7
CHAPTER
Cash Flow Analysis
Statement of Cash Flows
Relevance of Cash Flows
Cash Defined -- refers to cash and cash
equivalents,
Cash equivalents are short-term,highly liquid
investments that are (1) readily convertible to
known amounts of cash,and (2) near maturity
(typically within 3 months) with limited risk of price
changes due to interest rate shifts,
Statement of Cash Flows
Relevance of Cash Flows
Cash is the beginning and the end of a company’s operating cycle,
Net cash flow is the end measure of
profitability,
Cash repays loans,replaces equipment,
expands facilities,and pays dividends,
Analyzing cash inflows and outflows helps assess liquidity,
solvency,and financial flexibility,
Liquidity is the nearness to cash of assets and liabilities,
Solvency is the ability to pay liabilities when they mature,
Financial flexibility is the ability to react to opportunities and
adversities,
Statement of Cash Flows
Relevance of Cash Flows
Statement of cash flows (SCF) helps address questions such
as,
? How much cash is generated from or used in operations?
? What expenditures are made with cash from operations?
? How are dividends paid when confronting an operating loss?
? What is the source of cash for debt payments?
? What is the source of cash for redeeming preferred stock?
? How is the increase in investments financed?
? What is the source of cash for new plant assets?
? Why is cash lower when income increased?
? What is the use of cash from new financing?
Statement of Cash Flows
Cash Flow Relations
Illustration,Consider two consecutive years’ balance sheets divided into
(1) cash,and (2) all other balance sheet accounts,
Accounts Year 1 Year 2
Cash and cash equivalents $3,000 $5,000
Noncash accounts,
Noncash current assets $(9,000) $(11,000)
Noncurrent assets (6,000) (8,000)
Current liabilities 8,000 10,000
Long-term liabilities 3,000 5,000
Equity accounts 7,000 9,000
Net noncash balance $3,000 $5,000
Note,
Change in cash from Year 1 to Year 2 (increase of $2,000) = Change in noncash
balance sheet accounts ($2,000 increase) from Year 1 to Year 2
Interrelations between cash and noncash balance sheet
accounts can be generalized,
? Net changes in cash are explained by net changes in
noncash balance sheet accounts,
? Changes within or among noncash balance sheet
accounts do not affect cash,Yet,there is disclosure of all
significant financing and investing activities in a separate
schedule of noncash investing and financing activities,
? Changes within the components of cash
are not reported,
Statement of Cash Flows
Cash Flow Relations
Statement of Cash Flows
Reporting by Activities
Statement of cash flows reports receipts and payments by
operating,financing,and investing activities
Operating activities are the earning-related activities of
a company,
Investing activities are means of acquiring and
disposing of noncash assets,
Financing activities are means of contributing,
withdrawing,and servicing funds to support business
activities,
Statement of Cash Flows
Reporting by Activities
Transaction or Event Effect on Account Activity
Sales for cash Credit (increase) retained earnings via income Operating
Accounts receivable collection Credit (decrease) receivable Operating
Insurance paid in cash Debit (decrease) retained earnings via income Operating
Interest payment Debit (decrease) retained earnings via income Operating
Accounts payable paid Debit (decrease) payable Operating
Collection of noncurrent
operating receivable Credit (decrease) receivable Operating
Payment for plant assets Debit (increase) plant assets Investing
Sale of investment Credit (decrease) investments Investing
Repayment of loans Debit (decrease) loans Financing
Payment of dividends Debit (decrease) retained earnings Financing
Illustration,
Toronto Technology Corporation
Condensed Balance Sheets
December 31 Changes during Year 2*
Operating Investing Financing Noncash
(in thousands) Year 1 Year 2 Activity Activity Activity Transactions
[1]–Cash $ 120 $ 100
[2]–Accounts receivable 200 145 $ 55
[3]–Inventories 150 175 (25)
[4]–Fixed assets 660 874 $ (214)
[5]–Accumulated depreciation (200) (244) 64 (20)
[6]–Intangible assets 150 100 50
Total assets $ 1,080 $1,150
[7]–Accounts payable $ 150 $ 130 (20)
[8]–Long-term debt 420 400 $ (10) $ (10)
[9]–Capital stock accounts 250 300 40 10
[10]–Retained earnings 260 320 180 (120)
Total liabilities and equity $ 1,080 $1,150
Totals $ 304 $ (234) $ (90) $ 0
Statement of Cash Flows
Constructing the Statement
Illustration Continued,Some observations
1,The $20 cash decrease is the focus of explanation for the statement of cash flows—it is explained
by changes in noncash balance sheet accounts,
2,The $55 decrease in accounts receivable is a positive (cash inflow) adjustment to income in
arriving at cash flow from operations it implies cash collections exceed accrual sales,
3,The $25 increase in inventories is a negative (cash outflow) adjustment to income because cash
outlays for inventory exceed purchases in cost of sales,
4,To summarize changes in fixed assets a T-account is used,
Fixed Assets
Beginning 660 Acquisitions 314 100 Disposals
Ending 874
Both acquisitions and disposals are part of investing activities,While each transaction is reported
separately in the statement of cash flows,the balance sheet shows the net of $214 ($314 – $100),
5,Changes in accumulated depreciation are summarized in a T-account,
Accumulated Depreciation
Accumulated 200 Beginning
depreciation on assets disposed 20 64 Depreciation
244 Ending
Depreciation ($64) is a noncash expense—a debit to income (retained earnings) and a credit to
accumulated depreciation,It is added back to income in arriving at cash from operations,The $20
in accumulated depreciation relates to the $100 (original cost) of fixed assets sold at book value
($100 – $20 = $80),The $20 of accumulated depreciation adjusts the $100 amount included in
investing activities,
Statement of Cash Flows
Constructing the Statement
Illustration Continued,Some observations
6,The $50 decline in intangible assets reflects amortization,Amortization is a noncash expense
similar to depreciation and is added back to income,
7,The $20 decrease in accounts payable is a negative (cash outflow) adjustment to income because
amounts due suppliers declined,
8,The $20 decrease in long-term debt reflects a $10 repayment (a financing outflow) and a $10
reduction due to conversion of debt into equity (a noncash transaction),
9,The $50 increase in capital stock reflects a $40 issuance of stock (a financing inflow) and a $10
stock issuance by converting debt (a noncash transaction),
10,The $60 increase in retained earnings is summarized in T-account form,
Retained Earnings
260 Beginning Dividends paid 120 180 Net income
320 Ending
The $180 net income,after adjustments,yields the source of cash from operations of $304,The
$120 dividend is a financing cash outflow,
Statement of Cash Flows
Constructing the Statement
Illustration Continued,Drawing on the analysis,change in cash is explained as,
Toronto Technology Corporation
Statement of Cash Flows ($ thousands)
For the Year Ended December 31,Year 2
Cash flows from operating activities,
Net income $ 180
Add (deduct) adjustments to cash basis,
Depreciation 64
Amortization of intangibles 50
Decrease in accounts receivables 55
Increase in inventory (25)
Decrease in accounts payable (20)
Net cash flows from operating activities $ 304
