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Chapter 6: Statement of Cash Flows

Outline:

• Why a cash flow statement?

• Classifications of cash flows• Preparation of cash flow statements

– Determining the change in cash– Determining net cash from operating activities

• methods• Sidestep: net income vs. net cash from operating activities

– Determining net cash from investing and financing activities

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Purpose of cash flow statement

• Objective of a business enterprise: profit– Corporations maximize profitability, RoE

• Essential constraint: solvency– all liabilities can be paid out of liquid assets at due date– otherwise Management loses control over assets

In the long-run you cannot maintain solvency without profitability

and vice versa!

Profitability

Liquidity

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Profitability vs. liquidity –the W. T. Grant Bankruptcy in 1975

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Income Cash Flow from Operations

• at that time, largest bankruptcy filing in the U.S.

• (credit) sales increased steadily; profits were generated

• first cash shortages emerged in 1969

• filing of bankruptcy on October 2, 1975

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Substantial content

• information on sources and uses of cash during the accounting period

• independent of accounting discretion, more objective than income statement

• important to forecast– the entity‘s ability to generate future cash flows,– the entity‘s ability to pay dividends and meet obligations,

• important to understand – the reasons for the difference between net income and net cash

flow from operating activities, and– the cash and noncash investing and financing transactions

during the period

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Cash flow statements according to IAS 7

• If a firm sets up financial statements according to IFRS it is required to prepare a Cash flow statement– This holds for all types of firms, industries and sizes

• Detailed rules are specified in IAS 7– Cash flow includes changes in cash and cash equivalents– Operating cash flow, cash flow from investment activities, and financing

activities need to be presented separately– To determine the cash flow from operating activities one of two methods

is to be applied:• Direct method• Indirect method

– For cash flows from financing and investment always direct method

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Classification of Cash Flows

• Cash flows are the results of either– Operating activities

• principal revenue-producing activities of the entity, and all other non-investing or non-financing activities

– Investing activities• acquisition and disposal of long-term assets and other investments

not included in cash equivalents – Financing activities

• transactions that lead to changes in size and composition of the entity‘s equity capital and liabilities

• interest and dividend payments or receipts can be either considered a result from operating, investing or financing activities

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Graphical model of cash flows

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Range of Cash Flow Statement for a period

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Preparation of cash flow statements

• Sources of information:– comparative balance sheet– changes in assets, liabilities, and equities over a period– current income statement

operating profit– selected transaction data

additional information of cash provisions and uses during the period (e.g. dividends, share repurchases,...)

• Three steps from the data to statement of cash flow:1. Determine change in cash2. Determine net cash flow from operating activities3. Determine net cash flows from investing and financing activities

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Two methods to analyze and report cash from operating activities

• Direct methoddiscloses major classes of gross cash receipts and gross cash payments directly– derived directly from the „cash“ account– a respective account is not usually present in the accounting system

• easily implementable with EDP-based accounting

• Indirect methodadjusting net income – eliminate noncash revenues and expenses– adjust for any deferrals or accruals of past or future operating cash

receipts or payments– adjust for items of income or expense associated with investing or

financing cash flows

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Example

• We use the following data to go through the preparation process:

Dream Grades, Inc.Comparative Balance Sheet

ChangeAssets Dec. 31, 2001 Jan. 1, 2001 Increase / (Decrease)Cash 75.000 0 75.000Accounts receivable 65.000 0 65.000Prepaid insurance 10.000 0 10.000

Total 150.000 0 150.000

Liabilities andstockholder's equityAccounts payable 14.000 0 14.000Long-term liability 81.000 0 81.000Unearned revenue 10.000 0 10.000Common stock (€ 10 par) 20.000 0 20.000Retained earnings 25.000 0 25.000

Total 150.000 0 150.000

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Dream Grades, Inc.Income Statement

For the year ended December 31, 2001

Revenues 145.000Operating expenses 85.000

Income before taxes 60.000Income tax expense (35%) 21.000

Net income 39.000

Additional informationThe company obtained € 90.000 in cash through a bank loan; repayment of the loan is due in ten installment payments of € 9.000 and the first of them was due during the year.Cash dividends in a total amount of € 14.000 were paid during the year.

