LECTURE 1:Statement of Cash

Flows:

STATEMENT OF CASH FLOWS: A statement reporting the impact of a

firm’s operating, investing and financing activities on cash flows over an accounting period.

It summarizes the changes in a company’s cash position.

OBJECTIVE: The objective of the statement of cash flows is

to provide the user of the financial statements with information as to how the reporting entity has generated cash during the reporting period and how the entity has spent that cash during the reporting period.

It is important to know your cash flow so that you may adequately plan your expenditures. Should there be a cut back on payments because of a cash problem? Where are you getting most of your cash? What products or projects are cash drains or cash cows? Is there enough money to pay bills and buy needed machinery?

PURPOSES AND USES OF STATEMENT OF CASH FLOWS. :

Purposes of the statement. a. To provide information about the cash receipts and cash

payments of an entity during a period. Important information for financial statement users.

b. To summarize the operating, investing, and financing activities of the business.

Uses of the statement. a. Assessing the entity’s ability to generate positive future

cash flows. b. Assessing the entity’s ability to pay dividends and meet

obligations. c. Reconciling the difference between net income and net

cash flow from operating activities. d. Assessing the cash and noncash investing and financing

transactions during the period

CONTENTS OF THE STATEMENT: The statement of cash flow is segregated into the following three parts; Operating activities are the day-to-day revenue-producing activities. They are

connected to the manufacture and sale of goods or the rendering of services. These include

net income, depreciation and changes in current assets and current liabilities other than cash and short

term debt. Investing activities are the acquisition and disposal of long-term assets that

are not considered to be cash equivalents. These can comprise: Acquisition of property, plant and equipment (PPE). Disposals of PPE. Investing in long term investments. Acquisitions and disposals of subsidiaries/joint ventures/associates. Financing activities are those activities which change the capital and

borrowing structure of the reporting entity. Examples of such financing activities are:

Loans taken out in the year. Proceeds from share issues. Buy back of equity shares. Redemption of preference shares/debentures.

OPERATING ACTIVITIES: Cash inflow Revenue from sale of goods and services Interest (from debt instruments of other

entities) Dividends (from equities of other entities) Cash outflow Payments to suppliers Payments to employees Payments to Government Payments to Lenders Payments for other expenses

INVESTING ACTIVITIES: Cash inflow Sale of Property, Plant, and Equipment Sale of Debt or Equity Securities (other

entities) Collection of principal on loans to other

entities Cash outflow Purchase Property, Plant, and Equipment Purchase Debt or Equity Securities (other

entities) Lending to other entities

FINANCING ACTIVITIES: Cash inflow Sale of Equity Securities Issuance of Debt Securities Cash outflow Dividends to shareholders Redemption of long-term debt Redemption of capital stock

TWO METHODS TO DETERMINE NET CASH FLOWS Direct Method: uses cash receipts from

operations and cash disbursements to create the income statement on a cash basis

Indirect Method: starts with net income and adjusts it for change in current asset and current liability accounts, generally easier and more commonly used method

We will use the indirect method

Information for the preparation of the Statement of Cash Flows is derived from three sources:

Comparative Balance Sheets Current income statements Selected transaction data Three steps: Determine Change in Cash Determine net cash flow from operating

activities Determine cash flow from investing and

financing activities

Net income

+

Depreciation in expenseIncrease in deferred taxesDecrease in accounts receivablesDecrease in inventoriesDecrease in prepaid expensesIncrease in payablesLoss in disposal

-

Decrease in deferred taxesIncrease in account receivablesIncrease in inventoriesIncrease in prepaid expensesDecrease in payablesGain in disposal

=

Net cash flow from Operating Activities

HOW THE STATEMENTS TIE TOGETHER:

STATEMENT OF RETAINED EARNINGS The retained earnings statement reconciles the

beginning and ending balances in the retained earnings account. This statement can be presented as a separate statement or in a combined statement of income and retained earnings.

A company's overall net income will cause retained earnings to increase and a net loss will result in a decrease. Retained earnings is also reduced by shareholder dividends.

The statement of retained earnings provides a succinct reporting of these changes in retained earnings from one period to the next. In essence, the statement is nothing more than a reconciliation or “bird’s-eye view” of the bridge between the retained earnings amounts appearing on two successive balance sheets.

