MODULE 5– STATEMENT OF CASH FLOWS 1

MODULE 5 – STATEMENT OF CASH FLOWS

INTRODUCTION

Considering the importance of cash, it is not surprising that the statement of cash flows
has become one of the primary financial statements. The statement of cash flows gives
managers, equity analysts, commercial lenders, and investment bankers a thorough
explanation of the changes that occurred in the firm’s cash balances. The statement of
cash flows provides an explanation of the changes that occurred in the firm’s cash
balances for a specific period. Cash is considered to be the lifeblood of the firm.
Understanding the flow of cash is critical to having a handle on the pulse of the firm.

LEARNING OUTCOMES:

After reading this module, the learner should be able to:

1. Identify and describe the basic elements of the statement of financial position
2. Discuss the statement of stockholders’ equity.
3. Explain problems in the preparation of the statement of financial position
(balance sheet)

TIME:

The time allotted for this module is three (3) hours.

LEARNER DESCRIPTION

The participants in this module are 3rd year BSBA students

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MODULE CONTENTS:

Lesson 5.1: BASIC ELEMENTS OF THE STATEMENT OF CASH FLOWS

The STATEMENT OF FINANCIAL CASH FLOWS

The statement of cash flows is prepared using a concept of cash that includes not
only cash itself but also short-term, highly liquid investments. This is referred to as
the “cash and cash equivalent” focus. The category cash and cash equivalents
include cash on hand, cash on deposit, and investments in short-term, highly liquid
investments. The cash flow statement analysis explains the change in these focus
accounts by examining all the accounts on the balance sheet other than the focus
accounts.

Management may use the statement of cash flows to determine dividend policy,
cash generated by operations, and investing and financing policy. Outsiders, such
as creditors or investors, may use it to determine such things as the firm’s ability to
increase dividends, its ability to pay debt with cash from operations, and the
percentage of cash from operations in relation to the cash from financing.

The statement of cash flows must report all transactions affecting cash flow. A
company will occasionally have investing and/or financing activities that have no
direct effect on cash flow. For example, a company may acquire land in exchange
for common stock. This is an investing transaction (acquiring the land) and a
financing transaction (issuing the common stock). The conversion of long-term
bonds into common stock involves two financing activities with no effect on cash
flow. Since transactions such as these will have future effects on cash flows, these
transactions are to be disclosed in a separate schedule presented with the
statement of cash flows.

The statement of cash flows classifies cash receipts and cash payments into
operating, investing, and financing activities.1 In brief, operating activities involve
income statement items. Investing activities generally result from changes in long-
term asset items. Financing activities generally relate to long-term liability and
stockholders’ equity items. A description of these activities and typical cash flows are
as follows:

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1. Operating activities.

Operating activities include all transactions and other events that are not investing or
financing activities. Cash flows from operating activities are generally the cash
effects of transactions and other events that enter into the determination of net
income.

Typical cash inflows:

From sale of goods or services

From return on loans (interest)
From return on equity securities (dividends)

Typical cash outflows:

Payments for acquisitions of inventory

Payments to employees
Payments to governments (taxes)
Payments of interest expense
Payments to suppliers for other expenses

2. Investing activities.

Investing activities include lending money and collecting on those loans and
acquiring and selling investments and productive long-term assets.

Typical cash inflows:

From receipts from loans collected

From sales of debt or equity securities of other corporations
From sale of property, plant, and equipment

Typical cash outflows:

Loans to other entities

Purchase of debt or equity securities of other entities
Purchase of property, plant, and equipment

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3. Financing activities.

Financing activities include cash flows relating to liability and owners’ equity.

Typical cash inflows:

From sale of equity securities

From sale of bonds, mortgages, notes, and other short- or long-term borrowings

Typical cash outflows:

Payment of dividends
Reacquisition of the firm’s capital stock
Payment of amounts borrowed

The statement of cash flows presents cash flows from operating activities first,
followed by investing activities and then financing activities. The individual inflows
and outflows from investing and financing activities are presented separately. The
operating activities section can be presented using the direct method or the indirect
method. (The indirect method is sometimes referred to as the reconciliation method.)
The direct method essentially presents the income statement on a cash basis,
instead of an accrual basis. The indirect method adjusts net income for items that
affected net income but did not affect cash.

