AC310

Principles of
Accounting I: Financial
Accounting
Session 4:
The Cash Flow Statement
 After studying this chapter, you should be able to
1. Identify the purposes of the statement of cash flows
2. Classify activities affecting cash as operating,
investing, or financing activities
3. Explain the link between the balance sheet and the
statement of cash flows

Learning 4. Compute and interpret cash flows from investing

activities

Objectives 5. Compute and interpret cash flows from financing

activities
6. Compute and interpret cash flows from operations
7. Use the indirect method to explain the difference
between net income and net cash provided by
(used for) operating activities
8. Use free cash flow to evaluate cash management of
a company

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 Overview of the Cash Flow Statement

Content Purpose
• Report cash receipts and cash • Shows the relationship of net income
payments of an entity over a period of to changes in cash balances
time • Helps to predict future cash flows
• Classify the cash flows as operating, • Evaluates how management generates
investing, and financing activities and uses cash
• Detail the changes in the cash account • Determines a company’s ability to pay
on the balance sheet interest, dividends, and debts when
they are due
• Identifies specific increases and
decreases in a firm’s productive assets

3
Cash and Cash Equivalents
• The cash flow statement reports the changes in cash and cash
equivalents between two balance sheet dates
• Cash refers to notes and coins on hand and bank deposits
• Cash equivalents are highly liquid short-term investments that a
company can easily and quickly convert into cash
• Money market funds
• Treasury bills

4
Cash and Cash Equivalents
(continued)

5
Classifying Cash Flows
• Cash is affected by three types of activities or decisions:
• Operating activities
• Financing activities
• Investing activities
• The cash effect of each of these activities is reported in a separate
section of the cash flow statement
• Each section reports cash inflows (cash receipts coming into the
company) and cash outflows (cash going out of the company) based
on these three activities

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Operating Activities
• Operating activities refer to the major day-to-day transactions that
generate revenues and expenses, for example:
• Making sales
• Collecting accounts receivable
• Purchasing inventory
• Paying accounts payable
• The first major section of the statement of cash flows is labeled cash
flows from operating activities

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Investing Activities
• Investing activities are transactions that acquire or dispose of long-
term assets, for example,
• Purchasing or disposing of equipment
• Investing in other companies by buying their shares
• The investing section on the statement is labeled cash flows from
investing activities

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Financing Activities
• Financing activities are a company’s transactions to obtain funds by
contracting long-term debt or issuing equity, for example:
• Issuance of additional stock
• Borrowing money from the bank
• Repaying previous loans
• The financing section on the statement is labeled cash flows from
financing activities

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Summary of Cash Inflows and
Outflows
Cash Inflows Cash Outflows

Operating
Operating Activities:
Activities:
Collections
Collections from
from customers
customers Cash
Cash payments
payments toto suppliers
suppliers
Interest
Interest and
and dividends
dividends collected
collected Cash
Cash payments
payments toto employees
employees
Other
Other operating
operating receipts
receipts Interest
Interest and
and taxes
taxes paid
paid
Other
Other operating
operating cash
cash payments
payments

Investing
Investing Activities:
Activities:
Sale
Sale of
of property,
property, plant,
plant, and
and equipment
equipment Purchase
Purchase of
of property,
property, plant,
plant, and
and equipment
equipment
Sale
Sale of
of securities
securities that
that are
are not
not Purchase
Purchase of
of securities
securities that
that are
are not
not
cash
cash equivalents
equivalents cash
cash equivalents
equivalents
Receipt
Receipt of
of loan
loan repayments
repayments Making
Making loans
loans

Financing:
Financing:
Borrowing
Borrowing cash
cash from
from creditors
creditors Repayment
Repayment ofof amounts
amounts borrowed
borrowed
Issuing
Issuing equity
equity securities
securities Repurchase
Repurchase ofof the
the company’s
company’s own
own shares
shares
Issuing
Issuing debt
debt securities
securities (purchase
(purchase of of treasury
treasury stock)
stock)
Payment
Payment of
of dividends
dividends 10
How Cash Flows Affect the Balance
Sheet

11
 Please do now Exercice 1. You’ll find the
Exercises document Exercises on Moodle in the section
of Session 4.
You can check your answer after having
finished the exercises by referring to the
document Solutions.