Cash flows from investing activities,
Purchase of fixed assets (314)
Sale of fixed assets 80
Net cash flows used in investing activities (234)
Cash flows from financing activities,
Sale of capital stock 40
Payment of dividends (120)
Repayment of long-term debt (10)
Net cash flows used in financing activities (90)
Net increase (decrease) in cash $ (20)
Schedule of noncash financing and investing activities:*
Common stock issued in conversion of long-term debt $ 10
*Can be presented in a footnote,Any amounts paid for interest and income taxes must also be disclosed,
Statement of Cash Flows
Constructing the Statement
Reconstruction aims to provide an extensive analysis of
complex transactions,
T-account analysis is a common tool of reconstruction
analysis of transactions,
Aim of T-account analysis is to reconstruct in summary
form the transactions affecting all balance sheet
accounts during the reporting period,
Reconstruction Analysis
Objectives
Income Effect on
Statement Item Double-Entry Effects Cash from Operations
Debit expense or loss Cr,to cash Use of cash
Cr,to noncash account Add back—not using cash
Credit income or gain Dr,to cash Source of cash
Dr,to noncash account Deduct—not providing cash
Reconstruction Analysis
Determining Cash Flows - Important Relations
[Changes in operating working capital accounts]
Account Change Effect on Cash from Operations
Accounts Receivable Increase (Dr.) Sales not collected in cash,
Decrease (Cr.) Collections exceed sales (prior period
receivables collected),
Inventories Increase (Dr.) Cash purchases exceed cost of sales,
Decrease (Cr.) Some cost of goods sold represents a reduction
in inventories (cash purchases are less than cost
of goods sold),
Prepaid Expenses Increase (Dr.) Cash paid for expenses that are charged to
future periods (cash spent exceeds expenses
in income statement),
Decrease (Cr.) Some expenses in the income statement
were paid for in prior years and do not require
a current cash outlay,
Trade Accounts or Increase (Cr.) Some purchases are not yet paid for,
Notes Payable Decrease (Dr.) Cash payments to suppliers exceed purchases
for the period,
Reconstruction Analysis
Determining Cash Flows - Important Relations
Vatter Corporation
Comparative Balance Sheet As of December 31,Year 2
Increase
($ thousands) Year 1 Year 2 (decrease)
Assets
Current assets,
Cash $ 240 $ 120 $ (120)
Receivables 360 450 90
Inventories 750 1,053 303
Total current assets $ 1,350 $ 1,623 $ 273
Fixed assets 4,500 6,438 1,938
Accumulated depreciation (1,500) (1,740) (240)
Investment in affiliate 1,000 1,05 50
Goodwill 950 980 30
Total assets $ 6,300 $ 8,351 $ 2,051
Liabilities and Equity
Accounts payable $ 360 $ 590 $ 230
Bonds payable 300 700 400
Deferred income taxes 240 260 20
Capital stock 2,400 3,200 800
Additional paid-in capital 900 1,300 400
Retained earnings 2,100 2,301 201
Total liabilities and equity $ 6,300 $ 8,351 $ 2,051
Reconstruction Analysis
Illustration
Vatter Corporation
Income Statement ($ thousands)
Year Ended December 31,Year 2
Sales $19,950
Cost of goods sold (includes $360 of depreciation) 11,101
Gross profit $ 8,849
General,selling,and administrative expenses $ 7,000
Amortization of goodwill 30 7,030
$ 1,819
Equity in earnings of unconsolidated affiliate* 50
Gain on sale of fixed assets 2
Income before taxes $ 1,871
Income taxes,
Current 900
Deferred 20 920
Net income $ 951
*No dividends received,
Reconstruction Analysis
Illustration
Additional Information
1,On March 1,the company purchases for $510,000 cash a business with (a) fixed
assets valued at $450,000,(b) current assets (no cash) equal to current liabilities,
and (c) the excess of $60,000 over net assets treated as goodwill,
2,Machinery is sold for $18,000,It originally cost $36,000,and $20,000 depreciation is
accumulated to date of sale,
3,In April,the company acquires $100,000 in fixed assets by issuing bonds for
$100,000 par value,
4,In June,the company receives $1,000,000 cash for issuance of capital stock with a
par value of $600,000; convertible bonds of $200,000 are converted to capital stock
with a par value $200,000; and long-term bonds are sold for $500,000 (at par),
5,Fully depreciated assets of $100,000 are written off,
6,Dividends paid amount to $750,000,
7,General,selling,and administrative expenses include $50,000 of interest paid,
8,There are no liabilities for income taxes at the beginning or end of Year 2,
Reconstruction Analysis
Illustration
1,Set up a T-account for each noncash account in the balance sheet,and
post the opening and closing balances in each T-account,
2,Set up a Cash T-account,separated into four sections,operating,
investing,financing,and noncash transactions,
3,Balances in T-accounts are reconstructed using information drawn from
changes in noncash accounts by,
a,Debiting or crediting items of income or loss,or converting items to a
cash basis for the operating section,
b,Debiting or crediting nonoperating items to one or more of the other
three sections,
4,Prepare the statement of cash flows using details in the completed Cash
T-account,
5,Evaluate the company’s cash flows using the reconstructed statement
while drawing on the insights from the reconstruction process,
Reconstruction Analysis
Illustration - Steps in construction
Two methods to reconstruct transactions for T-
Account analysis,
? Analytical entries
? Intuitive reconstruct
Reconstruction of Transactions - Analytical Entries
Reconstruction Analysis
Accounts Receivable,
(a) Accounts Receivable 90,000
Cash—Operations 90,000
Inventories,
(b) Inventories 303,000
Cash—Operations 303,000
Investment in Affiliate,
(c) Investment in Affiliate 50,000
Cash—Operations 50,000
Fixed Assets,
(d) Fixed Assets 450,000
Goodwill 60,000
Cash—Investing 510,000
(e) Cash—Investing 18,000
Accumulated Depreciation 20,000
Fixed Assets 36,000
Cash—Operations (gain on sale) 2,000
(f) Fixed Assets 100,000
Noncash Transactions 100,000
(g) Noncash Transactions 100,000
Bonds Payable 100,000
(h) Accumulated Depreciation 100,000
Fixed Assets 100,000
(i) Fixed Assets 1,524,000
Cash—Investing 1,524,000
Reconstruction Analysis
Reconstruction of Transactions - Analytical Entries
Accumulated Depreciation,
(j) Cash—Operations 360,000
Accumulated Depreciation 360,000
Goodwill Amortization,
(k) Cash—Operations 30,000
Goodwill 30,000
Accounts Payable,
(l) Cash—Operations 230,000
Accounts Payable 230,000
Bonds Payable,
(m) Cash—Financing 500,000
Bonds Payable 500,000
(n) Bonds Payable 200,000
Noncash Transaction 200,000
(o) Noncash Transaction 200,000
Capital Stock 200,000
Deferred Income Taxes,
(p) Cash—Operations 20,000
Deferred Income Taxes 20,000
Capital Stock and Paid-In Capital,
(q) Cash—Financing 1,000,000
Capital Stock 600,000
Paid-In Capital 400,000
Retained Earnings,
(r) Cash—Operations 951,000
Retained Earnings 951,000
(s) Retained Earnings 750,000
Cash—Financing 750,000
Reconstruction of Transactions - Analytical Entries
Reconstruction Analysis
Cash
Beginning 240
Operations
Depreciation expense (g) 360 2 (b) Gain on sale of fixed assets
Deferred income taxes (k) 20 50 (p) Equity in earnings of
Net income (m) 951 affiliate
Goodwill amortization (o) 30 90 (q) Increase in receivables
Increase in accounts (s) 230 303 (r) Increase in inventories
payable
Investing
Sale of fixed assets (b) 18 450 (a) Acquisition of fixed assets
60 (a) Acquisition of goodwill
1,524 (f) Acquisition of fixed assets
Financing
Bonds sold (h) 500 750 (n) Dividends paid
