Statement of Cash Flows- First Approach

Appendix 6- Introduction to preparation of the Statement of Cash Flows

Cash Flow Statement

       Flow statement Periodic Provides information regarding the liquidity of a firm explains the reasons for increase or decrease in cash balance from one balance sheet date to the next classifies the reasons for the change as an operating, investing or financing activity.

amount of net income in a period is usually different than the amount of increase in cash in the same period reconciles net income with cash flow from operations.

Classification of Cash Flows

Operations -- cash flows related to selling goods and services; that is, the principle business of the firm.

Investing -- cash flows related to the acquisition or sale of noncurrent assets.

Financing -- long term and short term cash flows related to liabilities and owners’ equity; dividends are a financing cash outflow.

What is Cash?



Cash includes cash and cash equivalents



Cash equivalents:

   

treasury bills maturing in 90 days or less; investment funds; foreign currency on hand; checking account and free savings account

External Uses of CFS

     To assess the ability of a firm to manage cash flows To assess the ability of a firm to generate cash through its operations To assess the company’s ability to meet its obligations and its dividend policy To provide information about the effectiveness of the firm to convert its revenues to cash To provide information to estimate or anticipate the company’s need for additional financing

Internal Uses of CFS

 Along side with cash budget CFS is used:  To assess liquidity  Determine if short-term financing is necessary  To determine dividend policy  Decide to distribute; or increase or decrease  To evaluate the investment and financing decisions

Cash flow from operating activities

     Examples (IAS No.7): cash received from customers through sale of goods or services performed; cash received from non-operating activities such as dividends from investments, interest revenue, commissions, and fees; cash payments to suppliers or employees; cash payments for taxes and other expenses;

In effect, the income statement is changed from accrual basis to cash basis

Investing Activities

Examples of investing activities include:  cash payments to acquire property, plant, and equipment (PPE), other tangible or intangible assets, and other long-term assets; and sale of such assets  loans extended to other companies; and collection of such loans;

Financing Activities

Examples of financing activities are :  cash received from issuing share capital;    cash proceeds from issuing bonds, loans, notes, mortgages and other short or long-term borrowings; cash repayment of loans and other borrowings; and cash payments to shareholders as dividends.

Classification of Cash in-flows and outflows

From sales of goods and services to customers From receipt of customer advances From receipt of interest revenue or dividends or rent revenue or similar revenue items Operating Activities To wages salary payments To suppliers for purchases of inventories To other operating expenses To interest payments To tax payments To advance payments to suppliers From sale of PPE and other long-term assets From collection of loans Investing Activities To purchase PPE and other long-term assets To make loans and to collect such loans From sale of common or preferred stock From issuance of short or long term debt Financing Activities To repay debt To pay dividends

Format of the Cash Flow Statement

Name of the Company Cash Flow Statement For the period

…

Cash from operating activities Cash from investing activities A B Cash from financing activities Net Change in Cash C D = (A+B+C) increase or (decrease) + Beginning Cash balance Ending Cash balance CB, from the beginning balance sheet =CB + D should equal to ending cash balance in the ending balance sheet Non-cash Investing and Financing Activities

Determination of Cash Flows From Operating Activities

Direct Method Income Statement items are converted to cash flows individually Indirect Method Net income or loss is adjusted for accruals such as accounts receivable and payable, and for non-cash expenses such as depreciation reconciliation of the accrual based and cash based accounting

Comparison of Methods

   Direct method of presentation calculates cash flow from operations by subtracting cash disbursements to supplies, employees, and others from cash receipts from customers.

The indirect method calculates cash flow from operations by adjusting net income for non-cash revenues and expenses.

Most firms present their cash flows using the indirect method.

Only operating activities section is different between the methods, investing and financing sections are the same .

How to prepare cash flow statement

 Firms could prepare their own cash flow statement directly from the cash account.

 however, we need two consecutive balance sheets and the income statement that covers the period between the two balance sheets

Algebraic Formulation*

Assets = Liabilities + Shareholders’ Equity

or

A = L + SHE

Assets are either cash (C) or not (Non-Cash) Thus reorganizing

C + Non Cash Assets (NCA) = L + SE



C +



NCA =



L +



SE

Where  means the change in the balance of the item from the previous period.

Solving for change in cash: 

C =



L +



SE -



NCA

Based on Stickney and Weil, 10 th ed. Financial Accounting Slides http://www.swlearning.com/accounting/stickney/tenth_edition/stickney.html

Algebraic Formulation (Cont.)



C =



L +



SE -



NCA

The change in cash, 

C,

is the increase or decrease in the cash account.

This amount must equal changes in liabilities

plus

changes in shareholders’ equity

minus

changes in assets other than cash.

Thus, we can identify the causes in the change in the cash account by studying the changes in non-cash accounts.

Indirect Method – cash flow from operations Adjusting Net Income of the period (accrual) to cash basis income INCREASE DECREASE Assets Increase in non-cash assets shows that cash was spent, so cash outflow.

