chapter 5 statement of cash flows and articulation · pdf file5-1 1. important companion of...

5-1

1. Important companion of the income statement

2. Three main categories of the cash flow statement:

operating, investing, and financing

3. Cash flows from operations using either the direct

or the indirect method

4. Prepare a complete statement of cash flows

5. Analysis of a firm’s financial strength from

perspective of cash flows

6. Articulation of the three primary financial

statements

7. Forecasted statement of cash flows

Chapter 5 Statement of Cash Flows

and Articulation

5-2

What Good is a Cash Flow Statement?

• Sometimes earnings fail.

• Everything is on one page.

• It is used as a forecasting tool.

We need the cash flow statement because:

1. Describe the circumstances in which the

cash flow statement is a particularly important

companion of the income statement.

5-3

The Big Loss Scenario

When a company reports large noncash

expenses such as:

- write-offs

- depreciation

- provisions for future obligations

… earnings may give a gloomier picture of

current operations than warranted.

(continued)

Sometimes Earnings Fail

5-4

The Rapid Growth Scenario

• Rapidly growing firms use large amounts of

cash to expand inventory.

• Cash collections on the growing accounts

receivable often lag behind the need to pay

creditors.

• Reported earnings may be positive, but

operations are actually consuming rather

than generating cash.

5-5

The Reality Check Scenario

Companies entering phases in which it is critical

that reported earnings look good, accounting

assumptions can be stretched

• Just before making a large loan application

• Just before the initial public offering of stock

• Just before being bought out by another

company

• Cash flow from operations, which is not

impacted by accrual assumptions, provides

an excellent reality check for earnings.

5-6

Everything is on One Page

• The cash flow statement includes information

on operating, investing, and financing

activities.

• Everything you ever wanted to know about a

company’s performance for the year is

summarized in this one statement.

(continued)

5-7

It is Used as a Forecasting Tool

A pro forma cash flow statement is a

prediction of what the actual cash flow

statement will look like in future years if the

operating, investing, and financing plans are

implemented.

5-8

Statement of Cash Flows

A statement of cash flows explains the

change during the period in cash and

cash equivalents.

What is this?

2. Outline the structure of and information

reported in the three main categories of the

cash flow statement: operating, investing,

and financing

5-9

• A cash equivalent is a short-term, highly

liquid investment that can be converted

easily into cash.

• To qualify as a cash equivalent, an item

must be:

1. Readily convertible into cash

2. So near to its maturity that there is

insignificant risk of changes in value

due to changes in interest rates

Cash Equivalent

5-10

• Operating activities include those

transactions and events that enter into the

determination of net income.

Three Categories of Cash Flows

Cash receipts from selling goods or from

providing services.

Receipts from Interest, dividends, and

similar items.

Payments to purchase inventory and to pay

wages, taxes, and similar expenses.

5-11 5-11 (continued)

5-12

• The primary investing activities are the

purchase and sale of land, buildings,

equipment, and other assets not generally

held for resale.

• In addition, investing activities include those

transactions and events that involve the

purchase and sale of financial instruments

not intended for trading purposes, as well as

making and collecting loans.


(continued)

5-14

Financing activities include those transactions

and events whereby resources are obtained from,

or repaid to, owners (equity financing) and

creditors (debt financing):

• Cash proceeds from issuing stocks or bonds.

• Payments to reacquire stock (treasury stock)

or to retire bonds.

• Payment of dividends.

(continued)


5-15 5-15 (concluded)

5-16

• Most companies (73% in the United States

in 2006) generate positive cash flow from

operations.

• In normal times, most companies use cash

to expand or enhance long-term assets, so

cash from investing activities is usually

negative (83% of the time in the United

States in 2006).

• No general statement can be made about

cash flow from financing activities.

Cash Flow Patterns

(continued)

5-18

Noncash Investing and Financing Activities

• Noncash investing and financing activities

affect an entity’s financial position but not the

entity’s cash flow. Examples include:

• Significant transactions should be disclosed

separately.

• These transactions do NOT appear in the

statement of cash flows.

Equipment purchased with a note payable

Land acquired by issuing stock

5-19 5-19

Cash Flow Categories Under IAS 7

The provisions of IAS 7, Statement of Cash Flows, are more

flexible than the U.S. rules contained in SFAS No. 95. Here is

a summary of these differences:

5-20 5-20

3. Compute cash flow from operations using

either the direct or the indirect method

5-21 5-21

5-22

Operating Activities: Direct Method

• The direct method is essentially a

reexamination of each income statement

item with the objective of reporting how

much cash was received or disbursed in

association with the item.

• To prepare the operating section, each

income statement item must be adjusted

for the effects of accruals.

5-23

• The indirect method begins with net

income as reported on the income

statement and adjusts the accrual amount

for any items that do not affect cash flow.

• Both the direct and indirect methods

produce identical results—that is, the same

amount of net cash provided by (or used

in) operations.

(continued)

Operating Activities: Indirect Method

5-24

The adjustments for the indirect method are of

three basic types:

• Revenues and expenses that do not involve

cash inflow or outflow.

