chapters 4 b

Chapters 4 B

Statement of Cash Flows

Statement of Cash Flows 2

Objectives of this Chapter

I. Identify business activities which can generate or use cash and differentiate between income flows (i.e., accrual basis) and cash flows from operating activities.

II. The Importance and the usefulness of the statement of cash flows.


Objectives of this Chapter (contd.)

III. Learn how to prepare the statement of cash flows.

VI. The “cash burn rate” and the use of this rate in evaluating the financial viability of start-up companies.

V. Learn the two alternatives (direct and indirect methods) in preparing net cash flows from operating activities.


I. Activities which can either generate cash or use cash for a business entity

A. Operating activities.B. Investing activities.C. Financing activities.


A. Operating Activities (i.e., sales revenue, expenses)

All these activities are reported in the I/S (income statement). However, I/S only provides the accrual-basis net income (revenue –expense + gains – losses ) which very often is not the change in cash.

Therefore, we need to adjust from net income flows to cash flows in order to report the net cash provided by (or used in) operating activities.


A. Operating Activities (contd.)

There are two approaches to reconcile net income to net cash provided by (or used in) operating activities:

1. Indirect Method ==> Lump-Sum Adjustment

2. Direct Method ==> Individual Account Adjustment


1. Indirect Method

Adjust net income (the lump sum amount of all revenues and expenses) for all differences between income flows and cash flows.


2. Direct Method Adjust each revenue account to cash

collection and adjust each expense account to cash payment. Subtract total cash payments from total cash collections to derive net cash flows of the operation activities.

SFAS No. 95 allows a choice between the direct and indirect approach for the cash flow statement


Cash flows from operating activities

Cash Inflows:1. Collections from customers including

cash received from sales (or services) and collections of A/R.

2. Cash receipts of interests or dividends.3. Collections of other operating receipts

(i.e., unearned revenue, rent revenue).


Cash Flows from Operating Activities (contd.) Cash Outflows:

1. Payments to suppliers.2. Payments to employees.3. Payments for interest expense.4. Payments for income taxes.5. Payments for other expenses(i.e.,

Prepaid expenses; rent expenses).


Activities which can either generate cash or use cash for a business entity



B. Investing Activities In addition to generate cash from or use cash

in the operating activities, companies can also generate cash from (or use cash in) investing activities.


Cash Flows from Investing Activities Transactions involving acquiring

(Investing (Cash outflows)) and selling (Disinvesting (Cash inflows)) :

a. Property, Plant and Equipment.

b. Investments (current and non-current).

c. Notes Receivable (current and non-current).


Notes Receivable Notes Receivable (current and non-

current), including: Lending money (N/R , cash outflow); Collecting of loan (N/R , cash inflow); Selling of N/R (N/R, discounting N/R,

cash inflow)


Activities which can either generate cash or use cash for a business entity



C. Financing Activities

Companies can also generate cash or use cash through financing activities:


Cash Flows from Financing Activities Obtaining resources from owners and

creditors (cash inflows) and repaying the amount borrowed (cash outflows).

Cash inflows: Cash received from issuance of common

stock. Cash received from issuance of bonds. Cash received from issuance of N/P

(short-term or long term).


Cash Flows from Financing Activities (contd.) Cash Outflows:

Retirement of bonds. Retirement of stock. Payments of N/P. Payments of dividends.

II. The Importance and Usefulness of the Statement of Cash Flows Possible earnings managements may result

in unreliable accrual earnings. Accrual accounting relies on many

subjective judgments that may introduce measurement error and uncertainty into reported earnings.

One-time write-offs and restructuring charges can reduce the quality of reported earnings.

For these reasons, analysts scrutinize a firm’s cash flows—not just its accrual earnings—to evaluate performance and creditworthiness.


The Importance and Usefulness of the Statement of Cash Flows (cont.)

In order to show cash flows of a company, cash flows of all three activities should be reported.

In doing so, investors can also obtain all the information of operating, investing, and financing activities of a company. Moreover, the following questions can also be answered:


The Importance and the Usefulness of the Statement of Cash Flows (contd.)1. What is the relationship between net

income and cash provided by operations?

2. Why did cash decreased when net income increased?

3. What expansion (investment) activities took place and how were they financed?


The Importance and the Usefulness of the Statement of Cash Flows (contd.)4. How much is the cash provided by

operating activities?

