STATEMENT OF CASH FLOWS

Accounting ASW

Summer 2007

Overview of statement of cash flows

• Explains changes in “Cash” during the period

• “Cash” is cash plus cash equivalents - Equivalents are highly liquid short-term investments - E.g., bank accounts, certificates of deposits, treasury bills and uncashed checks • There are typically no “SCF” accounts - infer SCF amounts from income statement and balance sheet - typically prepared after the other statements - hardest statement to interpret

Uses of SCF

• Assess liquidity

• Alternate measure of performance

• Helpful in predicting free cash flows

Free Cash Flows

• Free cash flows=Cash from Operations + Cash from Investing

• Popular valuation approaches uses FCF - Firm value = net present value of future FCF

• However, net income is the best predictor of future free cash flows

Relation between NI and FCF

• In general, over the life of the firm

Total(FCF) = Total(NI)

• The only difference is timing

• Most differences between NI and FCF reverse quickly

- E.g., credit sales CFnow < NInow

CFlate r > NIlater

Classification on the SCF

• Specified by the FASB

• Follows the structure of the firm

- Operating

- Investing

- Financing

Components of the Statement of Cash Flows

Operating

Cash Inflows Cash OutflowsCollect from customers Pay suppliers

Collect interest and dividends Pay interest

Other operating receipts Other operating payments

Pay taxes

Pay employees

Investing

Cash Inflows

Sell PP&E

Sell securities owned

Receive loan repayments

Cash Outflows

Purchase PP&E

Purchase securities

Make loans

Financing

Cash Inflows

Borrow from creditors

Issue equity securities

Cash Outflows

Repay amounts borrowed

Repurchase stock

Pay dividends

Formats for SCF

• Both direct and indirect are allowed

• In both formats – investing and financing formats are the same

• list sources and uses of cash

– total operating cash flows is the same• format for getting there differs

• Direct method also lists sources and uses of cash for operating– preferred by FASB– rare in practice

• Indirect method operating section starts with net income – explains why cash from operations NI– uses changes in other accounts to explain

• When CF NI, slack is picked up by changes in other balance sheet accounts– if sales > cash receipts, Accts. Receivable s– if sales < cash receipts, Accts. Receivable s– if purchases > cash paid, Accts. Payable s– if purchases < cash paid, Accts. Payable s– if purchases > cost of goods sold, Inventory s– if purchases < cost of goods sold, Inventory s

Preparing SCF (Indirect Method)

• Start with attached worksheet with beginning and ending balances of non-cash accounts at ends & change in middle

• As you work through, note each change that you’ve accounted for

• If every change is accounted for, it must add

Preparing the Statement of Cash Flows

Changes in Assets Operating Investing Financing(1) Accounts Receivable x(-)

(2) Inventories x(-)

(3) Other Current Assets (Usually) x(-)(4) Investments in Securities1 x(-) Property, Plant & Equipment

(5) Cost2 (Purchases) x(-)

(6) Acc. Depr.2

(Current Yr’s Depr.) x(+)(7) Other Noncurrent Assets (Usually)1 x(-)

Changes in Liabilities and Shareholders’ Equity

Operating Investing Financing(8) Accounts Payable x(+)

(9) Notes Payable1 x(+)

(10) Current Portion of Long- Term Debt3 x(+)(11) Other Current Liabilities (Usually) x(+)(12) Long-Term Debt1 x(+)

(13) Deferred income Taxes x(+)

(14) Other Noncurrent Liabilities (Usually)1 x(+)(15) Contributed Capital x(+)

Changes in Liabilities and Shareholders’ Equity

Operating Investing Financing(16) Retained Earnings x(Net Inc)(+) x (Div.)(-)

(17) Treasure Stock __________ _________ x(-)

(18) Cash

1Increases and decreases are generally disclosed separately.2For sales of PP&E (or other investments), profits are subtracted from net income in the operating section and the entire proceeds is included as a source of cash in the investing section.3Generally combined with long-term debt.

Problem 4-26

Problem 4.26: Southwest Airlines Change Cash + 40 Accounts Receivable - 15 Inventories + 15 Prepayments + 17 Property, Plant and Equipment + 1,135 Accumulated Depreciation + 264 Other Noncurrent Assets + 9 Accounts Payable - 1 Other Current Liabilities + 115 Long-Term Debt + 244 Other Nonoperating Liabilities + 140 Common Stock + 97 Retained Earnings + 341 Note: Net income was $474. Southwest did not sell any Property, Plant & Equipment.

Formats for the SCFIndirect Format (most common)

Cash From Operations

Net Income

+ Depreciation

- Gain on Sale of PP&E

- Increase in Accounts Receivable

- Increase in Inventory

- Increase in Other Current Assets

+ Increase in Accounts Payable

+ Increase in Other Current Liab.

+ Increase in Def. Income Taxes

Cash From Investing

- Investments in Securities

+ Proceeds from Sales of Sec.

