PURPOSE OF SOCF

Provides information on cash inflows and outflows for a period.

Distinguishes among the sources and uses of cash flows by separating them into operating, investing, and financing activities.

BASIC ELEMENTS OF SOCF

FREE CASH FLOW
Cash concept – includes cash and ST highly liquid
investments (cash and cash equiv focus)
Change in cash – examine all accounts in SOFP other than
cash and cash equivalent
Uses of SOCF:
Internal – determine div. policy, evaluate cash generated STATEMENT OF CASH PROCEDURES TO DEVELOP SOCF
by operations, review investing and financing policy FLOWS
External – determine firm’s ability to increase dividends,
determine firm’s ability to pay debt from operations,
determine the percentage of cash from operations in
CASH FLOW FINANCIAL RATIOS
relation to the cash from financing
Operating CF to current maturities of
debt
Operating CF to total debt
RELEVANCE OF CASH Operating CF per share
Cash – the most liquid asset and offers liquidity, solvency and financial flexibility Operating CF to cash dividends
Relates to a company’s operating cycle
Provides information on the following questions: SOCF STRUCTURE
• How much cash is generated from or used in operations? Change in cash - CFO activities; CFI
• What expenditures are made with cash from operations? activities; CFF activities
• How are dividends paid when confronting an operating loss? Ending cash balance
• What is the source of cash for debt payments? Supplemental discl – non-cash investing
• How is the increase in investments financed? and financing activities
• What is the source of cash for new plant assets?
• Why is cash lower when income increased?
• What is the use of cash received from new financing?
 SOCF STRUCTURE CASH FLOW FINANCIAL RATIOS

OPERATING ACTIVITIES Operating CF to current maturities of debt

Include the cash effects of events that enter into the determination of Indicates a firm’s ability to meet its current maturities of debt
net income. Higher ratio indicates better liquidity
Cash inflows from sale of goods or services, returns on loans (interest), Formula:
return on equity securities (dividends) Operating CFs
Cash outflows for payments for acquisitions of inventory, to Current maturities of LT debt and current note payable
employees, for taxes, for interest expenses and for other expenses Exhibit 10-5
Presentation of CFO activities:
• Direct method (exhibit 10-1) Operating CF to total debt
– Converts the income statement from accrual basis to a cash basis Indicates a firm’s ability to cover total debt with the yearly operating cash flow
– Supplemental information required - reconciliation of net income The higher the ratio, the better the firm’s ability to carry its total debt
to cash provided by operations Conservative approach is to include all possible balance sheet debt
• Indirect method (exhibit 10-1) Formula: Operating CF/Total debt
– Adjusts net income for items that affected net income but did not Exhibit 10-6
affect cash
– Supplemental information required - cash paid for income taxes
and for interest Operating CF per share
Indicates the funds flow per common share outstanding
Higher than earnings per share as depreciation is not deducted
INVESTING ACTIVITIES
Formula:
Lending and collecting money and acquiring and selling investments
Operating CFs – Pref dividends
and long-term assets
Diluted weighted average OS outstanding
Cash inflows from receipts from loans collected, sales of debt or equity
A better indication of a firm’s ability to make capital expenditure decisions and
securities of other corporations and sale of PPE
pay dividends than is earnings per share
Cash outflows for loans to other entities, investment in debt or equity
Does not reflect firm’s profitability - firms are prohibited from reporting this on
securities of other entities, purchase of PPE
financial statements
Exhibit 10-7

FINANCING ACTIVITIES
Include cash flows relating to liability and owners’ equity Operating CF to cash dividends
Cash inflows from issue/sale of equity securities, issue/sale of bonds, Indicates a firm’s ability to cover cash dividends with the yearly operating cash
mortgages, notes, and other short- and long-term borrowings flow
Cash outflows for payment of dividends, reacquisition of capital stock, Higher the ratio, the better the firm’s ability to cover cash dividends
payment of amounts borrowed, lease payment Formula: Operating CF/Cash dividends
Exhibit 10-8
For Nike, this ratio substantially declined in 2009. Both years represent material coverage
The operating cash flow/total debt ratio is computed in Exhibit 10-6 for Nike for the years ended
May 31, 2009 and 2008. It indicates that cash flow is significant in relation to total debt in both
years.

Operating cash flow per share is computed for Nike for 2009 and 2008 in Exhibit 10-7. Operating
cash flow per share was significantly more than earnings per share in 2009. Operating cash flow per
share decreased materially in 2009.
Operating cash flow/cash dividends is computed for Nike for 2009 and 2008 in Exhibit 10-8. It
indicates material coverage of cash dividends in both 2009 and 2008, although there was a material
decline in 2009.
 PROCEDURES TO DEVELOP SOCF FREE CASH FLOW

Analysis of SOFP items other than C&CE

A useful analytical derivative of the statement of cash flows.
Increase Decrease
Free cash flow is how much money business has leftover to use
Current assets Operating o/flow Operating inflow for other purposes after it has paid for capital expenditures,
Non-current assets Investing o/flow Investing inflow including buildings and equipment, and other expenses needed
Current liabilities Operating inflow Operating o/flow to sustain its ongoing operation.
LT liabilities Financing inflow Financing o/flow 3 methods to calculate FCF:
S/holders’ equity Financing inflow Financing o/flow 1. Sales revenue – Operating cost and taxes – Required
3 techniques to prepare SOCF: investment in operating capital
– The visual method (exhibit 10-9) 2. Net operating PAT – Net investment in operating capital
• Determine change in cash and cash equivalents 3. Net CF from operation – Capital expenditure
• Compute the net change in all other SOFP accounts Positive free cash flow reflects the amount available for
• Classify as operating, investing, and financing business activities after allowances for financing and investing
– The T-account method requirements to maintain productive capacity at current levels.
– The worksheet method Companies that have a healthy free cash flow have enough
funds on hand to meet their bills every month, plus some left
over. A company with rising or high free cash flow generally is
doing well and might want to consider expanding, whereas a
Direct approach company with falling or low free cash flow (or no money left
Operating section describes income statement accounts in terms of receipts or payments over after covering the bills) may need to restructure.
Cash receipts Cash payments The funds can be used to expand the business, pay dividends to
– From customers – For merchandise shareholders, reduce debt or invest in research for new
– From other operating sources – To employees products.
– For other operating expenses Growth and financial flexibility depend on adequate free cash
Exhibit 10-11 flow.

Indirect approach
Begin with net income
Add or deduct adjustments to change accrual basis net income to cash basis net income
– Changes in current noncash assets
– Changes in noncash assets go in the inverse direction of changes in cash
– Changes in current liabilities
– Changes in non-cash liabilities go in the same direction of changes in cash
Adjust net income (loss) for noncash expenses (like depreciation expense) and noncash revenues
Eliminate non cash gains and losses that relate to investing and financing activities
Exhibit 10-12