5. What happened to the proceeds received from issuance of bonds or common stock?

All of these cannot be answered from either the income statement or the balance sheet statement.


SFAS No. 95

To improve the comparability, SFAS No. 95, “Statement of Cash Flows,” requires companies present the statement of cash flows using a specific format.


SFAS No. 95 (contd.)

Following SFAS No. 95, the statement of cash flows should have three sections:

1. Cash flows from operating activities (using a direct or an indirect method).

2. Cash flows from investing activities.3. Cash flows from financing activities.

Cash flow statement:Wal-Mart example

Adjustments to accrual earnings

4-25

Cash flow statement:Wal-Mart example

4-26


III. Procedures for Preparation of the Statement of Cash Flows1. Operating Cash Flows (indirect

method).

2. Investing Cash Flows.

3. Financing Cash Flows.


1. Operating Cash Flows (Indirect Method; Reconciliation Method)

Net Income Adjustments+ Any increase in current Liabilities (except for

N/P)+ Any decrease in current assets (except for

cash and N/R)- Any decrease in current liabilities (except for

N/P)- Any increase in current assets (except for cash

and N/R)


2. Investing Cash Flows

Inflows: decrease in noncurrent assets (i.e., long-term investments, P.P.E.) and certain current assets (i.e., trading securities, N/R).

Outflows: increases in noncurrent assets and certain current assets


3. Financing Cash Flows

Inflows: increases in noncurrent liabilities (i.e., B/P, N/P), stockholders’ equity and certain current liability (i.e., N/P).

Outflows: decreases in noncurrent liabilities, stockholders’ equity, certain current liability and dividend payment.


Adjustments to Convert Net Income to Net Cash Flow from Operating Activities

+ Depreciation, depletion and amortization expense, B/D expense

+ Amortization of discount on B/P+ Amortization of premium on investment

in bonds+ Increase in deferred income tax liability+ Loss on disposal of assets or liabilities+ Investment loss under the equity method

Net Income

Adjustments


Adjustments to Convert Net Income to Net Cash Flow from Operating Activities (contd.)

+ Increases in current liabilities other than N/P (i.e., A/P, salaries payable, interest payable, I/T payable, deferred I/T, and any other current liabilities related to operations)

+ Decreases in current assets other than cash and N/R (i.e., A/R, interest receivable, inventory, prepaids, and any other current assets related to operations)


Adjustments to Convert Net Income to Net Cash Flow from Operating Activities (contd.)

- Amortization of premium on B/P- Amortization of discount on investment in

bonds- Gain on disposal of assets or liabilities- Investment income under the equity

method- Decrease in deferred income tax liability- Decreases in current liabilities- Increases in current assets

| |Net Cash Flows from Operating Activities

Adjustments


Adjustments:+ Amortization of Discount on B/P

Example: Issue a 2-year bond, market int. rate = 12%, bond int. rate = 10%

P.V. of Bond = $10,000 x 0.797 + 1,000 x 1.690 = 9,600

1. 1/1/x1 Cash 9,660Discount on B/P 340

B/P 10,000


Adjustments:+ Amortization of Dis. on B/P (contd.)2. Payment of Interest on 12/31/x1

Interest Expense (12% x 9660) 1159.2

Cash 1,000.0Dis. On B/Pa 159.2

a. Amortization of bond discount increase interest expense but does not use cash.


Adjustments:+ Amortization of Dis. on B/P (contd.)3. Payable of Interest on 12/31/x2

Interest Expense (9660 +159.2) 0.12 1,174.4

Cash 1,000.0Discount On B/P 174.4

Dis340 159.2

174.4


Adjustments:+ Amortization of Premium on Investment in Bonds

Example: GEO Corp. purchased $100,000, 10% 5-year bonds on 1/1/x2, with interest payable on 7/1 and 1/1. The bonds sell for $108,111 which results in bond premium of $8,111 and an effective interest rate of 8%.


+ Amortization of Premium on Investment in Bonds (contd.)

Example (contd.)Record the purchase on 1/1/x2:

Investments 108,111Cash 108,111

Record the interest revenue on 7/1/x2:Cash 5,000Interest Revenue 4,324aInvestments 676

a. Interest revenue = $108,111 x 4% = $4,324


Adjustments:+ Loss on Disposal of PPE or Investments Example: Sale a piece of land with a cost

of $7,000 for $5,000

Cash 5,000Loss on Sale of Landa 2,000 Land 7,000a. This transaction results in a cash increase of

$5,000 reported in the investing activity section, not the operating activity section.


