Statement of Cash FlowsStatement of Cash Flows

Chapter 12

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Slide 2

The statement of cash flowsreports the entity’s cash flows

(cash receipts and cash payments)for the period.

Basic Concept

McGraw-Hill/Irwin Slide 3

Timing of the Financial Statements

December 31, 20x1(a point in time)

BalanceSheet

December 31, 20x2(a point in time)

BalanceSheet

For the Year Ended December 31, 20x2(a period of time)

IncomeStatement

Statement ofCash Flows

Statement ofStockholders’

Equity

McGraw-Hill/Irwin Slide 4

Understanding the BusinessPositive cash flows permit a company to . . .

Expand its operations

.

Expand its operations

.

Replace needed assets.

Replace needed assets.

Take advantage of market

opportunities.

Take advantage of market

opportunities.

Pay dividends to

owners.

Pay dividends to

owners.

Wall Street analysts consider cash flow an important indicator of a company’s

financial health.

Wall Street analysts consider cash flow an important indicator of a company’s

financial health.

McGraw-Hill/Irwin Slide 5

CashCashCurrency

Cash Equivalents

Short-term, highly liquid investments. Readily convertible into cash. So near maturity that market value is unaffected by

interest rate changes (i.e., less than 3 months to maturity).

Short-term, highly liquid investments. Readily convertible into cash. So near maturity that market value is unaffected by

interest rate changes (i.e., less than 3 months to maturity).

Classifications of the Statement of Cash Flows

Relationships to the Balance Sheet and the Income Statement

Information needed to prepare a statement of cash flows:

Comparative Balance Sheets.Income Statement.Additional details concerning

selected accounts.

Information needed to prepare a statement of cash flows:

Comparative Balance Sheets.Income Statement.Additional details concerning

selected accounts.

McGraw-Hill/Irwin Slide 7

Relationships to the Balance Sheet and the Income Statement

Cash = Liabilities Stockholders’ Equity Noncash Assets

Cash = Liabilities Stockholders’ Equity Noncash Assets

Derives from . . .

Assets = Liabilities Stockholders’ Equity

Assets = Liabilities Stockholders’ Equity

This ending cash balance should agree with the balance sheet.

McGraw-Hill/Irwin Slide 9

Classifications of the Statement of Cash Flows

Operating Activities

Cash inflows and outflows directly related to earnings

from normal operations.

Investing Activities

Cash inflows and outflows related to the acquisition or sale of productive

facilities and investments in the securities of other companies.

Financing Activities

Cash inflows and outflows related to external sources of financing (owners and creditors) for the

enterprise.

McGraw-Hill/Irwin Slide 10

Direct Method vs. Indirect Method

Two Formats for Reporting Operating Activities

Reports the cash effects of each operating

activity

Direct Method

Starts with accrual net income and converts to cash basis

Indirect Method

Note that no matter which format is used, the same amount of net cash flows from operating activities is generated.

McGraw-Hill/Irwin Slide 11

Reporting Cash Flows from Operating Activities-Direct Method

Cash Flows from

Operating Activities

Cash Flows from

Operating Activities

Inflows Cash received from: Customers Dividends and interest on

investments

Inflows Cash received from: Customers Dividends and interest on

investments

+

Outflows Cash paid for: Purchase of goods for resale

and services (electricity, etc.) Salaries and wages Income taxes Interest on liabilities

Outflows Cash paid for: Purchase of goods for resale

and services (electricity, etc.) Salaries and wages Income taxes Interest on liabilities

_

McGraw-Hill/Irwin Slide 12

Reporting Cash Flows from Operating Activities-Indirect Method

Net Income

Net Income

Cash Flows from Operating

Activities - Indirect Method

Cash Flows from Operating

Activities - Indirect Method

+/- Changes in current assets and current

liabilities.

+/- Changes in current assets and current

liabilities.

+ Losses and - Gains

+ Losses and - Gains

+ Noncash expenses such as depreciation and

amortization.

+ Noncash expenses such as depreciation and

amortization.

The indirect method adjusts net income by eliminating noncash items.

The indirect method adjusts net income by eliminating noncash items.

McGraw-Hill/Irwin Slide 13

The Statement of Cash Flows will begin with net income from the Income Statement.

Step 1Adjust net income for depreciation and

amortization expense.

