)
- cost (or purchase price) of
PP&E and long-term investments
purchased cash
MCQ
Caroline, Inc. had the following transactions during 2015:
Exchanged land for a building $764,000
Purchased treasury shares 160,000
Paid cash dividend 380,000
Purchased equipment 212,000
Issued ordinary shares 588,000
What is Caroline, Inc.’s net cash provided (used) by investing
activities?
a. $212,000 used by investing activities.
b. $552,000 provided by investing activities.
c. $372,000 used by investing activities.
d. $392,000 provided by investing activities.
3rd: Cash Flows from Financing Activities
Financing activities include: long-term

liabilities and owners equity
Cash flows from financing activities =
+ issuance of shares or bonds
(issued for cash)
+ increase in Loans (received in cash)
- dividends paid in cash
- decrease in bonds or loans (paid in cash)
MCQ
Caroline, Inc. had the following transactions during 2015:
Exchanged land for a building $764,000
Purchased treasury shares 160,000
Paid cash dividend 380,000
Purchased equipment 212,000
Issued ordinary shares 588,000
What is Caroline, Inc.’s net cash provided (used) by financing
activities?
a. 600,000 provided by financing activities.
b. 48,000 provided by financing activities.
c. 48,000 used by financing activities.
d. 428,000 used by financing activities.
Notes
1. Calculate the change in all balance sheet
items except cash focus accounts.
2. Change = ending balance – beginning balance
3. Depreciation expense = ending balance of
accumulated depreciation – beginning
balance of accumulated depreciation
4. Gains or losses from sale of assets or
investments = selling price – BV
So, selling price = BV + gains or – losses
5. Dividends declared and paid =

beginning R.E
+ net income (or – net loss)
– ending R.E
There are some significant financing and investing
activities that do not affect cash flow. Such as:
Issuance of common stock to purchase assets.
Conversion bonds into common stock.
Issuance of debt (bond) to purchase assets.
Exchanges on long-lived assets.
These transactions do not affect the statement of
cash flows. They should be disclosed in a separate
schedule presented with the statement of cash flows.
Problem 10-2. and problem 10-4.
Problem 10 – 4 (a)
BBB COMPANY
For the Year Ended December 31, 2011
Cash flow from operating activities: Net income $ 500
Non cash expenses included in income
Depreciation $ 2,800
Gain on sale of land (800)
Decrease in accounts receivable 400
Decrease in inventory 500
Increase in accounts payable 800
Increase in wages payable 50
Decrease in taxes payable (1,000) $ 2,750
Net cash flow from operating activities $ 3,250
Problem 10 – 4-a (cont.)
Net cash flow from operating activities $ 3,250
Cash flows from investing activities:
Land was sold for 1,800
Equipment was purchased for (3,500)
Net cash used for investing activities $ (1,700)
Cash flows from financing activities:
Dividends declared and paid (4,350)
Common stock was sold for 3,800
Net cash used for financing activities $ (550)
Net increase in cash and marketable securities $ 1,000
+ beginning cash balance (4,000 + 2,000) 6,000
= Ending cash balance (4,500 + 2,500) $ 7,000
Problem 10 – 4. B.
• Net cash flow from operating activities was substantially
more than the net income.
• Cash dividends were greater than the net cash flow from
operating activities.
• The cash from issuing the common stock was sufficient
to cover the net cash used for investing activities,
increase the cash and marketable securities accounts,
and partially cover the large cash dividend.
• The fact that a long-term source of funds (common
stock) was used to cover part of the cash dividends is a
negative observation.
• The large cash dividend in relation to net cash flow from
operating activities would also be considered a negative
situation.
Financial Ratios and the
• Financial ratios that relate to the statement of
cash flows were slowly developed, because most
financial ratios traditionally related an income
statement item(s) to a balance sheet item(s), and
the sstatement of cash flows did not become a
required statement until 1987.
Some of the cash flows ratios are as follows:
1. Operating Cash Flow to Current Maturities of
long- Term Debt and Current Notes Payable
2. Operating cash flow to total debt
3. Operating cash flow per share
4. Operating cash flow to cash dividends
Operating Cash Flow to Current Maturities of
long-Term Debt and Current Notes Payable
• Indicates a firm’s ability to meet its current

maturities of debt from cash generated by
• The higher this ratio, the better the firm’s
ability to meet its current maturities of debt,
and the better the firm’s liquidity.
Operating Cash Flow

Current Maturities of Long-Term Debt and Current Note Payable
Operating Cash Flow to Total Debt
• Indicates a firm’s ability to cover total debt with
the yearly operating cash flow
• The higher the ratio, the better the firm’s ability
to carry its total debt
• Conservative approach is to include all possible
balance sheet debt items. The total debt figure is
the same total debt amount that was computed in
chapter 7 for the debt ratio and the debt/equity
ratio
Operating Cash Flow

Total Debt
Operating Cash Flow per Share
• Indicates the funds flow per common share
outstanding
• In the short run, operating cash flow per share is
a better indication of a firm’s ability to pay
dividends than is earnings per share.
• This ratio does not reflect firm’s profitability.
 Operating Cash  Operating Cash Flow  Preferred Dividends

 Flow per Share  =
  Diluted Weighted Average Common
Shares Outstanding
Operating Cash Flow to Cash
Dividends
• Indicates a firm’s ability to cover cash
dividends with the yearly operating cash flow
• The higher the ratio, the better the firm’s
ability to cover cash dividends
Operating Cash Flows

Cash Dividends
• Problem 10 - 12, a and c.