Adjustments: + Investment Loss under equity method Equity method must be used to account for

return on investment in stock when gaining ownership of 20% ~ 50% with significant influence.

Example: Obtain 30% of ownership with significant influence on investment in stock of Green Corp. for $40,000


+ Investment Loss under equity method (contd.)2/4/x2

Investment in Stock 40,000Cash 40,000

12/31/x2Green’s Loss of Year x2 = 100,000Loss in Investment 30,000Investment in Stock 30,000


Data needed to prepare statement of cash flows1. Comparative balance sheet statements.

2. The income statement.

3. The retained earnings statement.

4. Other supplemental information concerning the reasons for the changes in the B/S accounts (other than cash).


Example 1Layton Company Balance Sheet (12/31/x2)

Balance Balance ChangeAccounts 1/1/x2 12/31/x2Cash 4,000 6,600A/R 6,300 9,000 2,700Land 9,000 6,000 3000a

Buildings & Equipment 48,000 60,000 12,000b

Accummulated Depreciation (12,500) (14,800)Total Assets 54,800$ 66,800$

a. Land was sold at cost for cash during the year.b. A building was purchased for cash during the year and

no building or equipment was sold during the year.


Example 1 (contd.) Layton Company Balance Sheet (12/31/x2)

Balance Balance ChangeAccounts 1/1/x2 12/31/x2A/P 7,500 9,000 1,500B/P 14,000 21,000 7000a

Common Stock, $10 22,000 22,000 0Retained Earnings 11,300 14,800Total Liabilities & Stockholdrs' Equity $54,800 $66,800

a. Bonds were issued at the end of year.


Example 1 (contd.) Income Statement (for the year ended 12/31x2)

Sales Revenue $31,800Opeating ExpensesDepreciation Expense 2,300Interest Expense 1,400Other Expenses 18,100 (21,800)

Income before Income Tax 10,000Income Tax Expense (3,000)Net Income $7,000


Example 1 (contd.)Layton Company Retained Earnings (20x2)

Beginning Retained Earnings $11,300Add: Net Income 7,000

$18,300Less: Dividends (3,500)Ending Retained Earnings $14,800


Layton CompanyStatement of Cash Flows

For the Year Ended December 31, 20x2Net cash flow from operating activities:Net Income $7,000 Adjustments to reconcile net income to net cash provided by operating activities:Add: Depreciation expense 2,300

Increase in A/P 1,500 Less: Increase in A/R (2,700)Net cash provided by operating activities $8,100


Layton CompanyStatement of Cash Flows (contd.)

Cash flows from investing activities:Proceeds from sale of land $3,000Payments for purchase of building (12,000)Net cash used by investing activities (9,000)Cash flows from financing activities:Proceeds from issuance of bonds 7,000Payments of dividends (3,500)Net cash provided by financing activities 3,500


Layton CompanyStatement of Cash Flows (contd.)

Net increase in cash$2,600

Cash, Jan 1, 20x2$4,000

Cash, Dec 31, 20x2$6,600


Example 2: Green Company Balance Sheet

Accounts 1/1/x212/31/x2DifferenceCash $3,500$5,500A/R 4,4003,600 800 Inventory 5,0006,6001,600 Land 8,20012,2004,000c Building & Equip 35,70048,70013,000a,d Acc. Depr. (6,000)(8,700)Total Assets $50,800$67,900


Green Company Balance Sheet (contd.)

A/P $5,100$3,2001,900 Salary Payable 1,4001,800400 B/P, 10% 7,00015,0008,000b Common Stock, $10 par 8,0009,0001,000 Paid-in Capital 16,00019,0003,000 R/E 13,30019,900Total Liabilities & Equity $50,800$67,900


Income Statement For the Year Ended 12/31/20x2

Sales Revenue$80,000

CGS(48,600)

Gross Profit$31,400

Operating Expenses:Deprecation Expense $3,400Other Expenses 15,900

(19,300)

$12,100 Other Revenues & Expenses

Gains on Sale of Equipment $600Interest Expense (700)

(100)Income Before Income Tax

$12,000 Income Tax Expense

(3,600)Net Income

$8,400 .

52


Retained Earnings (20x2)Beginning balance of retained earnings $13,300 Add: Net Income 8,400

21,700 Less: Dividends (1,800)Ending balance of retained earning $19,900


Supplemental Information for 20x2(a) Equipment was purchased for cash at a cost

of $15,200.(b) Ten-year bonds payable with a face value of

$8,000 were issued for $8,000 at the end of the year.

