Chapter 6

Statement of Cash Flows

Statement of Cash Flows--Purpose

• To provide information about

cash receipts,

cash payments, and the

net change in cash resulting from operating, investing, and financing activities

of a company during the period.

Statement of Cash Flows--Purpose

• Provides answers to the following:

Where did the cash come from during the period?

What was the cash used for during the period?

What was the change in the cash balance during the period?

Composition

• Cash Flows from Operations• Cash Flows from Investing Activities• Cash Flows from Financial Activities

Cash From Operations

Cash From Investing

Cash From Financing

Material Non-cash Transactions

• Examples:

Issuance of common stock to purchase assets.

Conversion of bonds into common stock.

Issuance of debt to purchase assets.

Exchanges of plant assets.

• Reported at the bottom of the statement of cash flows or in a separate note to the financial statements.

Direct & Indirect Method

Convert net income from an accrual basis to a cash basis.

Use either indirect or direct format.

Both methods arrive at same totals.

Investing and financing activities are the same for both methods.

99% of firms use the indirect method.

Preparing the Cash Flow Statement (Indirect Method)

Preparing Cash From Operations--Example

• Krauss Company’s financial statements for the year ended December 31, 2007, contained the following condensed information.

2007 2006 ChangeRevenues f rom fees 840,000$ Operating expenses 624,000 Depreciation expense 60,000 Loss on sale of equipment 26,000

I ncome before income tax 130,000 I ncome tax 40,000

Net income 90,000$

Accounts receivable 37,000$ 54,000$ (17,000)$ Accounts payable 41,000 31,000 10,000 I ncome taxes payable 4,000 8,500 (4,500)

Cash From Operations—Example(Indirect Method)

Cash flows f rom operating activitiesNet income 90,000$ Adjustment to reconcile net income to net cash provided by operating activities: Depreciation expense 60,000 Loss on sale of equipment 26,000 Decrease in accounts receivable 17,000 I ncrease in accounts payable 10,000 Decrease in income taxes payable (4,500) Net cash provided by operating activities 198,500

Adjustments to Cash From Operations

Statement of Cash Flows(Indirect Method)

Statement of Cash Flows

Cash flow from operating activities

Net income (loss) (50,000)$ Adjustment to reconcile net income to cash:

Depreciation expense 22,000 Loss on sale 2,700 Gain on sale (9,000)

Cash f rom operations (34,300)

Cash flow from investing activities

Sale of plant assets 5,400 Sale of land 39,000

Cash f rom investing activities 44,400

Cash flow from financing activities

Sale of common stock 430,000 Purchase of company stock (47,000)

Cash f rom financing activities 383,000

Net Change in Cash 393,100$

Cash Flow Issues

• CFO trends, especially related to net income; CFO is expected to be larger than net income (e.g., depreciation increases CFO) & should parallel net income over time

• The Dow 30 had an average CFO of $9.9 billion, 47% above net income

• Potential problem where net income is positive and CFO is negative—this is a possible indicator of manipulation (this was one of the signals at Enron of problems)

Free Cash Flows (FCF)• Free cash flows is a measure of cash available for

discretionary uses (that is; cash provided by operations less expenditures that are considered required):

• According to the book, the calculation is: CFO-Capital Expenditures-Cash dividends(in other words, cash available after fixed asset investments and maintaining dividends.)• Alternative definitions: FCF1 = CFO – Capital

Expenditures; FCF2 = CFO – CFI• Cash flows can highlight certain problems such as

lagging cash collections

Free Cash Flows

• Amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or adding to its liquidity.

Current Cash Debt Coverage Ratio

Cash From Operations Average Current Liabilities

Ratio indicates whether the company can pay off its current liabilities from its operations. A ratio near 1:1 is good.A Liquidity measure (similar to operating cash flow).

Cash Debt Coverage Ratio

Cash From Operations Average Total Liabilities

• Ratio indicates a company’s ability to repay its liabilities from net cash provided by operating activities, without having to liquidate the assets employed in its operations.

• A solvency (leverage) measure.

Corporate Life Cycle