Problem 12 a
SAMPSON COMPANY
For the Year Ended December 31, 2011
Net cash flow from operating activities:
Net income $ 19,000
Noncash expenses included in income:
Depreciation expense $ 10,000
Increase in net receivables (7,000)
Increase in inventory (13,000)
Increase in accounts payable 5,000
Decrease in accrued liabilities (17,000)
Net cash outflow from operating activities (3,000)
Problem 12 a (cont.)
Net cash outflow from operating activities (3,000)
Cash flows from investing activities:
Plant assets increase (15,000)
Cash flows from financing activities:
Mortgage payable increase $ 11,000
Common stock increase 6,000
Dividends paid (21,000)
Net cash flows from financing activities (4,000)
Net decrease in cash $ (22,000)
+ beginning cash balance 60,000
= Ending cash $ 38,000
Problem 12 (c)
• All major segments of cash flows were
negative.
• Net cash outflow from operating activities
was negative by $3,000, and yet dividends
were paid in the amount of $21,000.
• Also, the company had a negative cash flow
from investing activities.
• These negative cash flows were partially
made up for by issuing a mortgage payable
• ($11,000) and common stock ($6,000).
PROBLEM 10-13
• a. Zaro had substantially more net cash flow

from operating activities than it had net
income.
• Major reasons for this were depreciation,
decrease in accounts receivable, and decrease
in inventory.
• The substantial cash flows from operating
activities were used for investing activities and
financing activities.
• Cash was particularly used for the financing
activity of paying dividends.
b. 1. Current Ratio:
Current assets:
Cash $ 30,000
Accounts receivable, net 75,000
Inventory 90,000
Prepaid expense 3,000 $ 198,000 (A)
Current Liabilities:
Accounts payable $ 25, 500
Income taxes payable 2,500
Accrued liabilities 5,000
Current portion of bonds payable 20,000 $ 53,000 (B)
(A) $198,000 ÷ (B) $53,000 = 3.74 t0 1.
2. Acid-Test Ratio:
Cash $ 30,000
Accounts receivable, net 75,000 $ 105,000 (A)
Current liabilities $ 53,000 (B)
(A) $105,000 ÷ (B) $53,000 = 1.98
3. Operating Cash Flow/Current Maturities of Long-Term Debt and
Current Notes Payable:
Operating cash flow $ 51,000 (A)
Current maturities of long-term debt
and current notes payable $ 20,000 (B)
(A) $51,000 ÷ (B) $20,000 = 2.55
4. Cash Ratio:
Cash $ 30,000 (A)
Current liabilities $ 53,000 (B)
(A) $30,000 ÷ (B) $53,000 =0.57%
c. 1. Times Interest Earned:

Income before taxes $ 34,000
Plus interest expense 8,000 (B)
$ 42,000 (A)
(A) $42,000 ÷ $8,000 = = 5.25 times per year
2. Debt Ratio:
Total Liabilities:
Accounts payable $ 25,500
Income taxes payable 2,500
Accrued liabilities 5,000
Bonds payable 90,000
$ 123,000 (A)
Total assets $ 253,000 (B)
(A) $123,000 ÷ (B) $253,000 = 48.62%
d. 1. Return on assets = $20,000 ÷ (($253,000 + $274,000)/2 = 7.59%
2. Return on Common Equity = $20,000 ÷ ($85,000 + $54,000 +

$85,000 + $45,000)/2 = 14.87%
• e. All liquidity ratios are very good.
• f. The debt position is good.
• g. Profitability is good.
• h. Substantial cash flow came from
• A relatively small amount of funds were
used for investing activities and paying
down bonds.
• This left substantial cash available to pay
dividends.
Question
In December 31/ 2018 the Cairo Company had a net

Income of $100,000. In addition, selected accounts
showed the following changes:
Increase in Accounts Receivable $6,000
Decrease in Accounts Payable 2,000
Increase in Accumulated Depreciation 3000
Cash used by investing activities 50,000
Cash provided by financing activities 70,000
Ending cash balance 150,000
Required: prepare cash flow statement for the year
ended December 31/2018 in a good format.
Answer
Cairo Company
Cash Flow Statement
For the year ended December 31/2018
Net income $100,000
Depreciation expense 3,000
Increase in AR (6,000)
Decrease in AP (2,000)
Cash provided by operating activities 95,000
Cash used by investing activities (50,000)
Cash provided by financing activities 70,000
• Net increase in cash 115,000
• Beginning cash balance 35,000
• Ending cash balance 150,000
•
PROBLEM 10-7
• Owens appears to be the growth firm. Operating activities

may represent a use of cash because of the expansion of
receivables and inventory. The expansion of fixed assets
would use cash in investing activities. Financing activities are
providing cash for expansion.
• Alpha appears to be the firm in danger of bankruptcy. Cash
is used in operations, capital expenditures appear to be
nominal, and financing activities are using instead of providing
cash.
• Arrow appears to be the older firm expanding slowly. Arrow
is generating significant cash from operating activities, while
nominal cash is used for investing activities. Financing
activities are using cash instead of providing cash (dividends,
repayment of long-term debt, etc.).
•

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Financial Statement

Statement of Cash Flows

Beginning Cash Balance

Supplemental disclosure: Noncash investing

Investing activities include: sale or purchase

Financing activities include: long-term

5. Dividends declared and paid =

• Indicates a firm’s ability to meet its current

Operating Cash Flow

Operating Cash Flow

 Operating Cash  Operating Cash Flow  Preferred Dividends

Operating Cash Flows

• Problem 10 - 12, a and c.

• a. Zaro had substantially more net cash flow

c. 1. Times Interest Earned:

2. Return on Common Equity = $20,000 ÷ ($85,000 + $54,000 +

In December 31/ 2018 the Cairo Company had a net

• Owens appears to be the growth firm. Operating activities

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