(c) Land was acquired through the issuance of 100 shares of $10 par common stock when the stock was selling at a market price of $40 per share.

(d) Equipment with a cost of $2,200 and a book value of $1,500 was sold for $2,100 cash.


GREEN CompanyStatement of Cash Flows

For the Year Ended December 31, 20x2Net cash flows from operating activities:Net Income $8,400Adj. To reconcile net income to net cash provided by operating activities:Add: Depreciation Expense 3,400

Decrease in A/R 800Increase in S/P 400

Less: Increase in Inventory (1,600) Decrease in A/P (1,900)

Gain on sale of Equipment (600)Net cash provided by operating activities $8,900


Cash flows from investing activities:Payments for purchase of equip. (15,200)Proceeds from sale of equipment 2,100

Net cash used by investing activities(13,100)

Cash flows from financing activities:Proceeds from issuance of bonds 8,000Payments of dividends (1,800)

Net cash provided by financing activities6,200

Net increase in cash (see Schedule 1)$2,000

Cash, Jan 1, 20x2$3,500

Cash, Dec 31, 20x2$5,500

56

GREEN Company Statement of Cash Flows (contd.)


Schedule 1: Investing & financing activities not affecting cash flows:Investing activities:

Acquisition of land by Issuance of common stock ($4,000)

Financing Activities:

Issuance of common stock for land $4,000

57

GREEN Company Statement of Cash Flows (contd.)


Special Topics

1. Direct exchange.2. Partial cash investing and

financing activities.3. Cash dividends declared.


1. Direct Exchange

Direct exchange: An example of a direct exchange is issuing bonds to acquire a building. This transaction should appear in the supplementary schedule of the cash flow statement as an investing activity (i.e., acquisition of building) and as a financing activity (i.e., issue bonds for building).


2. Partial Cash Investing and Financing Activities

Example: acquiring land costing $10,000 by paying $1,000 down and signing a $9,000 notes payable.


2. Partial Cash Investing and Financing Activities (contd.)

Presentation on Cash Flow Statement for Partial Investing & Financing Activities:

Cash Flows from Investing Activities:Purchase of land by issuance

of note and cash ($10,000)Less: issuance of note 9,000 Cash payment for purchase of land ($1,000)

Other examples of Direct ExchangeOther examples of significant noncash investing

and financing activities include (required disclosure in the supplementary schedule of the cash flow statement):conversion of bonds to stock.purchase of assets with issue of stock.purchase of assets with debt.declaration (but not payment) of cash

dividend.stock dividends and stock splits.


3. Cash Dividends Declared

(Stock dividends not reported on statement of cash flows.)

a. Cash dividends declared and paid in the same year: Reported as a cash outflow of

financing activities


3. Cash Dividends Declared (contd.)

b. Cash dividends declared in the current year but paid in the next year:

(1)No impact on cash of the current year; only increase dividends payable (D/P).

(2)When D/P decrease next year, reported as a cash outflow of financing activity.

IV. Cash Burn Rate (Source: RCJ textbook)

The ability to generate positive operating cash flow is critical to the survival and success of any company.

This is particularly true for start-up companies:Cash is essential for establishing the business and for growth.Investment outlays are often large.

Operating cash flows are negative.

Cash burn rate is a popular metric for assessing how quickly a start-up firm will consume its cash reserves:

Cash burn rate =

Cash used for operations

Cash used for capital expenditures or acquisitions

# of months covered by cash flow statement

+

Cash burn rate: Amazon.com illustration

Cash burn rate:

Months to burnout:

= - ($119,782 + $50,321 +$6,198)/12 months = -$14,692 per month

= $996,585/14,692 = 67.8 months

Cash burn rate:Selected companies


V. Cash Flows from the Operating Activities ( the Direct Method)

Activities can be presented using:a. Indirect Method (as used in examples

1,2,and 3): N/I Adjustments to reconcile net income to

cash flows.b. Direct Method: The operating cash outflows

are deducted from the operating cash inflows to determine the net cash provided by (or used in) operating activities.


Cash Flows from the Operating Activities (contd.) SFAS No. 95 allows the use of both

methods, but encourages the use of the direct method. However, if the direct method is used, a reconcile of net income and cash using the indirect method must also be provided in the supplementary statement.


