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Statement of Cash FlowsChapter 14
14-2
External Reports
Income Income StatementStatement
Balance Balance SheetSheet
Statement of Statement of Cash FlowsCash Flows
The statement of cash flows highlights the major activities that impact cash flows and hence, affect the overall cash
balance.
14-3
Purpose of the Statement of Cash Flows
Are cash flows sufficient to
support ongoing operations?
Are cash flows sufficient to
support ongoing operations?
Can we pay debts?
Can we pay debts?
Can we pay dividends?
Can we pay dividends?
Why is there a difference
between net income and net
cash flow?
Why is there a difference
between net income and net
cash flow?
Will the company have to borrow money to make
needed investments?
Will the company have to borrow money to make
needed investments?
14-4
A Fundamental Principle
Cash Balance = Noncash Balance Sheet Accounts
This principle ensures that properly analyzing the changes in all noncash
balance sheet accounts always quantifies the cash inflows and
outflows that explain the change in the cash balance.
14-5
A Review of Basic Equations
Basic Equation for Asset Accounts
Beginning balance + Debits – Credits = Ending balance
Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts
Beginning balance – Debits + Credits = Ending balance
14-6
Statement of Cash Flows: Key Concepts
The term cash on the statement of cash flows refers broadly to both currency and cash equivalents.
Currency and Bank Accounts
Cash
Treasury Bills
Money Market Funds
Commercial Paper
Cash Equivalents
14-7
Learning Objective 1
Classify cash inflows and outflows as relating to operating, investing, or financing activities.
14-8
Organizing a Statement of Cash Flows
Operating Operating ActivitiesActivities
Revenue and expense Revenue and expense transactions that affect transactions that affect
net income. net income.
Investing Activities
Acquiring or disposing of noncurrent assets.
Financing Activities
Borrowing from and repaying principal to
creditors and transactions with stockholders.
14-9
Organizing a Statement of Cash Flows
14-10
Operating Activities: Direct or Indirect Method?
Reconstructs the income statement on a cash basis
from top to bottom
Direct Method
Accrual net income is adjusted
to a cash basis; Used by 99%
Indirect Method
Both methods result in the exact same amount of cash provided by operating activities.
14-11
The Indirect Method: A Three-Step Process Step 1
Step 2
Step 3
14-12
Step 1: Add Depreciation Charges
Accumulated Depreciation is a noncash balance sheet account and we must adjust net income for all of the changes in the noncash balance sheet accounts that
have occurred during the period.
Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts
Beginning balance – Debits + Credits = Ending balance
14-13
Step 1: Add Depreciation Charges
Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts
Beginning balance – Debits + Credits = Ending balance $300 – $70 + Credits = $500
Credits = $500 – $300 + $70Credits = $270
Account Activity for Accumulated Depreciation
Beginning balance $300
Ending balance $500
Accumulated depreciation of equipment sold
$70
14-14
Step 2: Analyze Net Changes in Noncash Balance Sheet Accounts
14-15
Step 3: Adjust for Gains and Losses
Under U.S. GAAP and IFRS rules, gains and losses must be included in the investing activities section of the
statement of cash flows.
Gains and losses must be removed from net income in
the operating activities section before they can be
shown in the investing activities section:
– Gains + Losses
14-16
Investing and Financing Activities: Gross Cash Flows
U.S. GAAP and IFRS require that the investing and financing sections of the statement of cash flows disclose
gross cash flows.
14-17
Property, Plant, and Equipment
Basic Equation for Asset Accounts
Beginning balance + Debits – Credits = Ending balance $1,000 + Debits – $100 = $1,800
Debits = $1,800 – $1,000 + $100 Debits = $900 (cash outflow)
Report $40 Report $40 cash inflow.cash inflow.
Report $900 Report $900 cash outflow.cash outflow.