- Investments in PP&E

+ Proceeds from Sales of PP&E

- Invest. in Other NC Assets

+ Proceeds from Other NC Assets

Cash From Financing

+ Issuance of Notes Payable

- Repayments of Notes Payable

+ Issuance of Long-Term Debt

- Repayments of Long-Term Debt

+ Issuance of Common Stock

- Dividends Paid

- Repurchase of Common Stock

Problem 4.37: Flight Training 1/1 12/31 Chg. Cash 583 159 - 424 Accounts Receivable 4,874 6,545 1,671 Inventories 2,514 5,106 2,592 Prepayments 829 665 - 164 Property, Plant & Equipment 76,975 106,529 29,554 Less: Accumulated Depreciation - 8,843 - 17,231 - 8,388 Other (Investing) Assets 665 470 - 195 77,597 102,243 24,646 Accounts Payable 6,279 12,428 6,149 Other Current (Operating) Liabilities 12,124 12,903 779 Notes Payable 945 0 - 945 Current Portion of Long-Term Debt 7,018 60,590 53,572 Noncurrent Portion of Long-Term Debt 41,021 0 - 41,021 Other Noncurrent (Operating) Liabilities 900 0 - 900 Contributed Capital 5,508 16,351 10,843 Retained Earnings 3,802 (29) - 3,831 77,597 102,243 24,646 Note: No dividends or sales of PP&E

Sales of PP&E

• Recreate the journal entryCash Selling Price

Acc. Depr. AD on Asset

PP&E HC on Asset

Gain on Sale Plug• goal is for only selling price to appear in investing• to do that, subtract gain (add loss) in operating• show selling price as a source of investing cash• that takes care of the AD and PP&E on worksheet

• Problem 4-34, etc.

Steps for preparing the statement of cash flows (numbers based on problem 4.34): 1. Compute changes in each balance sheet account. 1/1 12/31 Chg. Cash 52 58 6 Accounts Receivable 93 106 13 Inventory 151 162 11 Land 30 30 0 Buildings and Equipment 790 830 40 Accumulated Depreciation 460 504 44 Accounts Payable 136 141 5 Interest Payable 10 8 -2 Mortgage Payable 120 109 -11 Contributed Capital 250 250 0 Retained Earnings 140 174 34 Other: Net income = 44, Dividends = 10, Depreciation Expense = 54, Sold for 5 machinery originally costing 15 with accumulated depreciation of 10 (no gain/loss) Purchased building and equipment for 55 2. Fill in the indirect format worksheet for each of the changes other than PP&E and

accumulated depreciation. Use the Balance Sheet Accounts on the Statement of Cash Flows worksheet if you don’t know where something goes. Check to make sure you have picked up each account. I have filled in the numbers for this step in italics in the SCF below. You should have blanks on the SCF for “Investments in PP&E,” “Proceeds from Sale of PP&E,” “Depreciation” and “Gain on Sale of PP&E.”

3. Recreate the PP&E journal entries for the purchase of PP&E, depreciation for the period and dispositions of PP&E: Buildings and Equipment 55 Cash 55 Depr. Exp. (generally) 54 Accumulated Depreciation 54 Cash (proceeds from sale) 5 Accumulated Depreciation (accum. deprec. on assets sold) 10 Loss on Sale of PP&E (Proceeds - BV) 0 Property, Plant and Equipment (historical cost of assets sold) 15

4. In some cases you may have to figure out some missing numbers in the journal entries. To do that, fill in any pieces you know and solve t-accounts for missing pieces. In 4-34, you knew that you sold for 5 machinery costing 15 with accumulated depreciation of 10. You could solve the t-accounts for buildings and equipment purchased.

Indirect Format (most common) Cash From Operations Net Income 44 + Depreciation + 54 - Gain on Sale of PP&E (or other investments) 0 - Increase in Accounts Receivable - 13 - Increase in Inventories - 11 - Increase in Other Current Assets 0 + Increase in Accounts Payable + 5 + Increase in Other Current Liabilities - 2 + Increase in Deferred Income Taxes 0 Net Cash From Operations 77 Cash From Investing - Investments in Securities 0 + Proceeds from Sales of Securities 0 - Investments in Property, Plant and Equipment - 55 + Proceeds from Sales of Property, Plant and Equipment + 5 - Investments in Other Noncurrent Assets 0 + Proceeds from Sales of Other Noncurrent Assets 0 Net Cash from Investing

Cash From Financing + Issuance of Notes Payable 0 - Repayments of Notes Payable 0 + Issuance of Long-Term Debt 0 - Repayments of Long-Term Debt -11 + Issuance of Common Stock 0 - Dividends Paid - 10 - Repurchase of Common Stock 0 Net Cash from Financing - 21 Net Change in Cash 6

Old Book: Green Mountain Coffee Change Cash + 74 Accounts Receivable + 2,231 Inventories - 59 Prepayments - 475 Property Plant and Equipment + 2,129 Accumulated Depreciation + 1,038 Other Noncurrent Assets + 434 Accounts Payable + 1,574 Other Current Liabilities + 560 Bonds Payable + 2,827 Common Stock - 5,878 Retained Earnings + 4,213 Note: No dividends, sold equipment for 538 costing 2,468, with accumulated depreciation of 1,930. Purchased equipment for 4,597. Recorded depreciation of 2,968.

Direct Format (rare)

• Financing and investing sections are the same as in the indirect method

• The operating section is stated in terms of sources and uses of cash

Cash From Operations

Cash Inflows

+ Collections from Customers

+ Interest and Dividends Received

+ Other Operating Receipts

Cash Outflows

- Payments to Suppliers

- Payments to Employees

- Interest Paid

- Taxes Paid

- Other Operating Cash Payments

Indirect Format Worksheet (spare) Cash From Operations Net Income + Depreciation - Gain on Sale of PP&E - Increase in Accounts Receivable - Increase in Inventory - Increase in Other Current Assets + Increase in Accounts Payable + Increase in Other Current Liab. + Increase in Def. Income Taxes Net Cash From Operations Cash From Investing - Investments in Securities + Proceeds from Sales of Sec. - Investments in PP&E + Proceeds from Sales of PP&E - Invest. in Other NC Assets + Proceeds from Other NC Assets Net Cash from Investing Cash From Financing + Issuance of Notes Payable - Repayments of Notes Payable + Issuance of Long-Term Debt - Repayments of Long-Term Debt + Issuance of Common Stock - Dividends Paid - Repurchase of Common Stock Net Cash from Financing Net Change in Cash