Example cont‘d

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Example cont‘d

• Step 1 – Determine the Change in Cash– The balance in the cash account increased from zero

to € 75.000; thus, we record a change in cash for 2001 that was an increase of € 75.000.

• Step 2 – Determine Net Cash Flow from Operating Activities

– accrual accounting net income

– cash basis accounting net cash flow from operating activities

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Example cont. – direct method

– Cash collected from revenues: 145.000 – 65.000 + 10.000– Cash payment for expenses: 85.000 – 14.000 + 10.000

Cash collected from revenues € 90.000Cash payment for expenses 81.000

Income before income taxes 9.000Cash payments for income taxes 21.000

Net cash used by operating activities -€ 12.000

Note: The issue of deferred taxes is neglected here. For example, prepaid expenses and unearned revenues would cause a difference between taxable income and financial income. See chapter 17.

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Indirect method, adjustments

Additions:• Depreciation expense• Amortization of intangibles and

deferred charges• Loss on sale plant assets• Loss on writedown of assets• Decrease in receivables• Decrease in prepaid expense• Increase in accounts payable• Increase in accrued liabilities

Deductions:• Gain on sale of plant assets• Increase in receivables• Increase in inventories• Increase in prepaid expense• Decrease in accounts payable• Decrease in accrued liabilities

Net income

Net cash flow from operating activities

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Example cont. – indirect method

• Step 3 – Determine net cash flows from investing and financing activities– long-term loan of € 81.000 (net effect at year-end)– dividend payment of € 14.000– issuance of common stock for cash, € 20.000

Net income € 39.000Adjustments to reconcile net income to net cash provided by operating activities:

Increase in accounts receivable -€ 65.000 Increase in accounts payable 14.000 Increase in prepayments -10.000 Increase in unearned revenue 10.000 -51.000

Net cash used by operating activities -€ 12.000

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Cash flow statement for the year 2001

Dream Grades, Inc.Statement of Cash Flows

For the Year Ended December 31, 2001

Cash Flows from Operating Activities Net Income 39.000 Adjustments to reconcile net income to net cash used by operating activities Increase in Account Receivable -65.000 Increase in Prepaid Insurance -10.000 Increase in Unearned Revenue 10.000 Increase in Accounts Payable 14.000 -51.000

Net cash flows used by operating activities -12.000

Cash Flows from Financing Activities Issuance of common stock 20.000 Long-term borrowing 81.000 Payment of cash dividend -14.000

Net Cash Flows provided by Financing Activities 87.000

Net Increase (Decrease) in Cash 75.000Cash, January 1, 2001 0

Cash, December 31, 2001 75.000

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Example cont‘d, next year

• We continue with the example:Dream Grades, Inc.Comparative Balance Sheet

ChangeAssets Dec. 31, 2002 Jan. 1, 2002 Increase / (Decrease)Cash 100.000 75.000 25.000Accounts receivable 35.000 65.000 -30.000Prepaid insurance 6.000 10.000 -4.000Land 15.000 0 15.000Building 40.000 0 40.000Accumulated depreciation - building -1.000 0 -1.000Equipment 30.000 0 30.000Accumulated depreciation - equipment -10.000 0 -10.000

Total 215.000 150.000 65.000

Liabilities andstockholder's equityAccounts payable 38.000 14.000 24.000Long-term liability 72.000 81.000 -9.000Unearned revenue 0 10.000 -10.000Common stock (€ 10 par) 20.000 20.000 0Retained earnings 85.000 25.000 60.000

Total 215.000 150.000 65.000

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Step 1 – Determine change in cash

As indicated in the comparative balance sheet, cash increased € 25.000 during the year.

