CASH FLOW

STATEMENT
 BACKGROUND
 The critical importance of cash makes the statement of cash flows one of
the key statements.

 The statement explains the changes that occur in the firm’s cash balance
during the year.

 The statement of cash flows allows both investors and managers to keep
their fingers on the pulse of any company’s lifeblood—cash.

 Attitudes toward holding cash vary. Some managers and investors like the
safety of large amounts of cash.
 For example, after the great recession of 2008–2011 many companies held
onto large amounts of cash to provide flexibility to meet unforeseen needs.
Microsoft , for instance, held $57 billion in cash, cash equivalents, and
short-term investments in early 2012.

 In contrast, other companies minimized cash holdings, even during the

recession, because cash provides only small returns to the company.
Companies that lose too much cash may find it necessary to declare
bankruptcy.
 Bankruptcy means that a company seeks court protection from its creditors
under federal law. Court protection allows a firm to delay paying certain
obligations while it negotiates with its creditors to reorganize its business
and settle its debts.

 Enron and General Motors are recent examples of large and historically
successful companies that entered bankruptcy and either liquidated
entirely (Enron) or reorganized large portions of their business (GM).

 Although managers and investors benefit from watching cash flows, until
recently many countries did not require a statement of cash flows.

 For example, India began to require such a statement about 10 years ago.
 One of the basic financial statements that reports the cash receipts and
cash payments of an entity during a particular period and classifies them
as financing, investing, and operating cash flows.
 PURPOSE OF CASH FLOW
 It helps them understand the relationship of net income to changes in cash
balances.
 Cash balances can decline despite positive net income and vice versa.
 It reports past cash flows as an aid to

# predicting future cash flows,

# evaluating how management generates and uses cash, and
# determining a company’s ability to pay interest, dividends, and
debts when they are due.

 It identifies specific increases and decreases in a firm’s productive assets.

AND THE BOTTOM LINE
IS…..

It helps investors assess how well

management has managed cash.
WHAT AFFECT CASH??????

Operating

Financing

Investing
 OPERATING ACTIVITIES
 Transactions that affect the purchase, processing, and selling of a
company’s products and services.

 Examples!!!!!!

making sales, collecting accounts receivable, recording an expense

for cost of goods sold, purchasing inventory, and paying accounts
payable or employee wages

 The thing these transactions have in common is that they are an integral
part of the major income-generating activities of the company.
 FINANCING ACTIVITIES
 A company’s transactions that obtain resources by borrowing from
creditors or selling shares of stock and use resources to repay creditors or
provide a return to shareholders.

 Managers make financing decisions when they decide whether and how to
raise or repay cash. For example, when a company needs cash, financial
managers may decide whether to borrow money from a bank or other
lender or issue additional capital stock. When there is excess cash,
financial managers may decide to repay previous borrowings or to buy
back previously issued stock.
 INVESTING ACTIVITIES
 Transactions that acquire or dispose of long-lived assets or acquire or
dispose of securities held for investment purposes that are not cash
equivalents.
(Highly liquid short-term investments that a company can easily and quickly convert into cash, such as
money market funds and Treasury bills.)

 These investing decisions include the choices to

(1) acquire or dispose of plant, property, equipment, and other long-

term productive assets, and
(2) provide or collect cash as a lender or as an owner of securities.
 EXCHANGE RATE EFFECT
 Companies show this effect after the operating, investing, and financing activities. The
effect of exchange rates is not a cash flow, but it appears on the cash flow statement
because it is necessary for the reconciliation of cash balances at the beginning and end of
the period.

 Consider a U.S. company with a bank account in London. The account balance is £100,000
at the beginning of the year when the exchange rate is 2 U.S. dollars for every British
pound. The company would include this bank account as part of its total cash balance on a
U.S. balance sheet at a value of (£100,000 × $2/£) = $200,000.

 Suppose there were no cash flows into or out of the bank account during the year, but the
exchange rate changed to $1.7 per pound. At the end of the year, a U.S. balance sheet
would include this bank account at a value of (£100,000 × $1.7/£) = $170,000. Cash
measured in dollars fell by $30,000 in the absence of any cash flow. This change in cash is
reported on the cash flow statement as the effect of exchange rates on cash.
 Notice that the cash balance for Biwheels increased from $0 at the
beginning of the month to $351,000 at the end of the month.

 Since the statement of cash flows explains the changes in cash, the first
step in developing the statement is always to compute the amount of the
change.

 In this case an increase of $351,000.

 Next, we examine the three sections of the statement of cash flows that
combine to explain this $351,000 increase.
 GENERAL RULE FOR
FINANCING ACTIVITIES
 Increases in cash (cash inflows) stem from increases in liabilities or paid-
in capital

 Decreases in cash (cash outflows) stem from decreases in liabilities or

paid-in capital
 GENERAL RULE FOR
INVESTING ACTIVITIES
 Increases in cash (cash inflows) stem from sale of long-lived assets,
collection of loans made to others, and sale of investments

 Decreases in cash (cash outflows) stem from purchases of long-lived

assets, granting of loans to others, and purchases of investments
 REMEMBER!!!!!

Change in assets
= Acquisitions - Disposals - Depreciation
expense

(Depreciation has no impact on cash. It is not a cash outflow.)