12
 • The following two slides for eWheels Company
show the:
• Changes in the balance sheet equation
(transactions) during the first month of operations
• Income statement for the first month of operations
and the January 31 balance sheet

EXAMPLE • Transactions for January have been slightly

modified from Session 1, new transactions added
: eWheels • Notice that the cash balance increased from $0
to $311,200 during the month

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 EXAMPLE eWheels: Overview of
Transactions Accounts
Accounts
Assets
Assets
Merchandise
Merchandise Store
Store
== Liabilities
Liabilities
Note
Note
++
Accounts
Accounts
Stockholders'
Stockholders' Equity
Paid-in
Paid-in
Equity
Retained
Retained
Description
Description of
of Transactions
Transactions Cash
Cash ++ Receivable
Receivable ++ Inventory
Inventory ++ Prepaid
Prepaid Rent
Rent ++ Equipment
Equipment == Payable
Payable ++ Payable
Payable ++ Capital
Capital ++ Earnings
Earnings
(1)
(1) Initial
Initial investment
investment +400,000
+400,000 == +400,000
+400,000
(2)
(2) Loan
Loan fromfrom bank
bank +100,000
+100,000 == +100,000
+100,000
(3)
(3) Acquire
Acquire storestore equipment
equipment forfor
cash
cash -15,000
-15,000 +15,000
+15,000 ==
(4)
(4) Acquire
Acquire inventory
inventory for
for cash
cash -120,000
-120,000 +120,000
+120,000 ==
(5)
(5) Acquire
Acquire inventory
inventory on
on credit
credit +30,000
+30,000 == +30,000
+30,000
(6)
(6) Sales
Sales of of equipment
equipment +1,200
+1,200 -1,000
-1,000 == +200
+200
(7)
(7) Payments
Payments to to creditors
creditors -4,000
-4,000 == -4,000
-4,000
(8a)
(8a) Sales
Sales on on open
open account
account +160,000
+160,000 == +160,000
+160,000
(8b)
(8b) Cost
Cost of of merchandise
merchandise
inventory
inventory sold sold -100,000
-100,000 == -100,000
-100,000
(9)
(9) Collect
Collect accounts
accounts receivable
receivable +5,000
+5,000 -5,000
-5,000 ==
(10)
(10) Pay
Pay rent
rent in
in advance
advance -6,000
-6,000 +6,000
+6,000 ==
(11)
(11) Recognize
Recognize expiration
expiration of
of
rental services
rental services -2,000
-2,000 == -2,000
-2,000
(12)
(12) Depreciation
Depreciation -100
-100 == -100
-100
(13)
(13) Cash
Cash dividend
dividend -50,000
-50,000 -50,000
-50,000
Balance
Balance January
January 31, 31, 20X2
20X2 311,200
311,200 +155,000
+155,000 +50,000
+50,000 +4,000
+4,000 +13,900
+13,900 == 100,000
100,000 +26,000
+26,000 +400,000
+400,000 +8,100
+8,100

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534,100 534,100
Cash Flows From Investing and
Financing
• eWheels had two investing transactions relating to store equipment in
January:
• Transaction 3: Acquire store equipment for cash, $15,000
• Transaction 6: Sale of store equipment for cash, $1,200
(including a gain of $200). Book value of the equipment sold was $1,000.
• There were three financing transactions in January:
• Transaction 1: Initial investment, $400,000
• Transaction 2: Loan from bank, $100,000
• Transaction 13: Cash dividend, $50,000

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 Two approaches may be used:
Direct method: Indirect method:
• Restates the • Adjusts accrual-
entire income based net income
statement in from the income
Cash Flows terms of cash statement to reflect
from • Shows actual cash
receipts and cash
only cash receipts
and disbursements
Operating payments • Is used by most
companies
Activities
Both approaches produce the same cash flow
figure in the end, but take a different path to
get there!

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Direct Method
• Examining the cash column of eWheels balance sheet equation,
transactions 1, 2, 3, 6 and 13 are financing and investing activities
• The remaining transactions in the cash column must be operating
activities:
eWheels Company
Cash Flows from Operating Activities—Direct Method
For the Month of January 20X2

Cash collections from customers on accounts receivable

(transaction 9) 5,000
Cash payments to suppliers for inventory (cash purchase)
(transaction 4) $(120,000)
Cash payments to suppliers for accounts payable (transaction 7) (4,000)
Cash payments for rent (transaction 10) (6,000)
Net cash used by operating activities $(125,000) 17
Cash Collections From Customers
• The same cash flow figures can also be deduced from the income
statement and the balance sheet without using the detailed
movements on the cash account
• Formula:
Sales revenues $160,000
+ Beginning balance Accounts receivable 0 Add decrease
- Ending balance Accounts receivable (155,000) (deduct increase)
= Cash collections from customers 5,000 in receivables

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 The same logic applies to

Cash Payments to Suppliers Cash payments to employees:

Salaries expense
+ Beginning balance Salaries payable
• Procedure - Ending balance Salaries payable
= Cash payments to employees
1. Start with Cost of goods sold
2. Adjust Cost of goods sold to calculate Purchases
3. Adjust Purchases to calculate Payments to suppliers
• Formula:
Cost of goods sold $100,000
- Beginning balance Inventories 0
+ Ending balance Inventories 50,000
= Purchases 150,000 Add decrease
+ Beginning balance Accounts payable 0 (deduct increase)
- Ending balance Accounts payable (26,000) in payables
= Cash payments to suppliers 124,000
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Cash Payments For Rent
(Paid In Advance)
• Formula:
Rent expense $2,000
- Beginning balance Prepaid rent 0 Add increase
+ Ending balance Prepaid rent 4,000 (deduct decrease)
= Cash payment for rent 6,000 in prepaid rent
• The same formula can be used for any other prepaid expense
account, for example, prepaid insurance

