Chapter 11

The Statement
of Cash Flows

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Statement of Cash Flows
 Accounts provide information summarized
in balance sheet and income statement.
 Third statement required by GAAP.
 Does not affect the way transactions are
recorded.
 Derived from data reported in other
financial statements.

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 Balance sheet
 Status of firm’s funds at a point in time.
 Liabilities and owners’ equity side shows
sources of funds.
 Assets side shows uses of funds.

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 Flow Statements
 Explains changes between dates of two
balance sheet snapshots.
 2 types of flow statements:
 Income statement (and related statement of
retained earnings).
 Reconciles change in RE.
 Statement of Cash Flows.
 Reconciles changes in cash.

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 Income Statement
 Net income - dividends = Revenues - expenses
- dividends = Change in RE
 Key concepts:
 Revenue recognition (1) earned and (2) realized or
realizable
 Matching of expenses to revenues.
 Expenses measure resources consumed in generating the
period’s revenues.
 Does not necessarily bear a direct relationship to
cash flows associated with the period’s operations.
 Does not provide info about investing and financing
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 Statement of cash flows
 Provides info about cash flows associated
with the period’s operations and investing
and financing activities.
 Numbers on cash flow statement are
objective: cash is cash.
 Eliminates judgments and estimates
involved with accrual accounting as on
income statement and balance sheet.

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 Objective of Financial
Statements
• (Stock market) Value = PV of future cash
flows.
• Investors use Financial Statements to help
estimate future cash flows.
• Many believe:
– BS and IS provide better info to estimate
future cash flows than Stmt of Cash Flows.
– But cash flow statement is a useful
supplement.

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 Statement of Cash Flows:
2 Categories of Activities
 Sources = activities that generate cash.
 Uses = activities that involve spending
cash

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 Sources
 Operations.
 New borrowings.
 New stock issues.
 Sale of property, plant, and equipment.
 Sale of other non-current assets.

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 Uses
 Cash dividends.
 Repayment of borrowings.
 Repurchase of stock.
 Purchase of property, plant, and
equipment.
 Purchase of non-current assets.

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 Definition of Cash
 Cash and cash equivalents.
 Highly liquid investments that are or can
be converted to cash in no more than 90
days.

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 Statement of Cash Flows:
Categories Required by GAAP
1. Operating activities
2. Investing activities.
3. Financing activities.

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 Operating Activities
 All transactions that are not investing or
financing activity.
 Cash inflows and outflows associated with
operating activities.
 Inflows: Sales revenues
 Outflows: Operating expenses.
 Payments to suppliers, employees, taxes, and
interest on loans

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 Investing Activities:
Acquiring
 Long lived assets such as property plant
and equipment.
 Investments in securities other than cash
equivalents.
 Lending money.

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 Investing Activities:
Disinvesting
 Disposing of:
 Long lived assets such as property plant and
equipment.
 Investments in securities other than cash
equivalents.
 Collecting loans.

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 Financing Activities
 Borrowing and repaying of loans.
 Issuance of equity securities.
 Payment of dividends.
 Use of cash to retire stock.

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 Non-cash transactions
 Not reported in body of statement of cash
flows but in supplemental disclosure.
– Example:
• Conversion of bonds into common stock, acquiring
fixed assets by issuing notes payable.

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 Cash Flows from Operating
Activities

 Approaches to presentation
 Direct method.
 Indirect method.

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 Direct method of presenting cash
flows from operating activities

 Inflows (i.e. cash collections from

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 Collections from Customers
• Sales – Increase in accounts receivable

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 Payments to Suppliers
• Cost of goods sold + increase inventories
– increase in accounts payable.

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 Cash paid for Expense Items
• Cash paid for payroll = Salaries and
wages expense – increase in salaries and
wages payable.
• Cash paid for taxes = Taxes expense –
increase in taxes payable – increase in
Deferred tax credit.

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 Indirect method of presenting
CF from operating activities
 Start with net income.
 Adjust for non-cash items included in net
income (i.e. accrual based earnings):
 Add back deprecation & amortization.
 Differences between sales & cash collections.
 Change in accounts receivable.
 Differences between expenses & cash payments.
 Changes in accounts payable, inventory, prepaid
expenses.

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 Gains and Losses
• Cash proceeds from sale of PPE is cash
inflow.
• Gain (loss) is not a cash flow.
– Must be subtracted (added) in Operating
Activities section.

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 Operating Activities:
Summary
• Same net cash generated from operating
activities under direct or indirect method.
• In indirect method, adjustments reconcile
net income to net operating cash flows.

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 Supplemental Disclosure
• If direct method is used, GAAP requires
supplemental disclosure of reconciliation
between net income and operating cash
flows.
• In effect, if direct method is used, indirect
method is also required.

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 Summary of Cash Flow
Statement
1. Adjust net income to CF from operating
activities (as discussed earlier).
2. Identify investing activities. (Don’t include
portions of acquisitions financed by a liability.)
3. Identify financing activities. (Don’t include
conversion of convertible securities.)
4. Sum three sections, add to beginning cash
balance to determine ending balance.

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 Analysis of Cash Flow
Statement
• Chapter 8: times interest earned and fixed
charges coverage.
• Sources and uses calculated as a percent
of total sources.
• Cash realization ratio = (cash generated
by operations)/(Net income)
• Ratio of cash generated by operations to
total debt.

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 “Free” Cash Flow
• Cash from operations less:
– Fixed asset replacement necessary to
maintain existing capacity.
– Scheduled debt repayments.
– Normal dividend payments.

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 Cash Projections
• Projected cash flow statement useful to
ensure cash is available for debt
repayment and investment needs.
• Cash budget to plan shorter term
(seasonal) financing needs.

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