STATEMENT OF CASH FLOWS
FINANCIAL ACCOUNTING – LECTURE 3
ERIC FLOYD– FALL 2020
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LEARNING OBJECTIVES
Understand Understand Develop
why using the the types of an ability to
accrual basis of transactions that prepare a
accounting to result in cash statement of cash
prepare the flows from flows from a
balance sheet operating, comparative
and income investing, and balance sheet
statement creates financing and income
the need for a activities. statement.
statement of cash
flows.
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REVIEW
§ THE INCOME STATEMENT:
• PURPOSE: MEASURE PERFORMANCE OVER A PERIOD, E.G.,
A YEAR.
§ ACCOUNTING PERIODS:
YEAR 1 YEAR 2
•
Buy Sale and delivery. Costs: Receive payment:
inventory:
USD -50 USD -10 USD 100
Buy Sale and delivery. Costs: Receive payment:
inventory:
USD -50 USD -10 USD 100
• 4
WHAT MAKES UP WALMART’S CASH
BALANCE?
Cash and Cash Equivalents
The Company considers investments with a maturity when
purchased of three months or less to be cash equivalents.
All credit card, debit card and electronic benefits transfer
transactions that process in less than seven days are classified
as cash and cash equivalents.
The Company’s cash balances are held in various locations
around the world. Of the Company’s $8.7 billion and $9.1
billion of cash and cash equivalents at January 31, 2016 and
2015, respectively, $4.5 billion and $6.3 billion, respectively,
were held outside of the U.S. and were generally utilized to
support liquidity needs in the Company’s non-U.S. operations.
As of January 31, 2016 and 2015, cash and cash equivalents
of approximately $1.1 billion and $1.7 billion, respectively,
may not be freely transferable to the U.S. due to local laws or
other restrictions.
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WALMART'S CASH FLOW STATEMENT
Objective of the
CFS is to explain
the decrease in
cash of $430
(8,705-9,135)
Walmart’s 2016 Annual
6
Report
Operating activities
Transactions related to
providing goods and services
to customers and paying
expenses related to revenue
generating activities. Includes
interest payments.
Investing activities
Transactions related to
acquisitions or disposal of
investments and non-current
operating assets.
Financing activities
Transactions related to owners
and creditors (except for
interest payments.
Net change in cash = Net
cash from operations + Net
cash from investing activities +
Net cash from financing
activities
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PURPOSE OF THE STATEMENT OF CASH
FLOWS (SCF)
The statement of cash flows:
• Explains the reasons for a change in cash over a period.
• Reconciles net income with cash flows from operations.
Why do we care?
• “Net income” is not cash flow!
• Companies can fail even though they are profitable based on GAAP
accounting. Increased GAAP earnings do not always generate increased
cash flow.
Helps with understanding differences between net cash flows
and net income.
• 8
USES OF THE STATEMENT OF CASH FLOWS
Evaluation of liquidity
(nearness to cash).
• CFO ÷ Average Current Liabilities
Forecasting free cash flows
(important for valuation).
Evaluation of solvency
Major changes in the
financing of the firm. (ability to pay debts as
they mature).
Evaluation of financial
flexibility (ability to respond
and adapt to unexpected
needs and opportunities).
• CFO ÷ Average Total Liabilities
• Free Cash Flow = CFO - CFI
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CLASSIFICATION OF CASH FLOWS
How would you classify the following events? O, I, or F
• Payment of accounts payable
• Proceeds from issuing common stock
• Collection of accounts receivable
• Payment of interest on debt
• Sale of a machine
• Purchase of land
• Issue common stock to acquire land (in one transaction)
• Purchase of a patent
• Payment of dividends
• Purchase of common stock as an investment
• Receipt of dividends on that stock
• Purchase of a building with proceeds of a bank loan (in two
transactions)
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QUESTIONS
Firm 1: Firm 2:
• A firm generated net • A firm operated at a net
income for the current loss for the current year,
year, but cash flow from but cash flow from
operations was negative. operations was positive.
How can this happen? How can this happen?
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DIRECT AND INDIRECT METHODS
§ ONLY RELEVANT FOR OPERATING ACTIVITIES. INVESTING AND FINANCING
ACTIVITIES ALWAYS USE THE DIRECT METHOD.
§ DIRECT METHOD
• LISTS CASH RECEIPTS AND DISBURSEMENTS BY SOURCE/USE OF
FUNDS.
• ALWAYS USED FOR INVESTING AND FINANCING ACTIVITIES.
• OCCASIONALLY USED FOR OPERATING ACTIVITIES.
§ INDIRECT METHOD
• ONLY USED FOR OPERATING ACTIVITIES.