Sale of stock (l) 1,000
Noncash Transactions
Bonds issued to (d) 100 100 (c) Fixed assets acquired with bonds
acquire fixed assets
Stock issued in (j) 200 200 (i) Bond conversion to stock
conversion
Ending 120
Reconstruction of Transactions - T-Account Analysis
Reconstruction Analysis
Receivables Inventories Accounts Payable
Beg,360 Beg,750 360 Beg,
(a) 90 (b) 303 230 (l)
End,450 End,1,053 590 End,
Fixed Assets Accumulated Depreciation Investment in Affiliate
Beg,4,500 1,500 Beg,Beg,1,000
(d) 450 36 (e) (e) 20 360 (j) (c) 50
(f) 100 100 (h) (h) 100
if) 1,524
End,6,438 1,740 End,End,1,050
Goodwill Bonds Payable Deferred Income Taxes
Beg,950 300 Beg,240 Beg,
(d) 60 30 (k) (n) 200 100 (g) 20 (p)
500 (m)
End,980 700 End,260 End,
Capital Stock Paid-In Capital Retained Earnings
2,400 Beg,900 Beg,2,100 Beg,
200 (o) 400 (q) (s) 750 951 (r)
600 (q)
3,200 End,1,300 End,2,301 End,
Reconstruction of Transactions - T-Account Analysis
Reconstruction Analysis
Vatter Corporation
Statement of Cash Flows ($ thousands) For Year Ended December 31,Year 2
Cash flows from operating activities,
Net income $951
Add (deduct) adjustments to cash basis,
Depreciation 360
Amortization of goodwill 30
Deferred income taxes 20
Gain on sale of equipment (2)
Equity in earnings of affiliate (50)
Increase in receivables (90)
Increase in inventories (303)
Increase in accounts payable 230
Net cash flows from operating activities $1,146
Cash flows from investing activities,
Purchase of fixed assets (1,974)
Purchase of goodwill (60)
Sale of fixed assets 18
Net cash flows used in investing activities (2,016)
Cash flows from financing activities,
Net proceeds from sale of bonds 500
Sale of capital stock 1,000
Payment of dividends (750)
Net cash flows from financing activities 750
Net decrease in cash $(120)
Supplemental disclosure of cash flow information,
Interest paid during year $ 50
Income taxes paid during year 900
Schedule of noncash investing and financing activities,
Bonds issued to acquire fixed assets 100
Stock issued in conversion of bonds 200
Statement Deviation
Reconstruction Analysis
Two acceptable methods for reporting cash from
operations (CFO)
? Indirect method
? Direct methods
Both methods yield identical results—
only the presentation format differs
Cash From Operations
Reporting Formats for CFO
Cash From Operations
Reporting Formats for CFO
C o m p a n i e s R e p o r ti n g C a s h F l o w s u s i n g I n d i r e c t o r
D i r e c t F o r m a ts
I n d i r e ct M e t h o d
97%
D i r e ct M e t h o d
3%
Net income is adjusted for
noncash items requiring
conversion to cash flows
from operations—see prior
Vatter Corp,slide
Cash From Operations
Indirect Method for CFO
Deriving Operating Cash Flows from Income for VatterCorp,
Amount
Item (in thousands) Explanation
Net income,accrual basis $ 951 Starting point of conversion
Add (deduct) adjustment to cash basis,
Depreciation 360 Depreciation has no cash outflow,
Goodwill amortization 30 Amortization has no cash outflow,
Deferred income taxes 20 Deferred expense has no cash outflow,
Equity in earnings of affiliate (50) Item does not yield cash inflow,
Gain on sale of equipment (2) Remove gain (because it is onoperating)—cash
inflow is cash from investing activities,
Increase in receivables (90) Cash flow from sales is less than accrual sales,
Increase in inventories (303) Cash outflow for inventory exceeds accrual
inventory cost included in cost of sales,
Increase in accounts payable 230 Cash outflows for purchases (included in cost of
goods sold) is less than accrual purchases cost,
Cash flows from operations (Exhibit 7.6) $1,146
Cash From Operations
Indirect Method for CFO
Direct method also called Inflow-Outflow method
Reports gross cash receipts and gross cash
disbursements related to operations—essentially
adjusting each income statement item from accrual to
cash basis,
Preferred method by the majority of financial statement
users (not preparers),
Better format to assess the amount of
cash inflows and cash outflows,
Cash From Operations
Direct Method for CFO
Converting Vatter’s Operating Cash Flows from Indirect to Direct Format
Indirect Format Direct Format
Net income $ 951 Total revenues ($19,950 + $50 + $2) $20,002
Add,Depreciation 360 Remove gain on sale (2)
Amortization 30 Less equity in earnings of affiliate (50)
Deferred taxes 20 Less increase in receivables (90)
Remove,Gain on sale of equipment (2) Less—Cash receipts $19,860
Deduct equity in earnings of affiliates (50) Total expenses ($11,101 + $7,030 + $920) $19,051
Add (deduct) changes in,Less,Depreciation (360)
Receivables (90) Less—Amortization (30)
Inventories (303) Less—Deferred taxes (20)
Payables 230 Add increase in inventories 303
Less increase in payables (230)
Less—Cash payments $18,714
Cash flows from operations $1,146 Cash flows from operations $ 1,146
Cash From Operations
Converting Indirect to Direct
See Form A in Appendix
7A to aid in conversion
Cash From Operations
Converting Indirect to Direct
Vatter Corporation
Cash Flows from Operations ($ thousands)
For Year Ended December 31,Year 2
Cash flows from operating activities,
Cash receipts from customers [a] $19,860
Cash paid for inventories [b] (10,814)
Cash paid general,selling,and administrative expenses [c] (7,000)
Cash paid for income taxes—current [d] (900)
Net cash flows from operations $1,146
Computations,
[a] Sales of $19,950 less increase in accounts receivables of $90,
[b] Cost of goods sold of $11,101 plus increase in inventories of $303 less increase in
accounts payable of $230—also less (noncash) depreciation of $360 that is included in
cost of goods sold for Vatter,
[c] General,selling,and administrative expenses of $7,030 less (noncash) amortization of
$30,
[d] Income taxes—current of $920 less increase in deferred income taxes of $20,
Cash From Operations
Converting Indirect to Direct
To compute cash receipts,
Cash receipt = Revenue account + Decrease in its Receivable (or –
Increase in its Receivable)
To compute cash payments,
Cash payment = Expense account + Decrease in its Payable (or –
Increase in its Payable)*
*To compute cash paid for inventories we
must include,+ Increase in Inventory
(or – Decrease in Inventory),
Cash From Operations
Adjustments for Direct Method
? Direct method is not required and is rarely reported,
? No separate disclosure of cash flows pertaining to either extraordinary items or
discontinued operations,
? Interest and dividends received,and interest paid,are classified as operating
cash flows,Many users consider interest paid a financing outflow,and interest
and dividends received as cash inflows from investing activities,
? Income taxes are classified as operating cash flows,This classification can
distort our analysis of the three individual activities if significant tax benefits or
costs are attributed to them in a disproportionate manner,
? Removal of pre-tax (rather than after-tax) gains or losses on sale of
plant or investments from operating activities distorts our analysis
of both operating and investing activities,This is because their
related taxes are not removed,but left in total tax expense among
operating activities,
Cash From Operations
Reporting Limitations
Vatter Corporation
Comparison of Accrual and Cash Reporting
Income Operating
Statement Cash Flows
Sales $19,950 $19,860* Collections from customers
Equity in earnings of unconsolidated subsidiary 50 —
Gain on sale of fixed assets 2 —?