 TEST YOUR
UNDERSTANDING
 A company raised $1 million by selling common stock. The company put $400,000 into
securities that are cash equivalents and used the other $600,000 to buy equipment. What
are the effects of these transactions on the cash flow statement?

 The $1 million appears as cash provided by financing activities. The $600,000 appears as a
use of cash in the investing section.

 Because the securities are cash equivalents, the $400,000 does not appear in the investing
section; instead, it is simply a rearrangement of the form in which the company holds cash.

 The net increase in cash from these transactions is $400,000, or $1 million from financing
less $600,000 used for investing.
SOME MORE!!!
 Biwheels acquired $8,000 of the store equipment by issuing common stock.

 Biwheels acquired the other $7,000 of store equipment by signing a note

payable for $7,000.

 Biwheels converted $50,000 of its original note payable to common stock.

That is, Biwheels issued $50,000 of common stock in exchange for a
reduction of $50,000 in the note payable.

No Effect on Cash 

BUT IT'S IMPORTANT TO
REPORT
CASH FLOW FROM
OPERATING ACTIVITIES
 Users of financial statements appreciate information about management’s
ability to make financial and investment decisions.

 However, they often are more concerned with assessing management’s

operating decisions.

 Cash flows from operating activities (or cash flows from operations) shows
the cash effects of transactions that involve the major income-generating
activities of the company.

 These are activities that affect the purchase, processing, and selling of a
company’s products and services—in other words, the transactions that
affect the income statement
APPROACHES TO
CALCULATING THE CASH
FLOWS FROM OPERATING
ACTIVITIES
 Direct Method

A method for computing cash flows from operating activities that subtracts
operating cash disbursements from operating cash collections to arrive at
cash flows from operations.

 Indirect Method
 A method for computing cash flows from operating activities that adjusts
the previously calculated accrual net income from the income statement to
reflect only those income statement activities that involve actual cash
receipts and cash disbursements.

(Note: Both the IASB and FASB prefer the direct method because it is a
straightforward listing of cash inflows and cash outflows and is easier for
investors to understand)
 REMEMBER!!
 Recording revenue from the sales of goods or services does not necessarily
increase cash.

 Only sales for cash immediately increase cash. There is no cash effect of
credit sales until the customer actually pays.

 Similarly, cash received for services to be performed in the future is an

operating cash inflow recognized in the statement of cash flows even
though a company may not earn and record the revenue until a later
period.

 The cash effects of expenses are similar.

 EXAMPLE
 Biwheels incurred a $6,000 cash outflow for prepaid rent in January.

 What happen to income statement????????

Nothing (The company does not record rent expense on the income statement until
later, when it uses the rented facilities. )
 Record $6,000 as an asset.

But
 The entire $6,000 would appear as CASH FLOWS FROM OPERATING ACTIVITIES on
January’s statement of cash flows.
 COST OF GOODS SOLD
EXPENSE
Accounting for the acquisition and sale of inventory usually requires
recording three transactions:

(1) Purchase of inventory on credit,

(2) Payment of accounts payable, and
(3) Delivery of goods to the customer and thus the recording of an expense,
where steps (2) and (3) may occur in either order. If the purchase of
inventory is for cash, steps 1 and 2 combine to form a single transaction.

Consider that Biwheels bought a bicycle seat on credit for $30 on June 7.
Biwheels sold the seat on June 29 and paid the supplier in full on July 7.
 CONTD.
 June 7.

The balance sheet accounts Merchandise Inventory and Accounts Payable

increased by $30.

 June 29.

The balance sheet account Merchandise Inventory decreased by $30, and

Biwheels recorded a $30 cost of goods sold expense on the income
statement.

So!!!
At the end of June, no cash transaction had occurred
 EFFECT OF OPERATING
TRANSACTIONS ON CASH
BIWHEELS CASH FROM
OPERATING ACTIVITIES
ADJUSTMENTS FOR
REVENUES
ADJUSTMENT FOR COST OF
GOODS SOLD
SIMPLIFYING IT FURTHER…..
 ADJUSTMENTS FOR OTHER
EXPENSES
Adjust for revenues and expenses that do not require cash:
 Add back depreciation.
 Add back other expenses that do not require cash.
 Deduct revenues that do not generate cash.

Adjust for changes in noncash assets and liabilities relating to operating

activities:
 Add decreases in operating assets.
 Deduct increases in operating assets.
 Add increases in operating liabilities.
 Deduct decreases in operating liabilities.
 CONCEPTUAL FRAMEWORK
Assets = Liabilities + Stockholders’ Equity

Cash + Noncash assets = Liabilities + Shareholders’ Equity

Cash = Liabilities + Shareholders’ Equity – Noncash Assets

(Any change (Δ) in cash must be accompanied by a change in one or more items on
the right side to keep the equation in balance)

Δ Cash = Δ L + Δ SE - Δ NCA

Direct method = Indirect method

PUTTING ALL THE PIECES TOGETHER (STATEMENT OF
CASHFLOW FOR JANUARY, 20XX
ANOTHER EXAMPLE
 CONCEPT OF FREE
CASHFLOW
It is the net cash flow from operations less capital
expenditures. This is the cash flow remaining after
undertaking the firm’s operations.

It requires to put investments in place to ensure its

continued operation. Some also subtract dividends,
assuming they are necessary to keep the shareholders
happy.
EXAMPLE