Accounting Organizations encouraged enterprises to use the direct method to

present cash flows from operating activities. However, if a company uses the direct
method, the standard requires a reconciliation of net income to net cash provided by
operating activities in a separate schedule. If a firm uses the indirect method, it must
make a separate disclosure of interest paid and income taxes paid during the period.

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Lesson 5.2: FINANCIAL RATIOS AND THE STATEMENT OF CASH FLOWS

Financial ratios that relate to the statement of cash flows were slow in being
developed. This was related to several factors. For one thing, most financial ratios
traditionally related an income statement item(s) to a balance sheet item(s). This
became the normal way of approaching financial analysis, and the statement of cash
flows did not become a required statement until 1987.

Thus, it took a while for analysts to become familiar with the statement. Ratios have
now been developed that relate to the cash flow statement. Some of these ratios are
as follows:

1. Operating cash flow/current maturities of long-term debt and current notes

payable
2. Operating cash flow/total debt
3. Operating cash flow per share
4. Operating cash flow/cash dividends

1. Operating cash flow/current maturities of long-term debt and current notes

payable

The operating cash flow/current maturities of long-term debt and current notes
payable is a ratio that indicates a firm’s ability to meet its current maturities of debt.
The higher this ratio, the better the firm’s ability to meet its current maturities of debt.
The higher this ratio, the better the firm’s liquidity.

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2. Operating cash flow/total debt

The operating cash flow/total debt indicates a firm’s ability to cover total debt with
the yearly operating cash flow. The higher the ratio, the better the firm’s ability to
carry its total debt.

It is a type of income view of debt, except that operating cash flow is the perspective
instead of an income figure. The operating cash flow is the same cash flow amount
that is used for the operating cash flow/current maturities of long-term debt and
current notes payable. For the primary computation of the operating cash flow/total
debt ratio, all possible balance sheet debt items are included, as was done for the
debt ratio and the debt/equity ratio. This is the more conservative approach to
computing the ratio. In practice, many firms are more selective in what is included in
debt. Some include only short-term liabilities and long-term items, such as bonds
payable. The formula for operating cash flow/total debt is as follows:

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3. Operating cash flow per share

Operating cash flow per share indicates the funds flow per common share
outstanding. It is usually substantially higher than earnings per share because
depreciation has not been deducted. In the short run, operating cash flow per share
is a better indication of a firm’s ability to make capital expenditure decisions and pay
dividends than is earnings per share. This ratio should not be viewed as a substitute
for earnings per share in terms of a firm’s profitability. For this reason, firms are
prohibited from reporting cash flow per share on the face of the statement of cash
flows or elsewhere in their financials. However, it is a complementary ratio that
relates to the ratios of relevance to investors The operating cash flow per share
formula is as follows:

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4. Operating cash flow/cash dividends

The operating cash flow/cash dividends indicate a firm’s ability to cover cash
dividends with the yearly operating cash flow. The higher the ratio, the better the
firm’s ability to cover cash dividends.

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MODULE REFERENCES:

Aduana, Nick L. (2015). Financial statements: Preparation, presentation, analysis and

interpretation. C & E Publishing

Ahmad N., Koh E., Gee C, Ramly Z., Abu N. Corporate Finance: An Asian Perspective.
Malaysia: Oxford University Press

Cornett M., Adair T., Nofsinger J. (2018). Finance: Applications and Theory 4th edition.
New York: McGraw-Hill Education

Higgins, Robert C. (2019). Analysis of Financial Statement. McGraw Hill

Pineda A. (2019). Basic Financial Management. Intramuros, Manila: Mindshapers Co.

Inc.

3G E-Learning LLC. Business Finance 2nd edition. 3G E-Learning, USA

https://taxacctgcenter.ph/knowing-basic-business-accounting-non-accountants-
philippines/

https://corporatefinanceinstitute.com/resources/knowledge/accounting/qualitative-
characteristics-of-accounting-information/

FM6- FINANCIAL REPORTING AND ANALYSIS