CHAPTER 1



CHAPTER 14

The Statement of Cash Flows

reviewing the chapter

Objective 1: Describe the principal purposes and uses of the statement of cash flows, and identify its components.

1. The statement of cash flows focuses on a company’s liquidity and contains much information not found in the income statement, balance sheet, or statement of stockholders’ equity. It explains the changes in cash and cash equivalents from one accounting period to the next by showing the cash inflows and outflows from a company’s operating, investing, and financing activities during an accounting period. For the statement of cash flows, cash is defined as including both cash and cash equivalents. Cash equivalents are short-term, highly liquid investments, such as money market accounts, commercial paper (short-term notes), and U.S. Treasury bills. Marketable securities are not considered cash equivalents.

2. The principal purpose of the statement of cash flows is to provide information about a company’s cash receipts and cash payments during an accounting period. A secondary purpose is to provide information about a company’s operating, investing, and financing activities.

3. Management uses the statement of cash flows to assess the company’s debt-paying ability, to determine dividend policy, and to plan for investing and financing needs. Investors and creditors use the statement to assess such things as the company’s ability to manage cash flows, to generate positive future cash flows, to pay its liabilities, to pay dividends and interest, and to anticipate its need for additional financing.

4. The statement of cash flows classifies cash receipts (inflows) and cash payments (outflows) as stemming from operating, investing, and financing activities. The statement may be accompanied by a schedule of significant noncash transactions.

a. Operating activities include receiving cash from the sale of goods and services, receiving interest and dividends on loans and investments, receiving cash from the sale of trading securities, and making cash payments for wages, goods and services, interest, taxes, and purchases of trading securities.

b. Investing activities include purchasing and selling property, plant, and equipment and other long-term assets; purchasing and selling long- or short-term held-to-maturity and available-for-sale securities; and making and collecting on loans to other entities.

c. Financing activities include issuing and buying back stock, as well as borrowing and repaying loans on a short- or long-term basis (i.e., issuing bonds and notes). Dividend payments are also included in this category, but payments of accounts payable and accrued liabilities are not (they are classified as operating activities).

d. Settling a debt by issuing stock and purchasing land by taking out a mortgage are significant financing and investing activities, but they do not involve cash inflows and outflows and are therefore not reflected on the statement of cash flows. However, because they will affect future cash flows, they should be disclosed in a separate schedule of noncash investing and financing transactions that accompanies the statement of cash flows. These transactions involve only long-term assets, long-term liabilities, and stockholders’ equity.

5. The three main sections of a statement of cash flows are operating activities, investing activities, and financing activities. A reconciliation of the beginning and ending balances of cash appears near the bottom of the statement, tying into the cash balances of the balance sheets.

6. Because users often focus on cash flows from operations to gauge performance, an incentive exists to overstate these cash flows. For example, a business could boost net cash flows from operating activities by classifying outflows for operations as investing activities or by classifying inflows that are really financing activities as operating activities. Such practices are unethical, and possibly in violation of GAAP, when they obscure the company’s true performance.

Objective 2: Analyze the statement of cash flows.

7. Two areas that analysts focus on when evaluating a firm’s statement of cash flows are cash-generating efficiency and free cash flow. Because cash flows can vary from year to year, it is best to look at trends in these areas over several years.

8. Cash-generating efficiency is a company’s ability to generate cash from its current or continuing operations. It can be expressed in terms of three ratios: cash flow yield, cash flows to sales, and cash flows to assets.

a. Cash flow yield equals net cash flows from operating activities divided by net income (or by income from continuing operations). A cash flow yield of 2.0 times, for example, means that operating activities have generated twice as much cash flow as net income.

b. Cash flows to sales equals net cash flows from operating activities divided by sales. A ratio of 5.7 percent, for example, means that operating cash flows of 5.7 cents have been generated for every dollar of sales.

c. Cash flows to assets equals net cash flows from operating activities divided by average total assets. A ratio of 4.8 percent, for example, means that operating cash flows of 4.8 cents have been generated for every dollar of average total assets.

9. Free cash flow is the cash that remains from operating activities after deducting the funds a company must commit to continue operating at its planned level. It equals net cash flows from operating activities minus dividends minus purchases of plant assets plus sales of plant assets. A positive free cash flow means that the company has met its cash commitments and has cash remaining to reduce debt or expand further. A negative free cash flow means that the company will have to sell investments, borrow money, or issue stock to continue at its planned level.

Objective 3: Use the indirect method to determine cash flows from operating activities.

10. To determine cash flows from operating activities, the figures on the income statement must be converted from an accrual basis to a cash basis using either the direct method or the indirect method. The direct and indirect methods produce the same net figure, and both conform to GAAP, but the indirect method is far more widely used.

11. Under the indirect method, the net cash flows from operating activities are determined by adding to or deducting from net income items that do not affect cash flows from operations. Items that are added include depreciation expense, amortization expense, depletion expense, losses, decreases in certain current assets (accounts receivable, inventory, and prepaid expenses), and increases in certain current liabilities (accounts payable, accrued liabilities, and income taxes payable). Items that are deducted include gains, increases in certain current assets (see above), and decreases in certain current liabilities (see above).

Objective 4: Determine cash flows from investing activities.

12. To determine cash flows from investing activities, each account involving cash receipts and cash payments from investing activities is examined. The objective is to explain the change in each account balance from one year to the next.

13. Investing activities center on long-term assets shown on the balance sheet, but they also include transactions affecting short-term investments from the current assets section of the balance sheet and investment gains and losses from the income statement.

Objective 5: Determine cash flows from financing activities.

14. The procedure for determining cash flows from financing activities is similar to the procedure for determining cash flows from investing activities. The difference is that the accounts to be analyzed involve short-term borrowings, long-term liabilities, and stockholders’ equity. Cash dividends from the statement of stockholders’ equity are also considered.

15. Exhibit 5 in the text shows a statement of cash flows that was prepared using the indirect method. As already noted, the essence of the indirect approach is the conversion of net income to net cash flows from operating activities.

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