Account Activity for Property, Plant, and Equipment
Beginning balance $1,000 Original cost of equipment sold
$100
Ending balance $1,800 Accumulated depreciation of equipment sold
$70
Cash proceeds from sale of equipment
$40 Gain on the sale of equipment (included in net income)
$10
14-18
Retained Earnings
Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts
Beginning balance – Debits + Credits = Ending balance $2,000 – Debits + $1,200 = $3,000
$3,200 = $3,000 + Debits Debits = $200 (cash outflow)
Report $1,200 net Report $1,200 net income in Operating income in Operating
Activities.Activities.
Report $200 Report $200 dividends paid in dividends paid in
Financing Activities.Financing Activities.
Account Activity for Retained Earnings
Beginning balance $2,000
Ending balance $3,000
Net income $1,200
14-19
Summary of Key Concepts
14-20
Summary of Key Concepts
14-21
Learning Objective 2
Prepare a statement of cash flows using the indirect method to
determine the net cash provided by operating
activities.
14-22
Apparel, Inc. Financial Statements
14-23
Apparel, Inc. Financial Statements
14-24
An Example of a Statement of Cash Flows
In addition to the financial statements provided, assume the following:
1.The company sold a store that had an original cost of $15 million and accumulated depreciation of $10 million. The cash proceeds from the sale were $8 million. The gain on the sale was $3 million.
2.The company did not issue any new bonds during the year.
3.The company did not repurchase any of its own common stock during the year.
4.The company paid a cash dividend during the year.
14-25
Operating Activities: Step 1
Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts
Beginning balance – Debits + Credits = Ending balance$561 million – $10 million + Credits = $654 million Credits = $654 million – $561 million + $10 million Credits = $103 million
The first step in computing Apparel’s net cash provided by operating activities is to add
depreciation to net income.
14-26
Operating Activities: Step 2The second step in computing Apparel’s net cash provided by
operating activities is to analyze net changes in noncash balance sheet accounts that impact net income.
14-27
Operating Activities: Step 3
The third step in computing Apparel’s net cash provided by operating activities is to adjust for
gains and losses included in net income.
14-28
Operating Activities
14-29
Investing Activities
Basic Equation for Asset Accounts
Beginning balance + Debits – Credits = Ending balance$1,394 million + Debits – $15 million = $1,517 million Debits = $1,517 million – $1,394 million + $15 million Debits = $138 million (cash outflow)
Report Report $8 million $8 million
cash inflow.cash inflow.
Report Report $138 million $138 million cash outflow.cash outflow.
14-30
Financing Activities
Basic Equation for Contra-Asset, Liability, and Stockholders’ Equity Accounts
Beginning balance – Debits + Credits = Ending balance $897 million – Debits + $140 million = $1,009 million $1,037 million = $1,009 million + Debits Debits = $28 million (cash outflow)
14-31
Statement of Cash Flows
14-32
Seeing the Big Picture
14-33
Interpreting the Statement of Cash Flows
A statement of cash flows A statement of cash flows should be evaluated in the should be evaluated in the
context of a company’s context of a company’s specific circumstances.specific circumstances.
Useful information can also be Useful information can also be derived by examining the derived by examining the
relationships among numbers.relationships among numbers.
14-34
Learning Objective 3
Compute free cash flow.
14-35
Free Cash Flows
Free Cash Flow =Net Cash Provided by Operating Activities
- Capital Expenditures
- Dividends
Free cash flow measures a company’s ability to fund its capital expenditures and dividends from
its net cash provided by operating activities.
14-36
Free Cash FlowsFree cash flow measures a company’s ability to fund its capital expenditures and dividends from
its net cash provided by operating activities.
Free Cash Flow =Net Cash Provided by Operating Activities
- Capital Expenditures
- Dividends
93$ = 259$ - 138$ - 28$
14-37
Earnings Quality
Managers generally perceive that earnings are of higher quality when the earnings: 1.are not unduly influenced by inflation, 2.are computed using conservative accounting principles and estimates, and 3.are correlated with net cash provided by operating activities.
14-38
End of Chapter 14