$20,002 $19,860 Total collections
Cost of goods sold? 10,741 10,814§ Payments to suppliers and labor
Depreciation 360 —
General,selling,and administrative expenses 7,000 7,000 Payments for expenses
Amortization of goodwill 30 —
Income taxes,Current 900 900 Payments for taxes
Deferred 20 —
$19,051 $18,714 Total disbursements
Net income $ 951 Cash from operations $ 1,146
*$19,950 (sales) – $90 (increase in receivables),?Omitted because it is linked with proceeds from sales of assets under investing activities,
?Exclusive of depreciation,§$10,741 (cost of goods sold) + $303 (increase in inventories) – $230 (increase in payables),Note that
the linkage of accounts payable to cost of goods sold is arbitrary because some may relate to other expense categories,However,no further breakdown is possible,
Cash From Operations
Interpreting Accrual Income and Operating Cash Flow
Net income plus major noncash expenses
(typically depreciation and amortization)
Cash From Operations
Alternative Cash Flow Measure
Assume two companies (A and B) each invest $50,000 in machinery yielding
$45,000 per year cash flows before depreciation,Assuming a five-year
useful life and no salvage value for the machinery,results for the entire five-
year period are,
Five-Year Period
Cash provided by operations ($45,000 x 5 years) $225,000
Cost of the machine $ (50,000)
Income from operating machine $175,000
Average yearly net income $ 35,000
Cash From Operations
Alternative Cash Flow Measure - Illustration
Company A,Company B,
Straight-Line Sum-of-the-Years’-
Depreciation Digits Depreciation
Income
before
Year Depreciation Depreciation Net Income Depreciation Net Income
1 $ 45,000 $10,000 $ 35,000 $16,667 $ 28,333
2 45,000 10,000 35,000 13,334 31,666
3 45,000 10,000 35,000 10,000 35,000 4 45,000 10,000 35,000 6,667 38,333
5 45,000 10,000 35,000 3,332 41,668
Total $225,000 $50,000 $175,000 $50,000 $175,000
Income before depreciation for these two companies is identical--this faithfully reveals identical
earning power,
Income after depreciation is considerably different across the years—this does not reflect
changes in earning power,
Cash From Operations
Alternative Cash Flow Measure - Illustration
While both successful and unsuccessful companies can
experience problems with cash flows from operations,
the reasons are markedly different,
We must interpret changes in operating working capital
items in light of economic circumstances,
Inflationary conditions add to the
financial burdens of companies
and challenges for analysis,
Cash From Operations
Business Conditions and Cash Flows
Cash flows from operations
Deduct,Net capital expenditures required to
maintain productive capacity
Dividends on preferred stock and common
stock (assuming a payout policy)
Equals Free cash flow (FCF)
Cash From Operations
Free Cash Flow
Positive free cash flow reflects the amount available for
business activities after allowances for financing and
investing requirements to maintain productive capacity at
current levels,
Growth and financial flexibility depend on adequate free cash
flow,
Recognize that the amount of capital expenditures
needed to maintain productive capacity is generally
not disclosed—instead,most use total capital
expenditures,which is disclosed,but can include
outlays for expansion of productive capacity,
Cash From Operations
Free Cash Flow
The statement of cash flows is
useful in identifying misleading
or erroneous operating results
or expectations,
Cash From Operations
Cash Flow as Validators
Form A
Worksheet to Compute Cash Flow from Operations (CFO)
Direct Presentation
For:_______________________
Year Ended ______________
(in thousands)
Year
Cash receipts from operations,
Net sales or revenues(a) *1 $ $ $
Other revenue and income
(see also lines 22 and 25) *2
(I) D in current receivables 3
(I) D in noncurrent receivables(b) 4
Other adjustments(c) 5
Total Cash receipts 6
Cash disbursements for operations,
Total expenses (include interest and taxes)(a) *7
Less expenses and losses not using cash,
– Depreciation and amortization 8
– Noncurrent deferred income taxes 9
– Other ________ 10
– Other ________ 11
– Other ________ 12
Changes in current operating assets and liabilities,
I (D) in inventories 13
I (D) in prepaid expenses 14
(I) D in accounts payable 15
(I) D in taxes payable 16
(I) D in accruals 17
I or D other ________ 18
I or D other ________ 19
I or D in noncurrent accounts(b) 20
Total Cash disbursements(d) 21
Cash Flow Analysis
Converting CFO to Direct Format
Form A (Continued)
Worksheet to Compute Cash Flow from Operations (CFO)
Direct Presentation
For:_______________________
Year Ended ______________
(in thousands)
Year
Dividends received,
Equity in income of unconsolidated affiliates *22
Less undistributed equity in income of affiliates 23
Dividends from unconsolidated affiliates 24
Other cash receipts (disbursements)(e) *25
Describe _____________________(a) 25
Describe _____________________(b) 25
Total Cash flow from operations(f) 26
Footnote all amounts that are composites or that are not self-evident,Indicate all sources for figures,I(D) refers to
increases (decreases) in accounts,
*The sum of these five lines must equal reported net income per income statement,
(a)Including adjustment (grossing up) of revenue and expense of discontinued operations disclosed in footnote(s),
Describe computation,Include other required adjustments and explain,
(b)Those relating to operations—describe in notes,
(c)Such as removal of gains included above—describe in notes,
(d)Which include (from supplemental disclosures),
Cash paid for interest (net of amount capitalized) $______ ______ ______
Cash paid for income taxes $______ ______ ______
(e)These include extraordinary items,discontinued operations and any other item not included above,The amount in line
25 is after adjustment to cash basis while the * refers to item(s) included in income before such adjustment,(Present
details in notes.)
(f)Reconcile to amount reported by company,If not reported,reconcile to change in cash for period along with investing
and financing activities,
Converting CFO to Direct Format
Cash Flow Analysis
Form B
Analytical Statement of Cash Flows*
For:_______________________
Year Ended ______________
(in thousands)
Year
Cash flows from operations,
Income before extraordinary items 1 $ $ $
Add (deduct) adjustments to cash basis,
Depreciation and amortization 2
Deferred income taxes 3
Equity in income of investees 4
Other (a) 5
Other (a) 6
(I) D in receivables 7
(I) D in inventories 8
(I) D in prepaid expenses 9
I (D) in accounts payable 10
I (D) in accruals 11
I (D) in taxes payable 12
I or D in other current operating accounts(a) 13
I or D in noncurrent operating accounts(a) 14
Extraordinary items net of noncash items(b) 15
Discontinued operations net of noncash items(b) 16
Cash from operations(c) 17
Cash flows from investing activities,
Additions to properties 18
Additions to investments (advances) 19
Additions to other assets 20
Converting SCF to Analytical Format
Cash Flow Analysis
Form B (Continued)
Analytical Statement of Cash Flows*
For:_______________________
Year Ended ______________
(in thousands)
Year
Cost of acquisition—net of cash 21
Disposals of properties 22
Decreases in other assets(a) 23
Other(a) 24
Cash from (used in) investing 25
Cash flows from financing activities,
Net I (D) in short-term debt 26
I (D) in long-term debt 27
I (D) of common and preferred stock(a) 28
Dividends paid 29
Other(a) 30
Cash from (used in) financing 31
Effect of exchange rate changes on cash,32
Net increase (decrease) in cash and equivalents 33
Schedule of noncash activities(a),
Other (a) 34
Other (a) 35
Other (a) 36
*Use all figures from company’s statement of cash flows,I (D) refers to increases (decreases) in accounts,
(a)Provide full details in statement or in separate notes,
(b)This information is not required to be disclosed,Provide details if this information is disclosed or can otherwise be
obtained or reconstructed,
(c)To convert to the direct format use Form A in Exhibit 7A.1,
Converting SCF to Analytical Format
Cash Flow Analysis
CHAPTER
Cash Flow Analysis
Statement of Cash Flows
Relevance of Cash Flows
Cash Defined -- refers to cash and cash
equivalents,
Cash equivalents are short-term,highly liquid
investments that are (1) readily convertible to
known amounts of cash,and (2) near maturity
(typically within 3 months) with limited risk of price
changes due to interest rate shifts,
Statement of Cash Flows
Relevance of Cash Flows
Cash is the beginning and the end of a company’s operating cycle,
Net cash flow is the end measure of
profitability,
Cash repays loans,replaces equipment,
expands facilities,and pays dividends,
Analyzing cash inflows and outflows helps assess liquidity,
solvency,and financial flexibility,
Liquidity is the nearness to cash of assets and liabilities,
Solvency is the ability to pay liabilities when they mature,
Financial flexibility is the ability to react to opportunities and
adversities,
Statement of Cash Flows
Relevance of Cash Flows
Statement of cash flows (SCF) helps address questions such
as,
? How much cash is generated from or used in operations?