Dream Grades, Inc.Income Statement

For the year ended December 31, 2002

Revenues 320.000Operating expenses 180.000

Income before taxes 140.000Income tax expense (35%) 49.000

Net income 91.000

Additional information

1 – a cash dividend of € 31.000 was paid during the year.2 – the second installment payment on the long-term loan was made.3 – land, building, and equipment were acquired for cash.

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Indirect Method

Net income € 91.000Adjustments to reconcile net income to net cash provided by operating activities:

Decrease in accounts receivable € 30.000 Increase in accounts payable 24.000 Decrease in prepayments 4.000 Decrease in unearned revenue -10.000 Depreciation expense 11.000 59.000

Net cash provided by operating activities € 150.000

Step 2 – Determine net cash from operating activities

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Step 3 – Determine net cash flows from investing and financing activities

• repayment on loan, € 9.000• dividend payment of € 31.000• purchase of land, building, and equipment, € 85.000

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Dream Grades, Inc.Statement of Cash Flows

For the Year Ended December 31, 2002

Cash Flows from Operating Activities Net Income 91.000 Adjustments to reconcile net income to net cash provided by operating activities Depreciation Expense 11.000 Decrease in Prepaid Insurance 4.000 Decrease in Account Receivable 30.000 Decrease in Unearned Revenue -10.000 Increase in Accounts Payable 24.000 59.000

Net cash flows provided by operating activities 150.000

Cash Flows from Investing Activities Purchase of land -15.000 Purchase of building -40.000 Purchase of equipment -30.000

Net cash flows used by investing activities -85.000

Cash Flows from Financing Activities Installment Payment on Long-Term Loan -9.000 Payment of cash dividend -31.000

Net cash flows used by financing activities -40.000

Net Increase (Decrease) in Cash 25.000Cash, January 1, 2002 75.000

Cash, December 31, 2002 100.000

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Step 1 – Determine change in cash

As indicated in the comparative balance sheet, cash increased € 25.000 during the year.

Dream Grades, Inc.Income Statement

For the year ended December 31, 2002

Revenues 320.000Operating expenses 180.000

Income before taxes 140.000Income tax expense (35%) 49.000

Net income 91.000

Additional information

1 – a cash dividend of € 31.000 was paid during the year.2 – the second installment payment on the long-term loan was made.3 – land, building, and equipment were acquired for cash.

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Indirect Method

Net income € 91.000Adjustments to reconcile net income to net cash provided by operating activities:

Decrease in accounts receivable € 30.000 Increase in accounts payable 24.000 Decrease in prepayments 4.000 Decrease in unearned revenue -10.000 Depreciation expense 11.000 59.000

Net cash provided by operating activities € 150.000

Step 2 – Determine net cash from operating activities

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Step 3 – Determine net cash flows from investing and financing activities

• repayment on loan, € 9.000• dividend payment of € 31.000• purchase of land, building, and equipment, € 85.000

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Dream Grades, Inc.Statement of Cash Flows

For the Year Ended December 31, 2002

Cash Flows from Operating Activities Net Income 91.000 Adjustments to reconcile net income to net cash provided by operating activities Depreciation Expense 11.000 Decrease in Prepaid Insurance 4.000 Decrease in Account Receivable 30.000 Decrease in Unearned Revenue -10.000 Increase in Accounts Payable 24.000 59.000

Net cash flows provided by operating activities 150.000

Cash Flows from Investing Activities Purchase of land -15.000 Purchase of building -40.000 Purchase of equipment -30.000

Net cash flows used by investing activities -85.000

Cash Flows from Financing Activities Installment Payment on Long-Term Loan -9.000 Payment of cash dividend -31.000

Net cash flows used by financing activities -40.000

Net Increase (Decrease) in Cash 25.000Cash, January 1, 2002 75.000

Cash, December 31, 2002 100.000