Chapter 11

The Statement
of Cash Flows

McGraw-Hill/Irwin

Copyright 2011. The McGraw-Hill Companies. All Rights Reserved.

Statement of Cash
Flows
Third required financial
statement.
Does not affect the way
transactions are recorded (i.e.,
information for statement is
derived from data reported in
other financial statements).
11-2

Income Statement vs.

Statement of Cash
Flows

Income statement.

Accrual basis results of entitys operating

activities during a period.
Revenue recognition, matching of expenses.

Statement of Cash Flows.

Cash flows associated with an entitys
operating, investing, and financing activities
during a period.
Reconciles changes in cash account on
balance sheet (i.e., beginning balance to
ending balance).
11-3

Benefits of the
Statement of Cash
Flows
Numbers on cash flow statement are

objective (i.e., cash is cash).

Eliminates judgments and estimates
involved with accrual accounting as on
income statement and balance sheet.
Useful information for users dependent
upon a healthy cash flow from entity (e.g.,
employees, suppliers, lenders).
But in some instances, balance sheet and
income statement may provide better
information about financial status and
operating performance.
11-4

 Sources.

Flows:
Categories of
Activities

Activities that generate cash.

Uses.
Activities that involve spending
cash.

11-5

Cash Sources
Operations.
New borrowings.
New stock issues.
Sale of property, plant, and
equipment.
Sale of other non-current assets.
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Cash Uses
Cash dividends.
Repayment of borrowings.
Repurchase of stock.
Purchase of property, plant, and
equipment.
Purchase of non-current assets.
11-7

Definition of Cash
Cash.
Cash equivalents.
Short-term investments.
Highly liquid.
Convertible to known amounts of cash.
Mature in no more than 90 days
(GAAP).
Subject to insignificant risk of changes
in value (IASB).
11-8

Organization of the
Statement of Cash
Flows
1. Operating activities
2. Investing activities.
3. Financing activities.

11-9

Operating Activities
All transactions that are not
investing or financing activity.
Cash inflows associated with sales
revenues.
Cash outflows associated with
operating activities (e.g., payments
to suppliers, employees, taxes,
interest on loans).
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Investing Activities
Outflows:
Acquiring long-lived assets (e.g.,
property, plant, equipment).
Making investments in securities
(i.e., other than cash equivalents).
Lending money.

11-11

Investing Activities
Inflows:
Disposing of long-lived assets (e.g.,
property, plant, equipment).
Disposing of investments in
securities (i.e., other than cash
equivalents).
Collecting loans.

11-12

Financing Activities
Inflows:
Borrowing of cash.
Issuance of equity securities.

Outflows:
Repaying loans.
Retiring equity securities.
Payment of dividends.
11-13

Interest and
Dividends
FASB.
Interest received or paid: operating
activity.
Dividends received: operating activity.
Dividends paid: financing activity.

IASB.
Can be classified in any activity category
as long as done in a consistent manner.
11-14

Significant Noncash
Transactions
Significant investing and financing
activities that did not involve cash.
E.g., conversion of a convertible
bond into stock, purchase of a
building with a notes payable.

Not reported in body of statement

of cash flows; narrative statement
or supplemental disclosure.
11-15

Operating Activities:
Approaches to
Presentation
Direct method.
Inflows (i.e. cash provided by operating activities).
Outflows (i.e. cash disbursed for operating
activities).
Net cash flow (i.e. inflows - outflows).
Encouraged by FASB.

Indirect method.
Reconciliation of periods net income and the
periods net cash flow from operations.
More difficult to understand.

Note: Cash flow from operating activities

will be the same under either method.
11-16

Supplemental
Disclosure
If direct method is used, FASB
requires supplemental disclosure
of reconciliation between net
income and operating cash flows.
In effect, if direct method is
used, indirect method is also
required.
11-17

Operating Activities
Cash Flow
Collections from customers.
Sales (End AR Beg AR).

Payments to suppliers.
Cost of goods sold + (End Inventory
Beg Inventory) (End AP Beg AP).

Interest paid.
Interest expense (End Int. Pay Beg
Int. Pay).
11-18

Indirect Method of
Presenting Operating
Activities
Start with net income.
Adjust for noncash items included in
net income (i.e., adjustment of accrual
based earnings).
Depreciation and amortization (add back).
Difference between sales and cash
collected (i.e., the change in accounts
receivable).
Differences between expenses and cash
payments (i.e., Changes in accounts
payable, inventory, prepaid expenses).
11-19

Indirect Method of
Presenting Operating
Activities

Additions to net income.

Depreciation expense.
Decreases in:
Accounts receivable.
Inventories.
Prepaid Expenses.

Increases in:

Accounts payable.
Wages payable.
Interest payable.
Taxes payable.
Deferred taxes.

Loss on disposal.

11-20

Indirect Method of
Presenting Operating
Activities

Subtractions from net income.

Increases in:

Accounts receivable.
Inventories.
Prepaid Expenses.

Decreases in:

Accounts payable.
Wages payable.
Interest payable.
Taxes payable.
Deferred taxes.

Gain on disposal.

11-21

Indirect Method of
Presenting Operating
Activities

Depreciation.

Cash paid for property, plant, or equipment is a

cash outflow.
Allocation of this amount to expense (via
depreciation) is not a cash flow.
Therefore, must be subtracted out (added back)
in operating activities section.

Gains and losses.

Cash proceeds from the sale of property, plant,

or equipment is a cash inflow.
Recorded gain (loss) is not the cash flow.
Therefore, must be subtracted out (added back)
in operating activities section.
11-22

Summary of
Cash Flow Statement
Cash flow from operating activities
+ Cash flow from investing activities
+ Cash flow from financing activities
= Increase (decrease) in cash and cash
equivalents
+ Cash and cash equivalents at beginning
of year
= Cash and cash equivalents at end of year
11-23

Cash Flow Ratios

Cash realization ratio (i.e., quality of
earnings).
Cash generated by operations Net income.

Coverage ratios.
Use cash flow as numerator in Chapter 8
coverage ratios (i.e., times interest earned,
fixed charges coverage).

Source and use percentages.

Reorganize data into sources and uses format;
then show each item as percent of total sources.
Ratio of cash generated by operations to total
debt.
11-24

Cash Flow Projections

Free Cash Flow.
Cash from operations less:
1. Fixed asset replacements necessary
to maintain existing capacity.
2. Scheduled debt repayments.
3. Normal dividend payments.

11-25

Cash Flow Projections

Projected cash flow statement.
Useful to project amount, timing, and
character of new financing.
For management: anticipate future cash
needs.
For potential lenders: indicate ability to
repay debt.

Cash budget.
Useful for shorter-term financial planning
(e.g., seasonal needs, when excess cash is
available to invest in short-term securities).
11-26