reimers 2006 chap 11

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2006 Prentice Hall, Inc.

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11-22006 Prentice Hall, Inc.

THE STMT OF CASH FLOWS (1of 2)

Learning objectives

Categories of cash flows

Accrual-basis accounting vs. cash-basis accounting

Overview of statement of cash flowsStatement of cash flowsindirect

method

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THE STMT OF CASH FLOWS (2of 2)

Cash flows from operating activitiesdirect method

Cash flows from investing and financingactivities

Preparing the statement of cash flowsFinancial statement analysis

Business risk, control, and ethics

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Learning Objectives(1 of 4)

Categorize cash flows as operating,investing, or financing cash flows

Explain the difference betweenaccrual-basis and cash-basis

accountingExplain the difference between the

two methods of preparing and

presenting the statement of cash

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Compute cash from operating activitiesusing the indirect method

Compute cash from operating activitiesusing the direct method

Compute cash from investing activitiesand cash from financing activities

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Prepare a complete statement ofcash flows and know the requiredsupplemental disclosures

Use the statement of cash flows to

help evaluate a firms past andfuture performance

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Identify the risk of investing in agiven firm by using the statement ofcash flows and the related controls

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Categories of Cash Flows(1 of 3)

Cash flow

Inflows and outflows that result fromtransactions

Cash account must increase ordecrease

Operating activities

Cash receipts and cash

disbursements from revenues andex enses

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Investing activities

Cash receipts and disbursements thatresult from purchasing or selling long-term assets or investments in otherfirms

Financing activities

Cash receipts and disbursements fromlong-term debt and equity transactions

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Financing activities (continued)Debt

Issuing debtRepaying debt

Interest expense results from financingactivities because it arises from debt financing.

Why is it reported in the operating section?EquityReceiving contributions from owners

Paying dividends to owners

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Accrual-basis Accounting vs.Cash-basis Accounting (1 of 2)

Must convert from accrual-basisaccounting (GAAP) to cash-basisaccounting to prepare statement ofcash flows

Accrual-basis accountingRevenues recorded when earned and

expenses recorded when incurred

Timing of cash receipt is irrelevant

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Accrual-basis Accounting vs.Cash-basis Accounting (2 of 2)

Cash-basis accountingRevenues recorded when cash received

and expenses recorded cash paidTiming of revenue and expense recognition is

irrelevant

Convert from accrual basis to cashbasisAccounts payable (assume for inventory)Beg bal $1,200; End bal $400; purch $36,300Compute cash paid

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Overview of theStatement of Cash Flows (1 of 3)

Operating activities

Direct method

Cash inflows and outflows explicitlyidentified

Analyzes every item on income statement

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Operating activities (continued)Indirect methodReconciles net income and cash flow

Starts with net income

Makes adjustments for income statement

items that do not affect cashAdjust for changes in current assets and

current liabilities

Ends with net cash flow

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Investing and financing activities

Same presentation for both direct andindirect methods

Cash flows for each activity directlyidentified

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Statement of Cash FlowsIndirect Method

Used by 90% of companies. Why?

Financial statements needed

Current year income statement

Beginning and ending balance sheet

Steps to calculate operating cashflows

Cash flow indirect method example

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Steps to Calcu late Operat ing

Cash Flows(1 of 2)

1. Start with net income

2. Add back non-cash expenses suchas depreciation Undo the effect of non-cash expenses

3.Adjust for changes in current assets Increase (decrease) in account should

be subtracted from (added to) netincome to arrive at cash balance.Why?

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Steps to Calcu late Operat ing

Cash Flows(2 of 2)

4. Adjust for changes in currentliabilities Increase (decrease) in account should

be added to (subtracted from) netincome to arrive at cash balance. Why?

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Cash Flow Ind irec t Method

Example(1 of 4)

Sales Revenues 500,000$

Cost of Goods Sold 284,000

Gross M argin 216,000Depreciation Expense 50,000$

Interest Expense 5,000

Salary Expense 105,000 160,000N et Income 56,000$

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Example(2 of 4)

Beginning Ending

Cash 37,500$ 75,000$

Accounts Receivable, net 17,000 13,000

Inventory 27,000 20,000Prepaid Insurance - 12,000

Prepaid Rent 28,000 4,000

Total Current Assets 109,500 124,000

Equip, net of $75K & $125K Accum Depr 175,000 193,000

Total Assets 284,500$ 317,000$

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Example(3 of 4)