? What expenditures are made with cash from operations?
? How are dividends paid when confronting an operating loss?
? What is the source of cash for debt payments?
? What is the source of cash for redeeming preferred stock?
? How is the increase in investments financed?
? What is the source of cash for new plant assets?
? Why is cash lower when income increased?
? What is the use of cash from new financing?
Statement of Cash Flows
Cash Flow Relations
Illustration,Consider two consecutive years’ balance sheets divided into
(1) cash,and (2) all other balance sheet accounts,
Accounts Year 1 Year 2
Cash and cash equivalents $3,000 $5,000
Noncash accounts,
Noncash current assets $(9,000) $(11,000)
Noncurrent assets (6,000) (8,000)
Current liabilities 8,000 10,000
Long-term liabilities 3,000 5,000
Equity accounts 7,000 9,000
Net noncash balance $3,000 $5,000
Note,
Change in cash from Year 1 to Year 2 (increase of $2,000) = Change in noncash
balance sheet accounts ($2,000 increase) from Year 1 to Year 2
Interrelations between cash and noncash balance sheet
accounts can be generalized,
? Net changes in cash are explained by net changes in
noncash balance sheet accounts,
? Changes within or among noncash balance sheet
accounts do not affect cash,Yet,there is disclosure of all
significant financing and investing activities in a separate
schedule of noncash investing and financing activities,
? Changes within the components of cash
are not reported,
Statement of Cash Flows
Cash Flow Relations
Statement of Cash Flows
Reporting by Activities
Statement of cash flows reports receipts and payments by
operating,financing,and investing activities
Operating activities are the earning-related activities of
a company,
Investing activities are means of acquiring and
disposing of noncash assets,
Financing activities are means of contributing,
withdrawing,and servicing funds to support business
activities,
Statement of Cash Flows
Reporting by Activities
Transaction or Event Effect on Account Activity
Sales for cash Credit (increase) retained earnings via income Operating
Accounts receivable collection Credit (decrease) receivable Operating
Insurance paid in cash Debit (decrease) retained earnings via income Operating
Interest payment Debit (decrease) retained earnings via income Operating
Accounts payable paid Debit (decrease) payable Operating
Collection of noncurrent
operating receivable Credit (decrease) receivable Operating
Payment for plant assets Debit (increase) plant assets Investing
Sale of investment Credit (decrease) investments Investing
Repayment of loans Debit (decrease) loans Financing
Payment of dividends Debit (decrease) retained earnings Financing
Illustration,
Toronto Technology Corporation
Condensed Balance Sheets
December 31 Changes during Year 2*
Operating Investing Financing Noncash
(in thousands) Year 1 Year 2 Activity Activity Activity Transactions
[1]–Cash $ 120 $ 100
[2]–Accounts receivable 200 145 $ 55
[3]–Inventories 150 175 (25)
[4]–Fixed assets 660 874 $ (214)
[5]–Accumulated depreciation (200) (244) 64 (20)
[6]–Intangible assets 150 100 50
Total assets $ 1,080 $1,150
[7]–Accounts payable $ 150 $ 130 (20)
[8]–Long-term debt 420 400 $ (10) $ (10)
[9]–Capital stock accounts 250 300 40 10
[10]–Retained earnings 260 320 180 (120)
Total liabilities and equity $ 1,080 $1,150
Totals $ 304 $ (234) $ (90) $ 0
Statement of Cash Flows
Constructing the Statement
Illustration Continued,Some observations
1,The $20 cash decrease is the focus of explanation for the statement of cash flows—it is explained
by changes in noncash balance sheet accounts,
2,The $55 decrease in accounts receivable is a positive (cash inflow) adjustment to income in
arriving at cash flow from operations it implies cash collections exceed accrual sales,
3,The $25 increase in inventories is a negative (cash outflow) adjustment to income because cash
outlays for inventory exceed purchases in cost of sales,
4,To summarize changes in fixed assets a T-account is used,
Fixed Assets
Beginning 660 Acquisitions 314 100 Disposals
Ending 874
Both acquisitions and disposals are part of investing activities,While each transaction is reported
separately in the statement of cash flows,the balance sheet shows the net of $214 ($314 – $100),
5,Changes in accumulated depreciation are summarized in a T-account,
Accumulated Depreciation
Accumulated 200 Beginning
depreciation on assets disposed 20 64 Depreciation
244 Ending
Depreciation ($64) is a noncash expense—a debit to income (retained earnings) and a credit to
accumulated depreciation,It is added back to income in arriving at cash from operations,The $20
in accumulated depreciation relates to the $100 (original cost) of fixed assets sold at book value
($100 – $20 = $80),The $20 of accumulated depreciation adjusts the $100 amount included in
investing activities,
Statement of Cash Flows
Constructing the Statement
Illustration Continued,Some observations
6,The $50 decline in intangible assets reflects amortization,Amortization is a noncash expense
similar to depreciation and is added back to income,
7,The $20 decrease in accounts payable is a negative (cash outflow) adjustment to income because
amounts due suppliers declined,
8,The $20 decrease in long-term debt reflects a $10 repayment (a financing outflow) and a $10
reduction due to conversion of debt into equity (a noncash transaction),
9,The $50 increase in capital stock reflects a $40 issuance of stock (a financing inflow) and a $10
stock issuance by converting debt (a noncash transaction),
10,The $60 increase in retained earnings is summarized in T-account form,
Retained Earnings
260 Beginning Dividends paid 120 180 Net income
320 Ending
The $180 net income,after adjustments,yields the source of cash from operations of $304,The
$120 dividend is a financing cash outflow,
Statement of Cash Flows
Constructing the Statement
Illustration Continued,Drawing on the analysis,change in cash is explained as,
Toronto Technology Corporation
Statement of Cash Flows ($ thousands)
For the Year Ended December 31,Year 2
Cash flows from operating activities,
Net income $ 180
Add (deduct) adjustments to cash basis,
Depreciation 64
Amortization of intangibles 50
Decrease in accounts receivables 55
Increase in inventory (25)
Decrease in accounts payable (20)
Net cash flows from operating activities $ 304
Cash flows from investing activities,
Purchase of fixed assets (314)
Sale of fixed assets 80
Net cash flows used in investing activities (234)
Cash flows from financing activities,
Sale of capital stock 40
Payment of dividends (120)
Repayment of long-term debt (10)
Net cash flows used in financing activities (90)
Net increase (decrease) in cash $ (20)
Schedule of noncash financing and investing activities:*
Common stock issued in conversion of long-term debt $ 10
*Can be presented in a footnote,Any amounts paid for interest and income taxes must also be disclosed,
Statement of Cash Flows
Constructing the Statement
Reconstruction aims to provide an extensive analysis of
complex transactions,