Using The Direct Method in Preparing The Operating Cash FlowsCash inflows from operating activities:

1. Collections from customers.

2. Interest & dividends collected.

3. Other operating receipts.


Using The Direct Method in Preparing The Operating Cash Flows (contd.)Cash outflows from operating activities:

1. Payments to suppliers. 2. Payments to employees.3. Payments of interest.4. Other operating payments.5. Payments of income taxes.


Adjustments to Convert I/S Amount to Operating Cash Flows -- A Direct Approach

I/S Cash Flows fromAmounts Adjustments Operating Activities Net

CollectionsSales +Dec. in A/R; or = from Revenue -Inc. in A/R Customers

Cash+Dec. in Int. Rec.; or Inflows-Inc. in Int. Rec. fromOperating

Interest +Amort. Of Interest Activities Premium on = Collected

Revenue Invest in Bonds; or -Amort. Of Discount on Invest in Bonds


I/S Cash Flows fromAmounts Adjustments Operating Activities Net Dividend +Dec. in Dividend Rec. = Dividend Revenue -Inc. in Dividend Rec. Collected

Cash+Inc. in Unearned Rev.; Inflowsor from

Other -Dec. in Unearned Rev. Operating-Gain on Disposal of Other Activities

Revenue Assets & Liabilities = Operating Receipts-Investment Income* (Equity Method) +Dec. (-Inc.) in Other Receivable Accounts

* Unless listed as separate items on Income Statement (I/S).73

Adjustments to Convert I/S Amount to Operating Cash Flows (contd.)



+Inc. in Inventory; Cost of or Payments Goods -Dec. in Inventory = to Sold +Dec. in A/P; or Suppliers Cash

-Inc. in A/P Outflowsfrom

Salary +Dec. in Sal. Payable; Payments Operating or = to Activities

Expense -Inc. in Sal. Payable Employees

74




+Dec. in Int. Payable Interest -Inc. in Int. Payable = Payments Expense +Amort. of Prem. on B/P of Interest

or Cash-Amort. of Dis. on B/P Outflowsfrom+Inc. in Prepaids Operating-Dec. in Prepaids Activities-Depre., Depletion exp.

Other Amort. Exp.*, B/D exp. Other -Losses on disposal of = Operating

Expense Assets and Liabilities Payments-Investment lossa (Equity method) a. Unless listed as

+Dec. (-Inc.) in Other separate items on the Payable Accounts Income Statement75




+Dec. in I/T Payable; or

Income -Inc. in I/T Payable Payments Cash Tax +Dec. in Deferred I/T = of Income OutflowsExpense Liability; or Tax from

-Inc. in Deferred I/T OperatingLiability Activities

76



Green CompanyStatement of Cash Flows

(Using the direct method in preparing the operating activities section of a cash flow statement.Information as provided in Example 2.)

Cash flows from Operating Activities:Cash inflows:

Collections from customers $80,8001Cash inflows from operating activities $80,800

1. 80,000 + 800 = 80,800.


Green CompanyStatement of Cash Flows (contd.)

Cash outflows:Payments to suppliers $(52,100)1Payments of interest (700)Other operating payments (15,500)2Payments of income tax (3,600)Cash outflows from operating activities (71,900)

1. 48,600 + 1600 + 1900 = 52,100.2. 15,900 - 400 = 15,500.


Green CompanyStatement of Cash Flows (contd.)

Net cash inflow from operating activities $8,900Cash flows from investing activities

::

Cash flows from Financing Activities::

* A reconciliation of net income and cash flows using indirect method must also be presented.


Information as provided in Example 3 (direct method)

Statement of Cash Flows Cash flows from Operating Activities:Cash inflows:

Collections from customers $86,0201Cash inflows from operating activities $86,020Cash outflows:Payments to suppliers (53,200)2

1. 88,020 - 2,000 = 86,020.2. 52,200 - 300 + 1300 = 53,200.


Statement of Cash Flows (contd.)Payments of other expenses (16,000)1Payments of interest expense (500)2Payments if Income Tax (2,820)3Cash outflows from operating activities (72,520)Net cash inflows from operating activities $13,500

1. 15,800 + 200 = 16,000.2. 1100 - 500 - 100 = 500.3 3,630 - 630 -180 = 2,820.

chapters 4 b

Documents

net cash flows

cash outflows

total cash payments

total cash collections

cash burn rate

cash receipts of interests

net income flows

business activities