• GOAL IS TO RECONCILE NET INCOME WITH CASH FROM OPERATIONS
BY REMOVING NONCASH ITEMS FROM NET INCOME.
• ALMOST EVERY COMPANY USES THIS METHOD FOR OPERATING
ACTIVITIES.
§ THE TWO METHODS ARE SIMPLY ALTERNATIVE WAYS TO ARRIVE AT THE
SAME NUMBER.
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QUESTION
§ THE FASB (THE ORGANIZATION THAT ISSUES US ACCOUNTING
STANDARDS) AND IASB (THE ORGANIZATION THAT ISSUES IFRS)
HAVE EXPRESSED A PREFERENCE FOR THE DIRECT METHOD.
§ ALMOST 99% OF FIRMS USE INDIRECT METHOD.
WHY DO YOU THINK THAT MOST FIRMS USE THE INDIRECT
APPROACH FOR OPERATING ACTIVITIES?
EXAMPLE 13
OF
A DIRECT
METHOD Sources
and Uses
CASH FLOW of Cash
STATEMENT
Divestitures
Measures the
net cash-
based
revenues and
expenses of a
Northrop company.
Grumman
14
RECONCILIATI
ON (INDIRECT
METHOD -
ONLY APPLIES
TO OPERATING
SECTION)
Same amount as
in the direct
method
• 15
WHY IS DEPRECIATION A POSITIVE VALUE IN
THE CASH FLOW STATEMENT (INDIRECT
METHOD)?
CONSIDER A VERY SIMPLE FIRM. ONLY ONE NON-CASH ENTRY
(DEPRECIATION). THE FIRM COULD USE THREE DIFFERENT
DEPRECIATION POLICIES (WE NEED TO LEARN DEPRECIATION):
DEPRECIATION POLICY 1 2 3
NET INCOME BEFORE DEPRECIATION 50 50 50
DEPRECIATION 10 20 30
NET INCOME AFTER DEPRECIATION 40 30 20
NET INCOME 40 30 20
DEPRECIATION 10 20 30
CASH FLOW 50 50 50
•CASH IS USED WHEN PPE IS PURCHASED (INVESTMENT
ACTIVITY) NOT WHEN WE DEPRECIATE ON IT!
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HOW DO YOU PRODUCE A CASH FLOW
STATEMENT?
§ THE APPROACH TO PREPARE THE CASH FLOW STATEMENT IS
ALMOST THE SAME FOR THE DIRECT AND INDIRECT METHOD. THE
DIFFERENCE IS MAINLY IN PRESENTATION.
§ BEGIN WITH A COMPARATIVE BALANCE SHEET:
• COMPUTE THE CHANGE IN EACH BALANCE SHEET ACCOUNT
• CLASSIFY EACH CHANGE AS OPERATING, INVESTING, OR
FINANCING ACTIVITY
• MAKE ANY NEEDED ADJUSTMENTS (FOR EXAMPLE, DIVIDENDS
OR SALE OF LONG-LIVED ASSET)
• RECAST THE CLASSIFIED CHANGES IN THE FORM OF A CASH
FLOW STATEMENT
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THE BALANCE SHEET EQUATION AND
CHANGES IN CASH
•ASSET = LIABILITIES + SHAREHOLDERS’ EQUITY
•ASSETS ARE EITHER CASH OR NON-CASH ASSETS, SO
•CASH + NON-CASH ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY
•ΔCASH + ΔNON-CASH ASSETS = ΔLIABILITIES + ΔSHAREHOLDERS’ EQUITY
•WHERE Δ MEANS CHANGE. WE CAN THEN MOVE ΔNON-CASH ASSETS TO
THE OTHER SIDE,
• ΔCASH = ΔLIABILITIES - ΔNON-CASH ASSETS + ΔSHAREHOLDERS’ EQUITY
§ THE CHANGE IN CASH MUST EQUAL CHANGES IN LIABILITIES MINUS
CHANGES IN NON-CASH ASSETS PLUS CHANGES IN SHAREHOLDERS’
EQUITY.
§ WE CAN IDENTIFY CAUSES OF THE CHANGE IN CASH BY STUDYING
CHANGES IN NON-CASH ACCOUNTS.
§ EXAMPLE: NET INCOME VS. CASH FLOWS WITH ACCOUNTS RECEIVABLE.
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CHANGES IN SPECIFIC ACCOUNTS AND
CASH FLOWS
ΔCASH = ΔLIABILITIES – ΔNON-CASH ASSETS +
ΔSHAREHOLDERS’ EQUITY
Increase Decrease
Non-cash assets “Cash consumption” “Source of cash”
Liabilities and “Source of cash” “Cash consumption”
shareholders’ equity
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HOW DO THESE RELATE TO CASH FLOW?