T-account analysis is a common tool of reconstruction
analysis of transactions,
Aim of T-account analysis is to reconstruct in summary
form the transactions affecting all balance sheet
accounts during the reporting period,
Reconstruction Analysis
Objectives
Income Effect on
Statement Item Double-Entry Effects Cash from Operations
Debit expense or loss Cr,to cash Use of cash
Cr,to noncash account Add back—not using cash
Credit income or gain Dr,to cash Source of cash
Dr,to noncash account Deduct—not providing cash
Reconstruction Analysis
Determining Cash Flows - Important Relations
[Changes in operating working capital accounts]
Account Change Effect on Cash from Operations
Accounts Receivable Increase (Dr.) Sales not collected in cash,
Decrease (Cr.) Collections exceed sales (prior period
receivables collected),
Inventories Increase (Dr.) Cash purchases exceed cost of sales,
Decrease (Cr.) Some cost of goods sold represents a reduction
in inventories (cash purchases are less than cost
of goods sold),
Prepaid Expenses Increase (Dr.) Cash paid for expenses that are charged to
future periods (cash spent exceeds expenses
in income statement),
Decrease (Cr.) Some expenses in the income statement
were paid for in prior years and do not require
a current cash outlay,
Trade Accounts or Increase (Cr.) Some purchases are not yet paid for,
Notes Payable Decrease (Dr.) Cash payments to suppliers exceed purchases
for the period,
Reconstruction Analysis
Determining Cash Flows - Important Relations
Vatter Corporation
Comparative Balance Sheet As of December 31,Year 2
Increase
($ thousands) Year 1 Year 2 (decrease)
Assets
Current assets,
Cash $ 240 $ 120 $ (120)
Receivables 360 450 90
Inventories 750 1,053 303
Total current assets $ 1,350 $ 1,623 $ 273
Fixed assets 4,500 6,438 1,938
Accumulated depreciation (1,500) (1,740) (240)
Investment in affiliate 1,000 1,05 50
Goodwill 950 980 30
Total assets $ 6,300 $ 8,351 $ 2,051
Liabilities and Equity
Accounts payable $ 360 $ 590 $ 230
Bonds payable 300 700 400
Deferred income taxes 240 260 20
Capital stock 2,400 3,200 800
Additional paid-in capital 900 1,300 400
Retained earnings 2,100 2,301 201
Total liabilities and equity $ 6,300 $ 8,351 $ 2,051
Reconstruction Analysis
Illustration
Vatter Corporation
Income Statement ($ thousands)
Year Ended December 31,Year 2
Sales $19,950
Cost of goods sold (includes $360 of depreciation) 11,101
Gross profit $ 8,849
General,selling,and administrative expenses $ 7,000
Amortization of goodwill 30 7,030
$ 1,819
Equity in earnings of unconsolidated affiliate* 50
Gain on sale of fixed assets 2
Income before taxes $ 1,871
Income taxes,
Current 900
Deferred 20 920
Net income $ 951
*No dividends received,
Reconstruction Analysis
Illustration
Additional Information
1,On March 1,the company purchases for $510,000 cash a business with (a) fixed
assets valued at $450,000,(b) current assets (no cash) equal to current liabilities,
and (c) the excess of $60,000 over net assets treated as goodwill,
2,Machinery is sold for $18,000,It originally cost $36,000,and $20,000 depreciation is
accumulated to date of sale,
3,In April,the company acquires $100,000 in fixed assets by issuing bonds for
$100,000 par value,
4,In June,the company receives $1,000,000 cash for issuance of capital stock with a
par value of $600,000; convertible bonds of $200,000 are converted to capital stock
with a par value $200,000; and long-term bonds are sold for $500,000 (at par),
5,Fully depreciated assets of $100,000 are written off,
6,Dividends paid amount to $750,000,
7,General,selling,and administrative expenses include $50,000 of interest paid,
8,There are no liabilities for income taxes at the beginning or end of Year 2,
Reconstruction Analysis
Illustration
1,Set up a T-account for each noncash account in the balance sheet,and
post the opening and closing balances in each T-account,
2,Set up a Cash T-account,separated into four sections,operating,
investing,financing,and noncash transactions,
3,Balances in T-accounts are reconstructed using information drawn from
changes in noncash accounts by,
a,Debiting or crediting items of income or loss,or converting items to a
cash basis for the operating section,
b,Debiting or crediting nonoperating items to one or more of the other
three sections,
4,Prepare the statement of cash flows using details in the completed Cash
T-account,
5,Evaluate the company’s cash flows using the reconstructed statement
while drawing on the insights from the reconstruction process,
Reconstruction Analysis
Illustration - Steps in construction
Two methods to reconstruct transactions for T-
Account analysis,
? Analytical entries
? Intuitive reconstruct
Reconstruction of Transactions - Analytical Entries
Reconstruction Analysis
Accounts Receivable,
(a) Accounts Receivable 90,000
Cash—Operations 90,000
Inventories,
(b) Inventories 303,000
Cash—Operations 303,000
Investment in Affiliate,
(c) Investment in Affiliate 50,000
Cash—Operations 50,000
Fixed Assets,
(d) Fixed Assets 450,000
Goodwill 60,000
Cash—Investing 510,000
(e) Cash—Investing 18,000
Accumulated Depreciation 20,000
Fixed Assets 36,000
Cash—Operations (gain on sale) 2,000
(f) Fixed Assets 100,000
Noncash Transactions 100,000
(g) Noncash Transactions 100,000
Bonds Payable 100,000
(h) Accumulated Depreciation 100,000
Fixed Assets 100,000
(i) Fixed Assets 1,524,000
Cash—Investing 1,524,000
Reconstruction Analysis
Reconstruction of Transactions - Analytical Entries
Accumulated Depreciation,
(j) Cash—Operations 360,000
Accumulated Depreciation 360,000
Goodwill Amortization,
(k) Cash—Operations 30,000
Goodwill 30,000
Accounts Payable,
(l) Cash—Operations 230,000
Accounts Payable 230,000
Bonds Payable,
(m) Cash—Financing 500,000
Bonds Payable 500,000
(n) Bonds Payable 200,000
Noncash Transaction 200,000
(o) Noncash Transaction 200,000
Capital Stock 200,000
Deferred Income Taxes,
(p) Cash—Operations 20,000
Deferred Income Taxes 20,000
Capital Stock and Paid-In Capital,
(q) Cash—Financing 1,000,000
Capital Stock 600,000
Paid-In Capital 400,000
Retained Earnings,
(r) Cash—Operations 951,000
Retained Earnings 951,000
(s) Retained Earnings 750,000
Cash—Financing 750,000
Reconstruction of Transactions - Analytical Entries
Reconstruction Analysis
Cash
Beginning 240
Operations
Depreciation expense (g) 360 2 (b) Gain on sale of fixed assets
Deferred income taxes (k) 20 50 (p) Equity in earnings of
Net income (m) 951 affiliate
Goodwill amortization (o) 30 90 (q) Increase in receivables
Increase in accounts (s) 230 303 (r) Increase in inventories
payable
Investing
Sale of fixed assets (b) 18 450 (a) Acquisition of fixed assets
60 (a) Acquisition of goodwill
1,524 (f) Acquisition of fixed assets
Financing
Bonds sold (h) 500 750 (n) Dividends paid
Sale of stock (l) 1,000
Noncash Transactions
Bonds issued to (d) 100 100 (c) Fixed assets acquired with bonds
acquire fixed assets
Stock issued in (j) 200 200 (i) Bond conversion to stock
conversion
Ending 120
Reconstruction of Transactions - T-Account Analysis
Reconstruction Analysis
Receivables Inventories Accounts Payable
Beg,360 Beg,750 360 Beg,