• Gains and losses associated with investing

or financing activities.

• Adjustments for changes in current

operating assets and liabilities that indicate

noncash sources of revenues and

expenses.


5-25

Operating Activities

5-26

Sales and Cash Collected from

Customers

Sales and Cash Collected from

Customers

Beginning accounts receivable $ 40

+ Sales 150

= Cash available for collection $190

Ending accounts receivable 60

= Cash collected from customers $130

(continued)


5-27

Cost of Goods Sold and Cash Paid

for Inventory

Cost of Goods Sold and Cash Paid

for Inventory

Ending inventory $ 75

+ Cost of goods sold 80

= Required inventory $155

Beginning inventory 100

= Inventory purchased this year $ 55

(continued)


5-28

Wages Expense and Cash

Paid for Wages

Wages Expense and Cash

Paid for Wages

Beginning wages payable $ 7

+ Wages expense 25

= Total obligation to employees $32

– Ending wages payable 10

= Cash paid for wages $22

(continued)


5-29

Depreciation Expense Depreciation Expense


5-30

Sales Sales

The $20 increase in accounts receivable

means that cash collected is $20 less than

the $150 the sales number indicates. So,

the necessary adjustment is to subtract

the $20 to show that $130 was collected

on account.

(continued)


5-31

Cost of Goods Sold Cost of Goods Sold

The $25 decrease in inventory means that

although cost of good sold of $80 is

included in the income statement, less

cash was used to purchase inventory than

suggested—add $25 to net income.

(continued)


5-32

Wages Expense Wages Expense

The $3 increase in wages payable

indicates that only $22 of the $25 expense

was paid in cash. The $3 increase in

wages payable is added to net income.

(continued)


5-33

Depreciation Expense Depreciation Expense

The $30 depreciation expense is a noncash

expense. Because it was subtracted in

computing net income, it must be added

back to net income because it was

deducted from net income to determine the

accrual net income.

(continued)


5-34


Note the same net cash from

operating activities as calculated

using the direct method.

5-35

• Depreciation is not a source of cash.

Because you added depreciation back to net

income as an adjustment using the indirect

method does not mean that there is an inflow

of cash. However, depreciation does lower

the amount of income taxes paid.

• One advantage of the indirect method is that

it highlights how cash flow can be improved

in the short run by adjusting operating

procedures.

Important

5-36

Comparison of Direct and Indirect Methods

(continued)

Direct Method Direct Method

The shaded area is reported in the Operating

Activities section of the statement of cash flows.

5-37

Indirect Method Indirect Method

5-37

Comparison of Direct and Indirect Methods

(continued)

With the indirect method, only net income and the

adjustments are reported. The Operating Activities section

of the statement of cash flows includes the shaded

information above.

5-38 5-38

5-39 5-39

5-40

Preparing a Complete Statement of Cash Flows

• Operating—income statement adjusted for

changes in current operating assets and

liabilities.

• Investing—changes in long-term assets.

• Financing—changes in long-term liabilities

and owners’ equity.

Basic information to prepare the three sections

of the cash flow statement comes from the

balance sheet and income statement, as follows:

4. Prepare a complete statement of cash flows

and provide the required supplemental

disclosures

5-41

The statement of cash flow is not complete until

the sum of cash from operating, investing, and

financing activities exactly matches the total

change in the cash balance during the year.

(continued)

Step 1: Compute How Much the Cash Balance

Changed During the Year

Step 1: Compute How Much the Cash Balance

Changed During the Year


5-42 (continued) 5-42

Cash increased $10 during the year.

5-43

This is done in three steps:

(a) Eliminate expenses that do not

involve the outflow of cash, such as

depreciation expense.

(continued)

Step 2: Convert the Income Statement from an

Accrual-Basis to a Cash-Basis Summary of

Operations

Step 2: Convert the Income Statement from an

Accrual-Basis to a Cash-Basis Summary of

Operations


5-45

(b) Eliminate gains and losses

associated with investing or financing

activities to avoid counting these

items twice.

(continued)

Step 2: Continued Step 2: Continued

Preparing a Complete Statement of

Cash Flows


Replace

with new

5-7

5-47

(c) Adjust for changes in the balances of

current operating assets and

operating liabilities.

(continued)

Step 2: Continued Step 2: Continued


Cash Flows

5-53 5-53

Because an interest payable account does not

exist, we can safely assume that all interest

expense was paid for in cash. Therefore, there

is no need for an adjustment.

5-54

• Orchard Blossom reports two long-term asset

accounts: Land and Buildings.

(continued)

Step 3: Analyze the Long-Term Assets to Identify the

Cash Flow Effects of Investing Activities.

Step 3: Analyze the Long-Term Assets to Identify the

Cash Flow Effects of Investing Activities.


Cash Flows

5-55

Investing Activities

Cash Inflow

• Sale of plant assets

• Sale of securities,

other than trading

securities

• Collection of

principal on loans

Cash Outflow

• Purchase of plant

assets

• Purchase of

securities, other than

trading securities

• Making of loans with

other entities

(continued)

5-56

The land account increased by $15 during the

year. Because there is no indication of a land

sale, we conclude that the $15 represents the

price of new land purchased during the year.