Accounts Payable decreases
Common Stock increases
Accounts Receivable decreases
Interest Payable decreases
Acquire land and pay by issuing equity
Patent increases
Declaration of dividend (Retained Earnings decreases)
Payment of dividend (Dividends Payable decreases)
Investments increases
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COMPLICATIONS
§ FOR NOW, LET’S ASSUME WE ARE USING THE INDIRECT METHOD
(I.E. CFO IS DERIVED BY ADJUSTING NI BY ACCRUALS).
§ A FEW TRANSACTIONS COMPLICATE THE DERIVATION OF A CASH
FLOW STATEMENT FROM A COMPARATIVE BALANCE SHEET.
§ THIS HAPPENS WHEN CHANGES IN BALANCE SHEET ACCOUNTS
DO NOT INVOLVE CASH OR RELATE TO SEVERAL CASH FLOW
ACTIVITIES.
§ EXAMPLES:
§ SALE OF LONG-TERM ASSETS: THE GAIN OR LOSS FOR THE SALE
OF AN ASSET IS DETERMINED BY COMPARING THE CASH
RECEIPTS WITH THE BOOK VALUE OF THE ASSET SOLD.
§ CHANGES IN RETAINED EARNINGS CAN BE DUE TO NET INCOME
(OPERATING ACTIVITY) AND DIVIDENDS (FINANCING ACTIVITY).
§ IMPAIRMENTS AND WRITE-OFFS OF ASSET VALUES.
§ UNREALIZED GAINS/LOSSES ON MARK-TO-MARKET ASSETS.
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SALE OF AN ASSET AND ITS EFFECT ON SCF
§ WHEN YOU REMOVE AN ASSET FROM THE BALANCE SHEET YOU
NEED TO REMOVE ANY ASSOCIATED DEPRECIATION BALANCE.
§ GAIN/LOSS = CASH – BOOK VALUE OF AN ASSET (I.E., COST –
ACCUMULATED DEPRECIATION)
CASE OF A GAIN:
DR. CASH (A) 50
DR. ACCUMULATED DEPRECIATION (XA) 80
CR. PPE (A) 100
CR. GAIN (RE) 30
CASE OF A LOSS:
DR. CASH (A) 10
DR. ACCUMULATED DEPRECIATION (XA) 80
DR. LOSS (RE) 10
CR. PPE (A) 100
§ THE INVESTING SECTION SHOWS ALL THE CASH RECEIPTS FROM
SELLING THE ASSET.
§ GAIN/LOSS GOES TO THE OPERATING SECTION TO REVERSE A
NON-OPERATING PART OF NET INCOME.
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STEPS FOR PREPARING THE SCF
1. Compute changes in each Balance Sheet account
1/1
1. COMPUTE CHANGES IN EACH BALANCE SHEET ACCOUNT 12/31 Chg.
Cash 52 58
Accounts Receivable 93 106
Inventory 151 162
Land 30 30
Buildings and Equipment Building and 790 830
Accumulated Depreciation Equipment, 460 504
net
Accounts Payable 136 141
Interest Payable 10 8
Mortgage Payable 120 109
Contributed Capital 250 250
Retained Earnings 140 174
Paid
Other: Net income = 44, Dividends = 10, Depreciation Expense = 54,
Sold for 5 machinery originally costing 15 with accumulated depreciation of 10 (no gain/loss)
Purchased building and equipment for 55
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STEPS FOR PREPARING THE SCF
2. RECREATE THE PP&E JOURNAL ENTRIES (THREE STEPS):
(THIS IS A WAY TO ANALYZE WHAT WAS RECORDED DURING THE YEAR. IT IS NOT
AN ACTUAL JOURNAL ENTRY).
a. Purchase of PP&E (during the year):
Dr. Buildings and Equipment (A) (Purchases)
Cr. Cash (A)
b. Depreciation for the year:
Dr. Depreciation Expense (RE)
Cr. Accumulated Dep. (XA)
c. Dispositions of PP&E (during the year):
Dr. Cash (A) (proceeds from sale)
Dr. Acc. Dep. (XA) (assets sold)
Dr. Loss on Sale of PP&E (RE) (Proceeds – BV)
Cr. Buildings and Equipment (Historical cost)
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STEPS FOR PREPARING THE SCF
3. FILL IN THE INDIRECT FORMAT WORKSHEET. MAKE SURE YOU HAVE
INCORPORATED THE EFFECTS OF EACH BALANCE SHEET ACCOUNT.