Decrease in non-cash assets shows that they provided cash so cash inflow.

Liabilities and Shareholders’ equity Increase in liabilities cash savings; increase in SHE cash received; so cash inflow Decrease in liabilities or SHE shows cash paid; so cash outflow

Indirect Method- operating activities Adjustments to net income

Net income

+ noncash expenses: depreciation, amortization, uncollectible account expense,etc + loss on sale of asset + increases in current liabilities + decreases in current assets - gain on sale of asset - decrease in current liabilities increase in current assets =

Cashflow from operating activities

Noncash Expenses

  Noncash expenses, such as depreciation expense, are added back – because they were deducted to measure net income but did not require any cash payment in the current period They are not truly sources of cash, even though they are associated with cash inflows but reversal of an accrued expense

Portakal Company Prepare Cash Flow Statement Accounts with Debit Balances

Cash Notes Receivable (from loans to other companies) Accounts Receivable Merchandise Inventory Prepaid Operating Expenses Interest Receivable Land Property,Plant and Equipment-PPE-net

2008

37.500

69.000

53.700

158.000

2.100

1.400

110.000

377.000

808.700

2007

39.250

50.000

39.900

120.000

1.800

600 65.000

380.000

696.550

increase (decrease) (1.750) 19.000

13.800

38.000

300 800 45.000

(3.000) 112.150

Accounts with Credit Balances

Accounts Payable Accrued Wages Payable Income Taxes Payable Unearned Revenues Bank Notes Payable - long term Common Stock; TL 15 par value Additional Paid in Capital Retained Earnings 45.000

3.000

6.000

2.500

215.000

405.000

70.000

62.200

808.700

38.000

2.400

4.500

1.250

200.000

375.000

50.000

25.400

696.550

7.000

600 1.500

1.250

15.000

30.000

20.000

36.800

112.150

Portakal Company Income Statement

Sales Revenue Cost of Goods Sold Depreciation Expense Salary and Wages Expense Administrative Expenses Loss on Sale of Equipment Other Operating Expenses Interest Revenue Interest Expense Income Tax Expense Net Income 0

2008

750.000

(375.000) (43.000) (125.000) (80.000) (4.000) (5.000) 4.000

(20.000) (28.000) 74.000

The company paid TL 50.000 of Bank Notes and borrowed new bank loan. The company declared and paid cash dividends.

The company sold equipment with a cost of TL 12000 and accumulated depreciation of TL 6000 for TL 2000 receving a note in return to be collected in 2009. The company purchased equipment for TL 46.000; paid TL 44.000 in 2008 and gave a note for Jan. 2009.

The company issued common stock during the year .

Portakal Company Cash Flow Statement

Cashflow from Operating Activities Net Income Add back noncash: Depreciation Expense Loss on Sale of Equipment

2008

74000 43.000

4.000

121.000

adjustments that increase cash: increase in Acct.Payable

Increase in Acc.Wages Payable increase in Income Taxes payable increase in unearned revenued adjustments that decrease cash: increase in Accts Rec.

increase in Merch. Inv.

Increase in Prepaid Expense increase in interest recev.

Cashflow from operations

7.000

600 1.500

1.250

10.350

(13.800) (38.000) (300) (800) (52.900)

78.450

Cashflow from investing Sale of PPE (note will be received in 2009) Purchase of PPE Loans extended( to other companies) Purchase of land

Cashflow from investing

(44.000) (19.000) (45.000)

(108.000)

Cashflow from financing Bank Notes Payable - long term Common Stock; TL 15 par value Additional Paid in Capital Payment of Bank loan Payment of Dividends

Cashflow from financing

65.000

30.000

20.000

(50.000) (37.200)

27.800

Net Change in Cash (1.750)

Effects of a Sale of a Long-Term Assets on Cash Flows

  A few transactions complicate the derivation of a cash flow statement from a comparative balance sheet, for example, the sale of a long-term (or fixed) asset.

Recall the journal entry for the sale of an asset: Cash

nnnn

Accumulated Depreciation

nnnn

Asset

nnnn

Gain (or loss) on sale

nnnn

Sale of an Asset

     Each of the four parts of the above journal entry require an adjustment in the cash flow statement.

The first line, cash, adds a line to the investing section.

The second line, a debit to accumulated depreciation, increases the depreciation expense above the change in the change in the accumulated depreciation account.

The third line, a credit to the asset, increases the amount of cash invested in long-lived assets above the change in the fixed asset accounts.

The fourth line, a gain or loss, is reversed out in the operating sections since this is not a cash flow.

      

Comparison of Cash Flow to Net Income

Net income is an accrual based concept and purports to show the long-term.

Cash flows purport to show the short term.

Consider the outlook for both short-term and long-term and consider that each is either good or poor.

A strong growing firm would show both good long-term and good short-term outlooks.

A failing firm would show both poor long-term and poor short term outlooks.

What about a firm with good cash flows (short-term) but poor net income (long-term)?

What about a firm with poor cash flows (short-term) but good net income (long-term)?