(continued)


5-57

The building account increased $40 during the

year. In the absence of any other information,

this increase would suggest that Orchard

Blossom purchased buildings with a cost of $40.

However, additional…

(continued)


5-58

…information above is available that indicates

that buildings were sold for $32. The $32 cash

proceeds from the sale is a cash inflow from

investing activities.

(continued)


5-59

Cash proceeds (given) $32

Book value ($36 $14) 22

Gain on sale of building $10

(continued)


5-60

Known


(continued)

5-61

Building(s) costing $76 must have been

purchased during the year.


5-62

Step 4: Analyze the Long-Term Debt and

Stockholders’ Equity Accounts to Determine

the Cash Flow Effects of Any Financing

Transactions.

Step 4: Analyze the Long-Term Debt and

Stockholders’ Equity Accounts to Determine

the Cash Flow Effects of Any Financing

Transactions.


Cash Flows

(continued)

5-63

Financing Activities

Cash Inflow

• Issuance of own stock

• Borrowings

Cash Outflow

• Dividend payments

• Repaying principal on borrowing

• Treasury stock purchase

5-64

We can infer that Orchard Blossom repaid

$21 in long-term loans during the year.

(continued)


5-65

Retained earnings increased by $9. We know

there was a $15 net income, so we can use a T-

account to determine the amount of the dividend.

The $40 ($100 – $60) increase in Orchard

Blossom’s paid-in capital account during the year

represents a cash inflow from the issuance of new

shares of stock. This cash inflow is reported as

part of cash from financing activities.


5-66

The $6 debit, or “squeeze” figure, has to

be the dividends declared (and we will

assume paid) during the year.


5-67

(continued)

Step 5: Prepare a Formal Statement of Cash Flows. Step 5: Prepare a Formal Statement of Cash Flows.


Cash Flows

Based on our analyses of the income statement

and balance sheet accounts, we have identified

all inflows and outflow of cash for Orchard

Blossom for the year, and we have categorized

those cash flows based on the type of activity.

5-68 5-68

5-69

• FASB ASC Topic 230 requires separate disclosure of

the cash paid for interest and for income taxes during

the year.

o Cash paid for interest and income taxes

o Noncash investing and financing activities

Step 6: Prepare Supplemental Disclosure. Step 6: Prepare Supplemental Disclosure.


Cash Flows

5-70

Cash Flow Patterns

• It is possible to gain useful insights about a

company by analyzing the relationships among the

three cash flow categories.

• Exhibit 5-9 on Slides 5-71 and 5-72 shows the

eight different possible patterns.

5. Assess a firm’s financial strength by analyzing

the relationships among cash flows from

operating, investing, and financing activities

and by computing financial ratios based on

cash flow data

5-71 (continued)

5-71

5-72 5-72

5-73 5-73

5-74

Cash Flow to Net Income Ratio Cash Flow to Net Income Ratio

• Measure of earnings quality

• Tends to be greater than 1

• Should remain fairly stable for the

years for a specific company

Cash Flow Ratios

Cash from operations

Net income Cash-flow-to-net-

income ratio =

5-75

Cash Flow Adequacy Ratio Cash Flow Adequacy Ratio

• A cash cow is a business that is generating

enough cash from operations to completely pay for

all new plant and equipment purchases with cash

left over to repay loans or distribute to owners.

• This ratio indicates whether a business is a cash

cow.

Cash from operations Capital expenditures

and acquisitions

Cash flow

adequacy ratio =

(continued)

Cash Flow Ratios

5-76

Cash Flow Adequacy Ratio Cash Flow Adequacy Ratio

Cash Flow Ratios

5-77

• Measures interest-paying ability

• Generally, a higher ratio indicates more

solvency

Cash from operations +

Interest paid + Taxes paid

Interest expense

Cash times

interest earned

ratio =

(continued)

Cash Flow Ratios

Cash Times Interest Earned Cash Times Interest Earned

5-78

Cash Times Interest Earned Cash Times Interest Earned

Cash Flow Ratios

5-79

Articulation:

How the Financial Statements Tie Together

In an accounting context, articulation means that

the three primary financial statements are not

isolated lists of numbers but are an integrated set

of reports on a company’s financial health.

(continued)

6. Demonstrates how the three primary

financial statements tie together, or

articulate, in a unified framework

5-80 5-80

$6

5-81

1. Compute the change in cash.

2. Convert the income statement from an

accrual basis to a cash basis.

3. Analyze the long-term asset accounts.

4. Analyze the long-term debt and

stockholders’ equity accounts.

5. Prepare the statement of cash flows.

6. Disclose any significant noncash activities.

Forecasted Statement of Cash Flows

7. Use knowledge of how the three primary

financial statements tie together to

prepare a forecasted statement of cash

flows

5-82 5-82

5-83 5-83

chapter 5 statement of cash flows and articulation · pdf file5-1 1. important companion of...

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