DEFINITION: A statement reporting how much of the

firm’s earnings were retained in the business rather than paid out in dividends.

It is the sum of the annual retained earnings for reach year of the firm’s history.

FORMAT OF THE STATEMENT OF RETAINED EARNINGS

Prepare the Heading for the Statement of Retained Earnings

A Statement of Retained Earnings should have a three-line header. The first line is the name of the company. The second line is simply, "Statement of Retained Earnings." The third line is "For the Year Ended XXXXX." For the word "year," any accounting time period can be entered.

State the Balance of Retained Earnings from the Prior Year

The first item on the Statement of Retained Earnings should be the balance of retained earnings from the prior year. This comes from the prior year's balance sheet. Let's say that the balance of retained earnings for our hypothetical firm is $20,000. The first line for the Statement of Retained Earnings would look like this:

Retained Earnings, December 31, 2013  $20,000

Add Net Income from the Income Statement The Statement of Retained Earnings should be the

second financial statement prepared. The Income Statement is the first financial statement prepared. Let's say that net income from the hypothetical company is $10,000. That is the first item added into the Statement of Retained Earnings. Our retained earnings statement is now going to look like this:

Retained Earnings: December 31,2013  $20,000

Plus: Net Income 2014  +10,000 Total  $30,000 If the company has a net loss on the Income

Statement, then the net loss is subtracted from the existing retained earnings.

Subtract Dividends that your Company Pays out to Investors

Does your company pay dividends? If it does, you subtract the amount of dividends your company pays out of net income. If it does not, then you subtract $0. Let's say your company's dividend policy is to pay 50 percent of its net income out to its investors. In this example, $5,000 would be paid out as dividends and subtracted from the current total.

Retained Earnings, December 31, 2013  $20,000 Plus: Net Income 2014  +10,000 Total $30,000 Minus: Dividends  (5,000)

Prepare the Final Total for Retained Earnings for 2014

Subtract out the dividends, if you pay dividends, and total the Statement of Retained Earnings. This is the amount of retained earnings that you post to the retained earnings account on your new 2013 balance sheet.

Retained Earnings, December 31, 2013  $20,000 Plus: Net Income 2014  10,000 Total:  30,000 Minus: Dividends Paid  (5,000) Retained Earnings, December 31, 2014  $25,000 This completes the Statement of Retained Earnings.

CASE STUDY

EXTRA NOTES:SECURITY A security is a tradable asset of any

kind. Securities are broadly categorized into:

debt securities (such as banknotes, bonds and debentures),

equity securities, e.g., common stocks; and,

derivative contracts, such as forwards, futures, options and swaps

DEBT SECURITY Any debt instrument that can be bought or sold

between two parties and has basic terms defined, such as notional amount (amount borrowed), interest rate and maturity/renewal date. Debt securities include government bonds, corporate bonds, municipal bonds, preferred stock, collateralized securities (such as CDOs, CMOs, GNMAs) and zero-coupon securities. 

The interest rate on a debt security is largely determined by the perceived repayment ability of the borrower; higher risks of payment default almost always lead to higher interest rates to borrow capital.

Also known as "fixed-income securities." 

EQUITY SECURITY An instrument that signifies

an ownership position (called equity) in a corporation, and represents a claim on its proportional share in the corporation's assets and profits. Ownership in the company is determined by the number of shares a person owns divided by the total number of shares outstanding. For example, if a company has 1000 shares of stock outstanding and a person owns 50 of them, then he/she owns 5% of the company. Most stock also provides voting rights, which give shareholders a proportional vote in certain corporate decisions. Only a certain type of company called a corporation has stock; other types of companies such as sole proprietorships and limited partnerships do not issue stock. also called equity or stock or corporate stock.

AMORTIZATION The paying off of debt in regular

installments over a period of time.The deduction of capital expenses over a specific period of time (usually over the asset's life). More specifically, this method measures the consumption of the value of intangible assets, such as a patent or a copyright.

While amortization and depreciation are often used interchangeably, technically this is an incorrect practice because amortization refers to intangible assets and depreciation refers to tangible assets.

ACCRUALS Accounts on a balance sheet that

represent liabilities and non-cash-based assets used in accrual-based accounting. These accounts include, among many others, accounts payable, accounts receivable, goodwill, future tax liability and future interest expense.