(a) 90 (b) 303 230 (l)
End,450 End,1,053 590 End,
Fixed Assets Accumulated Depreciation Investment in Affiliate
Beg,4,500 1,500 Beg,Beg,1,000
(d) 450 36 (e) (e) 20 360 (j) (c) 50
(f) 100 100 (h) (h) 100
if) 1,524
End,6,438 1,740 End,End,1,050
Goodwill Bonds Payable Deferred Income Taxes
Beg,950 300 Beg,240 Beg,
(d) 60 30 (k) (n) 200 100 (g) 20 (p)
500 (m)
End,980 700 End,260 End,
Capital Stock Paid-In Capital Retained Earnings
2,400 Beg,900 Beg,2,100 Beg,
200 (o) 400 (q) (s) 750 951 (r)
600 (q)
3,200 End,1,300 End,2,301 End,
Reconstruction of Transactions - T-Account Analysis
Reconstruction Analysis
Vatter Corporation
Statement of Cash Flows ($ thousands) For Year Ended December 31,Year 2
Cash flows from operating activities,
Net income $951
Add (deduct) adjustments to cash basis,
Depreciation 360
Amortization of goodwill 30
Deferred income taxes 20
Gain on sale of equipment (2)
Equity in earnings of affiliate (50)
Increase in receivables (90)
Increase in inventories (303)
Increase in accounts payable 230
Net cash flows from operating activities $1,146
Cash flows from investing activities,
Purchase of fixed assets (1,974)
Purchase of goodwill (60)
Sale of fixed assets 18
Net cash flows used in investing activities (2,016)
Cash flows from financing activities,
Net proceeds from sale of bonds 500
Sale of capital stock 1,000
Payment of dividends (750)
Net cash flows from financing activities 750
Net decrease in cash $(120)
Supplemental disclosure of cash flow information,
Interest paid during year $ 50
Income taxes paid during year 900
Schedule of noncash investing and financing activities,
Bonds issued to acquire fixed assets 100
Stock issued in conversion of bonds 200
Statement Deviation
Reconstruction Analysis
Two acceptable methods for reporting cash from
operations (CFO)
? Indirect method
? Direct methods
Both methods yield identical results—
only the presentation format differs
Cash From Operations
Reporting Formats for CFO
Cash From Operations
Reporting Formats for CFO
C o m p a n i e s R e p o r ti n g C a s h F l o w s u s i n g I n d i r e c t o r
D i r e c t F o r m a ts
I n d i r e ct M e t h o d
97%
D i r e ct M e t h o d
3%
Net income is adjusted for
noncash items requiring
conversion to cash flows
from operations—see prior
Vatter Corp,slide
Cash From Operations
Indirect Method for CFO
Deriving Operating Cash Flows from Income for VatterCorp,
Amount
Item (in thousands) Explanation
Net income,accrual basis $ 951 Starting point of conversion
Add (deduct) adjustment to cash basis,
Depreciation 360 Depreciation has no cash outflow,
Goodwill amortization 30 Amortization has no cash outflow,
Deferred income taxes 20 Deferred expense has no cash outflow,
Equity in earnings of affiliate (50) Item does not yield cash inflow,
Gain on sale of equipment (2) Remove gain (because it is onoperating)—cash
inflow is cash from investing activities,
Increase in receivables (90) Cash flow from sales is less than accrual sales,
Increase in inventories (303) Cash outflow for inventory exceeds accrual
inventory cost included in cost of sales,
Increase in accounts payable 230 Cash outflows for purchases (included in cost of
goods sold) is less than accrual purchases cost,
Cash flows from operations (Exhibit 7.6) $1,146
Cash From Operations
Indirect Method for CFO
Direct method also called Inflow-Outflow method
Reports gross cash receipts and gross cash
disbursements related to operations—essentially
adjusting each income statement item from accrual to
cash basis,
Preferred method by the majority of financial statement
users (not preparers),
Better format to assess the amount of
cash inflows and cash outflows,
Cash From Operations
Direct Method for CFO
Converting Vatter’s Operating Cash Flows from Indirect to Direct Format
Indirect Format Direct Format
Net income $ 951 Total revenues ($19,950 + $50 + $2) $20,002
Add,Depreciation 360 Remove gain on sale (2)
Amortization 30 Less equity in earnings of affiliate (50)
Deferred taxes 20 Less increase in receivables (90)
Remove,Gain on sale of equipment (2) Less—Cash receipts $19,860
Deduct equity in earnings of affiliates (50) Total expenses ($11,101 + $7,030 + $920) $19,051
Add (deduct) changes in,Less,Depreciation (360)
Receivables (90) Less—Amortization (30)
Inventories (303) Less—Deferred taxes (20)
Payables 230 Add increase in inventories 303
Less increase in payables (230)
Less—Cash payments $18,714
Cash flows from operations $1,146 Cash flows from operations $ 1,146
Cash From Operations
Converting Indirect to Direct
See Form A in Appendix
7A to aid in conversion
Cash From Operations
Converting Indirect to Direct
Vatter Corporation
Cash Flows from Operations ($ thousands)
For Year Ended December 31,Year 2
Cash flows from operating activities,
Cash receipts from customers [a] $19,860
Cash paid for inventories [b] (10,814)
Cash paid general,selling,and administrative expenses [c] (7,000)
Cash paid for income taxes—current [d] (900)
Net cash flows from operations $1,146
Computations,
[a] Sales of $19,950 less increase in accounts receivables of $90,
[b] Cost of goods sold of $11,101 plus increase in inventories of $303 less increase in
accounts payable of $230—also less (noncash) depreciation of $360 that is included in
cost of goods sold for Vatter,
[c] General,selling,and administrative expenses of $7,030 less (noncash) amortization of
$30,
[d] Income taxes—current of $920 less increase in deferred income taxes of $20,
Cash From Operations
Converting Indirect to Direct
To compute cash receipts,
Cash receipt = Revenue account + Decrease in its Receivable (or –
Increase in its Receivable)
To compute cash payments,
Cash payment = Expense account + Decrease in its Payable (or –
Increase in its Payable)*
*To compute cash paid for inventories we
must include,+ Increase in Inventory
(or – Decrease in Inventory),
Cash From Operations
Adjustments for Direct Method
? Direct method is not required and is rarely reported,
? No separate disclosure of cash flows pertaining to either extraordinary items or
discontinued operations,
? Interest and dividends received,and interest paid,are classified as operating
cash flows,Many users consider interest paid a financing outflow,and interest
and dividends received as cash inflows from investing activities,
? Income taxes are classified as operating cash flows,This classification can
distort our analysis of the three individual activities if significant tax benefits or
costs are attributed to them in a disproportionate manner,
? Removal of pre-tax (rather than after-tax) gains or losses on sale of
plant or investments from operating activities distorts our analysis
of both operating and investing activities,This is because their
related taxes are not removed,but left in total tax expense among
operating activities,
Cash From Operations
Reporting Limitations
Vatter Corporation
Comparison of Accrual and Cash Reporting
Income Operating
Statement Cash Flows
Sales $19,950 $19,860* Collections from customers
Equity in earnings of unconsolidated subsidiary 50 —
Gain on sale of fixed assets 2 —?