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Indirect Method
• When the cash flow from a sale or outflow from an expense occurs in
one accounting period and the revenue or expense occurs in another,
net income differs from cash flows from operations
• The indirect method highlights these differences by starting with net
income, and adjusts it to cash flows from operating activities
• Example: Depreciation is added back to net income because it is a
noncash expense

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Indirect Method (continued)
Steps:
1. Start with net income*
2. Add back expenses not requiring cash such as depreciation
3. Adjust for gains (losses) from sales of long-term assets
• Add losses
• Deduct gains
4. Adjust for changes in noncash current assets and current liabilities (“working
capital”)
• Add decreases in assets
• Deduct increases in assets
• Add increases in liabilities
• Deduct decreases in liabilities
(*) A variant is to start with Income (or profit) before taxes 22
Indirect Method (continued)
eWheels Company
Cash Flows from Operating Activities—Indirect Method
For the Month of January 20X2

Net income $ 58,100

Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation 100
Gain from sale of store equipment (200)
Net increase in accounts receivable (155,000)
Net increase in inventory (50,000)
Net increase in prepaid rent (4,000)
Net increase in accounts payable 26,000
Net cash used by operating activities $(125,000)

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 eWheels
eWheels Company
Company
Statement
Statement of
of Cash
Cash Flows
Flows

Cash Flow Statement

For
For the
the Month
Month of
of January
January 20X2
20X2

Cash
Cash flows
flows from
from operating
operating activities:
activities:
EXAMPLE eWheels:
Net
Net income
income $$ 58,100
58,100
Adjustments
Adjustments to to reconcile
reconcile net
net income
income toto
net cash provided by operating activities:
net cash provided by operating activities:
Depreciation
Depreciation 100
100
Gain
Gain from
from sale
sale of
of store
store equipment
equipment (200)
(200)
Net
Net increase in accounts receivable
increase in accounts receivable (155,000)
(155,000)
Net
Net increase
increase in in inventory
inventory (50,000)
(50,000)
Net
Net increase
increase in in prepaid
prepaid rent
rent (4,000)
(4,000)
Net
Net increase in accounts payable
increase in accounts payable 26,000
26,000
Net
Net cash
cash provided
provided by by operating
operating activities
activities $(125,000)
$(125,000)

Cash
Cash flows
flows from
from investing
investing activities:
activities:
Purchase
Purchase of
of store
store equipment
equipment $$ (15,000)
(15,000)
Proceeds
Proceeds from
from sale
sale of
of store
store equipment
equipment 1,200
1,200
Net
Net cash
cash provided
provided by by investing
investing activities
activities (13,800)
(13,800)

Cash
Cash flows
flows from
from financing
financing activities:
activities:
Proceeds
Proceeds from
from initial
initial investment
investment $$ 400,000
400,000
Proceeds from bank
Proceeds from bank loan loan 100,000
100,000
Cash
Cash dividend
dividend paid
paid (50,000)
(50,000)
Net
Net cash
cash provided
provided by by financing
financing activities
activities 450,000
450,000

Net
Net increase
increase in
in cash
cash 311,200
311,200
Cash,
Cash, January
January 2,
2, 20X2
20X2 00
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Cash,
Cash, January 31, 20X2
January 31, 20X2 $311,200
$311,200
 Please do now Exercices 2-6. You’ll find the
Exercises document Exercises on Moodle in the section
of Session 4.
You can check your answer after having
finished the exercises by referring to the
document Solutions.

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The Importance of Free Cash Flow
• The income statement matches revenues and expenses using accrual
concepts and provides a measure of economic performance
• The statement of cash flows explains changes in the cash account
rather than owners’ equity
• Free cash flow
• Is a measure of cash management performance
• Formula: Free cash flow =
Cash flows from operations
- Capital expenditures (investments in long-term assets)
• Some analysts also deduct dividends

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 Please do now Exercices 7&8. You’ll find the
Exercises document Exercises on Moodle in the section
of Session 4.
You can check your answer after having
finished the exercises by referring to the
document Solutions.

27
End of Session 4
To complement this session:
• Read the relevant chapter in the
primary reading
• Measuring and reporting cash
flows
• Do the remaining exercises for self-
study
• Do Online Quiz 3 for Continuous
assessment on Moodle, to be done
within one week after Session 4
(graded)

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Next Session:
Financial Analysis
• In Sessions 1-4, we have studied the
three main financial statements. In the
next session, we will see how to analyse
these statements in order to evaluate a
company’s financial position and
performance.
• To prepare Session :
• Read the slides
• Read the relevant chapter in the
primary reading
• Analysing and interpreting
financial statements
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