statement of cash flows

Statement of Cash Flows

Revsine/Collins/Johnson: Chapter 17

2RCJ: Chapter 17 © 2005

Learning objectives

1. The major sources and uses of cash—operating, investing, and financing.

2. Why accrual net income and operating cash flows differ, and the factors that explain this difference.

3. The difference between the direct and indirect methods of determining cash flow from operations.

4. How to prepare a statement of cash flows from comparative balance sheet data, an income statement, and other information.


Learning objectivesConcluded

5. Why changes in balance sheet accounts over a year may not reconcile to the corresponding changes included in the statement of cash flows.

6. What “cash burn rates” are and how they can be used to evaluate the financial viability of start-up companies.


Why cash flows are important

Accrual earnings may not always provide a reliable measure of enterprise performance and health.

Accrual accounting relies on subjective judgments that may introduce measurement error and uncertainty into reported earnings.

One-time write-offs and restructuring charges can reduce the quality of reported earnings.

Management can readily manipulate accrual income.

For these reasons, analysts scrutinize a firm’s cash flows—not just its accrual earnings—to evaluate performance and creditworthiness.


Statement format

Result from events or transactions that enter into the determination of net income; i.e., the cash-based revenues and expenses of a company.

Result from the purchase or sale of productive assets like plant and equipment, marketable securities, and from acquisitions and divestitures.

Result when a company sells its own stocks or bonds, pays dividends or buys back its own shares, or borrows money and repays the amounts borrowed.

Changes in cash

Operating cash flows

Investingcash flows

Financing cash flows


Statement format:Direct approach

Measures the net cash-based revenues and expenses of a company


Statement format:Direct approach continued


Statement format:Cash flows and accruals at ABM

$110.919 $65.796Cash from operations


Statement format:Reconciling cash flows and net income


Statement format:Indirect approach

Operating cash flows

Accrual net income

Items included in accrual net income

but did not affect cash in the period

Items excluded from accrual net income

but did affect operating cash in the period

Non-cash revenues and gains

Non-cash expenses and losses

Cash inflows received but not recognized as earned

Cash outflows paid but not recognized for accrual purposes

-

+

+

-


Statement format:Special disclosure rules

SFAS No. 95 allows a choice between the direct and indirect approach for the cash flow statement.

Firms using the direct approach are also required to provide a reconciliation between accrual earnings and operating cash flow, and to separately disclose income taxes paid.

Firms using the indirect approach are required to separately disclose interest paid and income taxes paid.


Preparing the cash flow statement:Overview

The purpose of the cash flow statement is to explain the underlying causes for the change in the cash balance.

A three-step process:

1. Identify the journal entry that led to the reported change in each non-cash balance sheet account.

2. Determine the net cash flow effect of the journal entry.

3. Compare the financial statement effect of the entry (Step 1) with its cash flow effect (Step 2) to determine what cash flow statement treatment is needed .Changes in cash

Operating

Investing

Financing


Preparing the cash flow statement:Burris Products Illustration


Preparing the cash flow statement:Burris Products solution

The starting point for computing cash from operations

Why the cash balance changed.


Preparing the cash flow statement:Burris Products—depreciation

Step 1: The journal entry that generated the account change was:

Step 2: Neither of these two accounts involve cash.

Step 3: Because depreciation expense was included in the

determination of net income but does not represent a cash

outflow, the expense must be added back to net income.


Preparing the cash flow statement:Burris Products—gain on equipment sale

Step 1: The journal entry was:

Step 2: The sale resulted in a cash inflow of $57,000.

Step 3: The recognized accrual gain ($17,000) does not correspond

to the cash inflow ($57,000). The gain is removed from

income, and the cash inflow is shown as an investing activity.


Preparing the cash flow statement:Burris Products—amortization of bond discount

Step 1: The journal entry to record interest expense was:

Step 2: The cash outflow as only $40,000.

Step 3: Because interest expense ($44,000) exceeds the cash

outflow ($40,000), the $4,000 difference is added back to

net income.


Preparing the cash flow statement:Burris Products—deferred income taxes

Step 1: The journal entry to record tax expense was:

Step 2: The cash outflow for taxes was only $96,375.

Step 3: Because the income statement expense is larger than the

cash outflow, the $6,000 difference must be added in the

operating activities section of the cash flow statement.


Preparing the cash flow statement:Burris Products—accounts receivable

Step 1: The two journal entries associated with the account were:

Step 2: The amount of cash collections ($3,039,000) exceeded the

amount of accrual revenues included in income ($3,030,000).

Step 3: The $9,000 excess of cash collections over accrual revenue is added back to net income to obtain cash from operations.


Preparing the cash flow statement:Burris Products—customer advance deposits

Step 1: The journal entry for this account was:

Step 2: There was no corresponding cash flow effect.

Step 3: Because revenues exceed 2005 cash inflows by $11,000,

this amount must be deducted in the operating section of

cash flow statement.


Preparing the cash flow statement:Burris Products—inventories

Step 1: The journal entries associated with this account were:

Step 2: The cost-of-goods-sold deduction from net income ($4,526,625)

is $12,000 lower than the cash outflow to buy inventory.