Beginning Ending

Accounts Payable 9,000$ 4,250$

Unearned Revenue 4,375 3,125Interest Payable 1,500 4,000

Total Current Liabilities 14,875 11,375

Long-term Notes Payable 40,000 15,000

Common Stock 40,000 45,000Retained Earnings 189,625 245,625

Total Liabilities and Equity 284,500$ 317,000$

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Example(4 of 4)

+ / -

N et income

Depreciation expense

Decrease in accounts receivableDecrease in inventory

Increase in prepaid insurance

Decrease in prepaid rent

Decrease in accounts payable

Decrease in unearned revenue

Increase in interest payable

N et cash from operating activities

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Cash Flows from OperatingActivitiesDirect Method (1 of 6)

Changing revenues from accrualbasis to cash basis

Accounts receivable

Beginning balance (balance sheet)

+ Sales (income statement)

- Cash collected from customers(compute)

Ending balance (balance sheet)

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Changing expenses from accrualbasis to cash basis

Cost of goods sold

Inventory account

Beginning inventory (balance sheet)

+ Purchases (compute)

- Cost of goods sold (income statement)


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Cost of goods sold (continued)

Accounts payable

Beginning balance (balance sheet)+ Purchases (from inventory computation)

- Cash paid to vendors (compute)


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Changing expenses from accrualbasis to cash basis (continued)

Rent expense

Prepaid rent


+ Cash paid for rent (compute)

- Rent expense (income statement)


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Changing expenses from accrualbasis to cash basis (continued)

Interest expense

Interest payable


+ Interest expense (income statement)

- Cash paid for interest (compute)


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Use the information provided earlier

Cash collected from customers

Cash paid to vendors

Cash paid to employees

Cash paid for insurance

Cash paid for rent

Cash paid for interest

N et cash from operating activities

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Cash Flows from Investingand Financing Activities (1 of 3)

Investing cash flows

Equipment purchases/disposals

require the following accountsAsset account (beg & end)

Accumulated depreciation (beg & end)

Depreciation expense (current)

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Financing cash flowsDebt financingNeed to analyze changes in long-term

liability accounts

Equity financing

Additional capital contributionsCommon and preferred stock accounts

DividendsRetained earnings and current net income

C f

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Investing Activities

Purchase of equipment

N et cash used by investing activities

Financing Activities

Repayment of note payable

Proceeds from issue of new stock

N et cash used by financing activities

P i h S f

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Preparing the Statement ofCash Flows (1 of 3)

Prepare operating, investing, andfinancing sections

Supplementary disclosuresNoncash financing and investing

activities

Cash paid for interest expense andincome taxesBroken out in supplementary disclosures

because usually part of subtotals

P i th St t t f

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Add beginning cash to sum ofoperating, investing, and financing

activities to get ending cash balanceReconciles cash account on balance

sheet

Which financial statement is easier tomanipulate, the statement of cash

flows or the income statement? Why?

P i th St t t f

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N et cash provided by operations

N et cash used by investing activities

N et cash used by financing activities

Cash at beginning of year

Cash at end of year

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Financial Statement Analysis

Using cash flows to evaluateperformance

Free cash flow

Cash flow adequacy ratio

Cash needed to pay current liabilities

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Free Cash Flow

Net cash from operating activities

- Cash dividends

- Capital expenditures _

Free cash flow

Why does a company need positivefree-cash flow?

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Cash Flow Adequacy Rat io

Measures the firms ability to generate

enough cash from operating activities

to pay for its capital expendituresNet cash from operating activities _

Cash required for investing activities

Cash required for investing activities

Cash paid for capital expenditures andacquisitions minus cash proceeds from disposal

of capital assets

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Cash Needed to Pay Cur ren t

Liabi l i t ies(1 of 2)

Current cash debt coverage ratio

Measures a firms ability to generate the

cash it needs in the short-run

A liquidity measure

Net Cash Provided by OperationsAverage Current Liabilities

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Cash Needed to Pay Cur ren t

Liabi l i t ies(2 of 2)

How does current cash debt coverageratio differ from other liquidity

measures previously discussed?Current ratioQuick ratio

Working capital

B i Ri k C t l d

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Business Risk, Control, andEthics

Investors risks associated with

statement of cash flows

Investors look for positive cash flowsfrom operations

How could a company manipulate

operating cash flows?

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Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark atUniversity of Northern Colorados

Kenneth W. Monfort College of [email protected] 11-

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reimers 2006 chap 11

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