Step 1Adjust net income for depreciation and

amortization expense.

12-16

Step 2Adjust net income for changes in

current assets and current liabilities.

Step 2Adjust net income for changes in

current assets and current liabilities.

McGraw-Hill/Irwin Slide 17

Use this table when adjusting Net Income Use this table when adjusting Net Income to Operating Cash Flows using the to Operating Cash Flows using the

indirect methodindirect method..

Reporting Cash Flows from Operating Activities—Indirect Method

McGraw-Hill/Irwin Slide 18

Adjustment for Gains and Losses

GainsGains must be subtracted from net

income to avoid double counting the gain.

Losses Losses must be added to net income to avoid double counting the loss.

Transactions that cause gains and losses should be classified on the cash flow statement as operating, investing, or financing activities, depending on their dominate characteristics. For example, if the sale of

equipment produced a gain, it would be classified as an investing activity.

McGraw-Hill/Irwin Slide 19

Quality of Income Ratio

In general, this ratio measures the portion of income that was generated in cash. All other things equal, a higher quality of income ratio indicates greater ability to finance operating

and other cash needs from operating cash inflows.

Cash Flow from Operating ActivitiesNet Income

Quality of Income Ratio

=

McGraw-Hill/Irwin Slide 20

Cash Flows from

Investing Activities

Cash Flows from

Investing Activities

+

Cash Flows from Investing Activities

Inflows Cash received from:Sale or disposal of property,

plant and equipmentSale or maturity of investments

in securities

Inflows Cash received from:Sale or disposal of property,

plant and equipmentSale or maturity of investments

in securities

_

Outflows Cash paid for: Purchase of property, plant and

equipment Purchase of investments in

securities

Outflows Cash paid for: Purchase of property, plant and

equipment Purchase of investments in

securities

McGraw-Hill/Irwin Slide 21

Although short-term investments is a current asset, it is reported in

the investing section on the

statement of cash flows.

We must report individually the

cash used to purchase

equipment and the cash proceeds

received from the sale of

equipment.

McGraw-Hill/Irwin Slide 24

In general, this ratio reflects the portion of purchases of property, plant and equipment financed from operating

activities. A high ratio indicates less need for outside financing for current

and future expansions.

Capital Acquisitions Ratio

Cash Flow from Operating ActivitiesCash Paid for Property, Plant,

and Equipment

Capital Acquisitions

Ratio=

McGraw-Hill/Irwin Slide 25

Cash Flows from

Financing Activities

Cash Flows from

Financing Activities

+

_

Cash Flows from Financing ActivitiesInflows

Cash received from:Borrowings on notes,

mortgages, bonds, etc. from creditors

Issuing stock to owners

Inflows Cash received from:Borrowings on notes,

mortgages, bonds, etc. from creditors

Issuing stock to owners

Outflows Cash paid for: Repayment of principal to

creditors (excluding interest, which is an operating activity)

Repurchasing stock from owners

Dividends to owners

Outflows Cash paid for: Repayment of principal to

creditors (excluding interest, which is an operating activity)

Repurchasing stock from owners

Dividends to owners

McGraw-Hill/Irwin Slide 26

McGraw-Hill/Irwin Slide 27

Cash used to repay long-term

debt.

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Cash proceeds from the

issuance of common stock to employees.

Retained earnings decreased by

$65,560 due to the combined

effect of $40,754 of income and

$106,314 in dividends.

McGraw-Hill/Irwin Slide 30

Required Supplemental Information

1. Reconciliation of net income to cash flow from operations (for direct method).

2. Cash paid for income taxes and interest.

3. Significant noncash investing and financing activities.

Required Supplemental Information

1. Reconciliation of net income to cash flow from operations (for direct method).

2. Cash paid for income taxes and interest.

3. Significant noncash investing and financing activities.

Additional Cash Flow Disclosures

Example: Purchase of a building with a mortgage.

McGraw-Hill/Irwin Slide 31

In general, this measures a firm’s ability to pursue long-term investment opportunities.

Free Cash Flow

Free Cash Flow = Cash Flow from Operating Free Cash Flow = Cash Flow from Operating Activities – Dividends – Capital ExpendituresActivities – Dividends – Capital Expenditures

© 2008 The McGraw-Hill Companies, Inc.

End of Chapter 12