Step 3: Because net income understates cash flow to buy inventory, $12,000 must be deducted in the computation of operating

cash flow.


Preparing the cash flow statement:Burris Products—accounts payable

Step 1: The inventory adjustment was computed under the

assumption that all inventory was purchased for cash. We

now relax that assumption, and note that accounts payable

increased by $3,000 during the year.

Step 2: This accounts payable increase means that $3,000 of the

$12,000 inventory increase was not paid for in cash.

Step 3: Therefore, $3,000 is added to net income in the cash flow statement.


Preparing the cash flow statement:Operating cash flow summary


Preparing the cash flow statement:Burris Products—land

Step 1: The journal entry to reflect the increase in land was:

Step 2: This transaction represents an $86,000 cash outflow.

Step 3: The cash outflow is categorized as an investment outflow.


Preparing the cash flow statement:Burris Products—Buildings and equipment

Step 1: The changes in this account are summarized by :

Step 2: The transaction represents a $261,000 cash outflow.

Step 3: The outflow is again categorized as an investment outflow.


Preparing the cash flow statement:Burris Products—stock sale and dividend paid

Step 1: The journal entries were:

Step 2: The cash effects involve a $50,000 inflow and a $90,000

dividend outflow.

Step 3: Both the cash inflow and cash outflow are shown as financing

activities.


Reconciling between statements:Some complexities


Reconciling between statements:Source of complexities

There are at least four reasons why changes in working capital accounts (like inventory) and fixed assets don’t correspond to the changes shown on the cash flow statement:

1. Asset write-offs due to impairment, restructuring or retirement.

2. Translation adjustments on assets and liabilities held by foreign subsidiaries.

3. Acquisition and divestitures of other companies.

4. Simultaneous investing and financing activities not directly affecting cash.


Reconciling between statements:Inventories—write-offs due to restructuring


Reconciling between statements:Inventories—other complexities

Translation adjustments

Acquisitions and divestitures

Balance sheetinventory change

Cash flowsinventory change

Balance sheetinventory change

Cash flowsinventory change

• Computed using BOP and EOP foreign exchange rates.

• Computed by comparing purchases with cost of goods sold.

• Translated amounts are used for foreign subsidiaries.

• Includes the effects of acquisitions and divestitures.

• Includes cash flows from business segments owned at both the start and end of period.


Reconciling between statements:Plant and equipment—retirements

The journal entry to record a retirement is:

It is often not possible for statement readers to determine the exact dollar amount of retirements.


Reconciling between statements:Plant and equipment—other complexities

Foreign currency translation adjustments:

Changes in the balance sheet accounts that are due to foreign currency exchange rate fluctuations are not reflected in the cash flow statement.

Acquisitions and divestitures:

Changes in the balance sheet accounts that arise from acquisitions are often shown on a line separate from “Capital expenditures”.


Reconciling between statements:Simultaneous non-cash investing & financing

Some investing and financing activities occur simultaneously as part of a single transaction:

Buy a building and borrow the full amount as a mortgage.

Acquire an asset by entering into a capital lease.

Issue stock for non-cash assets as part of a business combination.

SFAS No. 95 requires firms to disclose these non-cash simultaneous investing and financing activities.


Reconciling between statements:Simultaneous non-cash investing & financing


Cash burn rate

The ability to generate positive operating cash flow is critical to the survival and success of any company.

This is particularly true for start-up companies: Cash is essential for establishing the business and for growth. Investment outlays are often large. Operating cash flows are negative.

Cash burn rate is a popular metric for assessing how quickly a start-up firm will consume its cash reserves:

Cash burn rate =

Cash used for operations

Cash used for capital expenditures or acquisitions

# of months covered by cash flow statement

+


Cash burn rate:Amazon.com illustration

Cash burn rate:

Months to burnout:

= - ($119.782 + $50.321 +$6.198)/12 months = -$14.692 per month

= $996.585/14.692 = 67.8 months


Cash burn rate:Selected companies


Summary

The statement of cash flows helps readers gauge the firm’s ability to generate sufficient cash to pay for operating expenses, capital improvements, and currently maturing obligations.

Firms that generate consistently strong positive cash flows from operations are considered better credit risks and benefit from a lower cost of capital.

The two alternative methods for presenting the operating section of a cash flow statement are the direct approach and the indirect approach.

Most firms use the indirect approach.


Summary concluded

Changes in non-cash balance sheet accounts may not correspond to the adjustments shown on the cash flow statement because of:

Asset write-offs due to impairment, restructuring, or retirement Translation adjustments on assets and liabilities held by foreign

subsidiaries. Acquisitions and divestitures of other companies. Simultaneous investing and financing activities.

Cash burn rates can be helpful in evaluating the financial viability of start-up companies.

statement of cash flows

Documents

cash flow statement

income statement

reconciling cash flows

gainsnoncash expenses

firms cash flowsnot

periodnoncash revenues

net cashbased revenues

cash burn rates