$20,002 $19,860 Total collections
Cost of goods sold? 10,741 10,814§ Payments to suppliers and labor
Depreciation 360 —
General,selling,and administrative expenses 7,000 7,000 Payments for expenses
Amortization of goodwill 30 —
Income taxes,Current 900 900 Payments for taxes
Deferred 20 —
$19,051 $18,714 Total disbursements
Net income $ 951 Cash from operations $ 1,146
*$19,950 (sales) – $90 (increase in receivables),?Omitted because it is linked with proceeds from sales of assets under investing activities,
?Exclusive of depreciation,§$10,741 (cost of goods sold) + $303 (increase in inventories) – $230 (increase in payables),Note that
the linkage of accounts payable to cost of goods sold is arbitrary because some may relate to other expense categories,However,no further breakdown is possible,
Cash From Operations
Interpreting Accrual Income and Operating Cash Flow
Net income plus major noncash expenses
(typically depreciation and amortization)
Cash From Operations
Alternative Cash Flow Measure
Assume two companies (A and B) each invest $50,000 in machinery yielding
$45,000 per year cash flows before depreciation,Assuming a five-year
useful life and no salvage value for the machinery,results for the entire five-
year period are,
Five-Year Period
Cash provided by operations ($45,000 x 5 years) $225,000
Cost of the machine $ (50,000)
Income from operating machine $175,000
Average yearly net income $ 35,000
Cash From Operations
Alternative Cash Flow Measure - Illustration
Company A,Company B,
Straight-Line Sum-of-the-Years’-
Depreciation Digits Depreciation
Income
before
Year Depreciation Depreciation Net Income Depreciation Net Income
1 $ 45,000 $10,000 $ 35,000 $16,667 $ 28,333
2 45,000 10,000 35,000 13,334 31,666
3 45,000 10,000 35,000 10,000 35,000 4 45,000 10,000 35,000 6,667 38,333
5 45,000 10,000 35,000 3,332 41,668
Total $225,000 $50,000 $175,000 $50,000 $175,000
Income before depreciation for these two companies is identical--this faithfully reveals identical
earning power,
Income after depreciation is considerably different across the years—this does not reflect
changes in earning power,
Cash From Operations
Alternative Cash Flow Measure - Illustration
While both successful and unsuccessful companies can
experience problems with cash flows from operations,
the reasons are markedly different,
We must interpret changes in operating working capital
items in light of economic circumstances,
Inflationary conditions add to the
financial burdens of companies
and challenges for analysis,
Cash From Operations
Business Conditions and Cash Flows
Cash flows from operations
Deduct,Net capital expenditures required to
maintain productive capacity
Dividends on preferred stock and common
stock (assuming a payout policy)
Equals Free cash flow (FCF)
Cash From Operations
Free Cash Flow
Positive free cash flow reflects the amount available for
business activities after allowances for financing and
investing requirements to maintain productive capacity at
current levels,
Growth and financial flexibility depend on adequate free cash
flow,
Recognize that the amount of capital expenditures
needed to maintain productive capacity is generally
not disclosed—instead,most use total capital
expenditures,which is disclosed,but can include
outlays for expansion of productive capacity,
Cash From Operations
Free Cash Flow
The statement of cash flows is
useful in identifying misleading
or erroneous operating results
or expectations,
Cash From Operations
Cash Flow as Validators
Form A
Worksheet to Compute Cash Flow from Operations (CFO)
Direct Presentation
For:_______________________
Year Ended ______________
(in thousands)
Year
Cash receipts from operations,
Net sales or revenues(a) *1 $ $ $
Other revenue and income
(see also lines 22 and 25) *2
(I) D in current receivables 3
(I) D in noncurrent receivables(b) 4
Other adjustments(c) 5
Total Cash receipts 6
Cash disbursements for operations,
Total expenses (include interest and taxes)(a) *7
Less expenses and losses not using cash,
– Depreciation and amortization 8
– Noncurrent deferred income taxes 9
– Other ________ 10
– Other ________ 11
– Other ________ 12
Changes in current operating assets and liabilities,
I (D) in inventories 13
I (D) in prepaid expenses 14
(I) D in accounts payable 15
(I) D in taxes payable 16
(I) D in accruals 17
I or D other ________ 18
I or D other ________ 19
I or D in noncurrent accounts(b) 20
Total Cash disbursements(d) 21
Cash Flow Analysis
Converting CFO to Direct Format
Form A (Continued)
Worksheet to Compute Cash Flow from Operations (CFO)
Direct Presentation
For:_______________________
Year Ended ______________
(in thousands)
Year
Dividends received,
Equity in income of unconsolidated affiliates *22
Less undistributed equity in income of affiliates 23
Dividends from unconsolidated affiliates 24
Other cash receipts (disbursements)(e) *25
Describe _____________________(a) 25
Describe _____________________(b) 25
Total Cash flow from operations(f) 26
Footnote all amounts that are composites or that are not self-evident,Indicate all sources for figures,I(D) refers to
increases (decreases) in accounts,
*The sum of these five lines must equal reported net income per income statement,
(a)Including adjustment (grossing up) of revenue and expense of discontinued operations disclosed in footnote(s),
Describe computation,Include other required adjustments and explain,
(b)Those relating to operations—describe in notes,
(c)Such as removal of gains included above—describe in notes,
(d)Which include (from supplemental disclosures),
Cash paid for interest (net of amount capitalized) $______ ______ ______
Cash paid for income taxes $______ ______ ______
(e)These include extraordinary items,discontinued operations and any other item not included above,The amount in line
25 is after adjustment to cash basis while the * refers to item(s) included in income before such adjustment,(Present
details in notes.)
(f)Reconcile to amount reported by company,If not reported,reconcile to change in cash for period along with investing
and financing activities,
Converting CFO to Direct Format
Cash Flow Analysis
Form B
Analytical Statement of Cash Flows*
For:_______________________
Year Ended ______________
(in thousands)
Year
Cash flows from operations,
Income before extraordinary items 1 $ $ $
Add (deduct) adjustments to cash basis,
Depreciation and amortization 2
Deferred income taxes 3
Equity in income of investees 4
Other (a) 5
Other (a) 6
(I) D in receivables 7
(I) D in inventories 8
(I) D in prepaid expenses 9
I (D) in accounts payable 10
I (D) in accruals 11
I (D) in taxes payable 12
I or D in other current operating accounts(a) 13
I or D in noncurrent operating accounts(a) 14
Extraordinary items net of noncash items(b) 15
Discontinued operations net of noncash items(b) 16
Cash from operations(c) 17
Cash flows from investing activities,
Additions to properties 18
Additions to investments (advances) 19
Additions to other assets 20
Converting SCF to Analytical Format
Cash Flow Analysis
Form B (Continued)
Analytical Statement of Cash Flows*
For:_______________________
Year Ended ______________
(in thousands)
Year
Cost of acquisition—net of cash 21
Disposals of properties 22
Decreases in other assets(a) 23
Other(a) 24
Cash from (used in) investing 25
Cash flows from financing activities,
Net I (D) in short-term debt 26
I (D) in long-term debt 27
I (D) of common and preferred stock(a) 28
Dividends paid 29
Other(a) 30
Cash from (used in) financing 31
Effect of exchange rate changes on cash,32
Net increase (decrease) in cash and equivalents 33
Schedule of noncash activities(a),
Other (a) 34
Other (a) 35
Other (a) 36
*Use all figures from company’s statement of cash flows,I (D) refers to increases (decreases) in accounts,
(a)Provide full details in statement or in separate notes,
(b)This information is not required to be disclosed,Provide details if this information is disclosed or can otherwise be
obtained or reconstructed,
(c)To convert to the direct format use Form A in Exhibit 7A.1,
Converting SCF to Analytical Format
Cash Flow Analysis