Indirect Format (most common)
Cash From Operations
Net Income
+ Depreciation
- Gain on Sale of PP&E (or other investments)
- Increase in Accounts Receivable
- Increase in Inventories
- Increase in Other Current Assets
+ Increase in Accounts Payable
+ Increase in Other Current Liabilities
+ Increase in Deferred Income Taxes
Net Cash From Operations
Cash From Investing
- Investments in Securities
You only + Proceeds from Sales of Securities
need lines - Investments in Property, Plant and Equipment
for items + Proceeds from Sales of Property, Plant and Equipment
that are in - Investments in Other Noncurrent Assets
the CFS
+ Proceeds from Sales of Other Noncurrent Assets
Net Cash from Investing
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STEPS FOR PREPARING THE SCF
3. FILL IN THE INDIRECT FORMAT WORKSHEET. MAKE SURE YOU HAVE
INCORPORATED THE EFFECTS OF EACH BALANCE SHEET ACCOUNT.
Cash From Financing
+ Issuance of Notes Payable
- Repayments of Notes Payable
+ Issuance of Long-Term Debt
You only
need lines
- Repayments of Long-Term Debt (Mortgage)
for items
that are in
+ Issuance of Common Stock
the CFS - Dividends Paid
- Repurchase of Common Stock
Net Cash from Financing
Net Change in Cash
Year 1 Year 2
Assets:
DIRECT METHOD Cash 22,000 10,000
Accounts receivable (retail) 8,000 8,900
• AMOUNT OF CASH RECEIVED Inventory (retail) 11,000 10,000
FROM CUSTOMERS: Adv. to employees 1,000 1,500
Adv. to landlords 5,000 5,600
Adv. to suppliers (retail) 10,000 10,500
Total assets 57,000 46,500
Liabilities and shareholders’ equity:
Accounts payable (retail) 8,000 7,700
Adv. from customers (retail) 9,000 10,000
• AMOUNT OF CASH PAID TO Rent payable to landlords 6,000 5,300
LANDLORDS: Wages payable to employees 2,000 1,800
Shareholder equity 32,000 21,700
Total liabilities and SE 57,000 46,500
Income statement for Year 2:
Sales revenue 120,000
Cost of Merchandise sold -90,000
Rent Expense -33,000
Wage expense -20,000
Net income -23,000
Year 1 Year 2
Assets:
DIRECT METHOD Cash 22,000 10,000
Accounts receivable (retail) 8,000 8,900
• AMOUNT OF CASH PAID TO Inventory (retail) 11,000 10,000
EMPLOYEES: Adv. to employees 1,000 1,500
Adv. to landlords 5,000 5,600
Adv. to suppliers (retail) 10,000 10,500
Total assets 57,000 46,500
Liabilities and shareholders’ equity:
Accounts payable (retail) 8,000 7,700
Adv. from customers (retail) 9,000 10,000
Rent payable to landlords 6,000 5,300
• AMOUNT OF CASH PAID TO Wages payable to employees 2,000 1,800
SUPPLIERS: Shareholder equity 32,000 21,700
Total liabilities and SE 57,000 46,500
Income statement for Year 2:
Sales revenue 120,000
Cost of Merchandise sold -90,000
Rent Expense -33,000
Wage expense -20,000
Net income -23,000
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DIRECT VS. INDIRECT METHOD
Direct method Indirect method
Cash received from customers +120,100 Net income -23,000
Cash paid to landlords -34.300 ∆A/R (A) -900
Cash paid to employees -20.700 ∆Adv. from customers (L) +1,000
Cash paid to suppliers -89,800 ∆Rent payable (L) -700
Net cash from operations -24,700 ∆Adv. to landlord (A) -600
∆Wage payables (L) -200
∆Adv. to employees (A) -500
It is just a matter ∆A/P (L) -300
∆Adv. to suppliers (A) -500
of presentation! ∆Inventory (A) +1,000
Net cash from operations -24,700
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SUMMARY
§ THE STATEMENT OF CASH FLOWS REPORTS THE EFFECTS ON
CASH OF A FIRM’S OPERATING, INVESTING, AND FINANCING
ACTIVITIES.
§ THE INFORMATION HELPS UNDERSTAND:
• HOW OPERATIONS AFFECT LIQUIDITY,
• THE LEVEL OF CAPITAL EXPENDITURES NEEDED TO
SUPPORT GROWTH, AND
• THE MAJOR CHANGES IN FINANCING
§ THE STATEMENT OF CASH FLOW IS PREPARED FROM THE
INFORMATION IN THE INCOME STATEMENT AND THE
COMPARATIVE BALANCE SHEET.
