Questions the Statement of Cash Flow Answers

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Chapter 13
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Questions the Statement of Cash Flow Answers
Where did the cash come from?
What was the cash used for?
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Operating Activities...

• Include
• The cash effects of transactions that create
  revenues and expenses and
• Enter into determination of net income.

4
Investing Activities...

• Include
• Purchasing and disposing of investments and
  productive long-lived assets using cash and
• Lending money and collecting the loans.

5
Financing Activities...

• Include
• Obtaining cash from issuing debt and repaying the
  amounts borrowed and
• Obtaining cash from stockholders and paying them
  dividends.

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Operating Activities - ALERT

• Some cash flows relating to investing or
  financing activities are classified as operating
  activities. For example...
• Receipts of investment revenue (interest and
  dividends) and
• Payments of interest to lenders are classified as
  operating activities because these items are
  reported in the income statement.

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Significant Noncash Activities...

• That do not affect cash are NOT reported in the
  body of the statement of cash flows.
• Are reported
• In a separate schedule at the bottom of the
  statement of cash flows or
• In a separate note or supplementary schedule to
  the financial statements.

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Significant Noncash Activities...

• 1. Issuance of common stock to purchase assets.
• 2. Conversion of bonds into common stock.
• 3. Issuance of debt to purchase assets.
• 4. Exchanges of plant assets.

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Format of the Statement of Cash Flows

• Four parts
• operating
• investing
• financing
• noncash investing and financing activities

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Sources of Information for the Statement of Cash
Flows

• Comparative balance sheet
• Current income statement
• Additional information

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Indirect and Direct Methods

• Convert net income from an accrual basis to a
  cash basis.
• This conversion may be done by two methods
• indirect
• direct

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Indirect and Direct Methods

• Both methods arrive at the same total amount for
  Net cash. provided by operating activities.
• The methods differ in disclosing the items that
  make up the total amount.
• The choice of methods affects only the operating
  activities section the investing and financing
  activities sections are the same.

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Indirect Method

• The indirect method is used extensively in
  practice.
• Most companies favor the indirect method for the
  following reasons
• it is easier to prepare
• it focuses on the differences between net income
  and net cash flow from operating activities
• it tends to reveal less company information to
  competitors.

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Direct Method

• The FASB prefers the direct method but allows the
  use of either method.
• When the direct method is used, the net cash flow
  from operating activities as computed using the
  indirect method must also be reported in a
  separate schedule.

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Statement Of Cash Flows - Indirect Method

• The transactions of Computer Services Company for
  the year ended 1997 are used to illustrate the
  preparation of a statement of cash flows .
• Computer services Company started in January 1,
  1997, when it issued 50,000 shares of 1 par
  value common stock for 50,000 cash.
• The company rented its office space and furniture
  and performed consulting services throughout the
  first year.

16
Determine Net Cash Provided/Used By Operating
Activities

• Adjust net income for items that did not affect
  cash.
• Net income must be converted because earned
  revenues may include credit sales that have not
  been collected in cash and expenses incurred that
  may not have been paid in cash.

17
Determine Net Cash Provided/Used By Operating
Activities

• Receivables, payables, prepayments, and
  inventories must be analyzed for their effects on
  cash.

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COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31, 1997
Illustration 13-5
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Income Statement and Additional Information
Illustration 13-6

• COMPUTER SERVICES COMPANY
• Income Statement
• For the Year Ended December 31, 1997
• Revenues 85,000
• Operating expenses 40,000
• Income before income taxes 45,000
• Income tax expense 10,000
• Net income 35,000
• Additional Information
• (a) Examination of selected data indicates that a
  dividend of 15,000 was declared and paid during
  the year.
• (b) The equipment was purchased at the end of
  1997. No depreciation was taken in 1997.

20
Determine Net Cash Provided/Used By Operating
Activities

• Computer Services Company had revenues of 85,000
  in its first year of operations.
• However, CSC collected only 55,000 in cash.
  Accrual basis revenue was 85,000, cash basis
  revenue would be 55,000.
• The increase in accounts receivable of 30,000
  must be deducted from net income.
• If accounts receivable decrease, the decrease
  must be added to net income.

21
Illustration 13-12

• COMPUTER SERVICES COMPANY
• Statement of Cash Flows--Indirect Method
  (Partial)
• For the Year Ended December 31, 1997
• Cash flows from operating activities
• Net income 35,000
• Adjustments to reconcile net income to
• net cash provided by operating activities
• Increase in accounts receivable (30,000)
  

22
Determine Net Cash Provided/Used By Operating
Activities

• Accounts payable - When accounts payable increase
  during a year, operating expenses on an accrual
  basis are higher than they are on a cash basis.
• For CSC, operating expenses reported in the
  income statement were 40,000.
• Since Accounts Payable increased 4,000, 36,000
  (40,000 4,000) of the expenses were paid in
  cash.
• To convert net income to net cash provided by
  operating activities, an increase in accounts
  payable must be added to net income, a decrease
  subtracted.

23
Illustration 13-12

• COMPUTER SERVICES COMPANY
• Statement of Cash Flows--Indirect Method
  (Partial)
• For the Year Ended December 31, 1997
• Cash flows from operating activities
• Net income 35,000
• Adjustments to reconcile net income to
• net cash provided by operating activities
• Increase in accounts receivable (30,000)
• Increase in accounts payable
  4,000 (26,000)
• Net cash provided by operating activities
  9,000

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COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31, 1997
Illustration 13-5
25
Determine Net Cash Provided/Used By Investing
and Financing Activities

• Reasons for the increase of 20,000 in the
  Retained Earnings.
• Net income increased retained earnings by
  35,000. REPORTED IN THE OPERATING ACTIVITIES
  SECTION.
• The additional information indicates that a cash
  dividend of 15,000 was declared and paid.
  REPORTED IN THE FINANCING ACTIVITIES SECTION.

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Illustration 13-12

• COMPUTER SERVICES COMPANY
• Statement of Cash Flows--Indirect Method
  (Partial)
• For the Year Ended December 31, 1997
• Cash flows from operating activities
• Net income 35,000
• Adjustments to reconcile net income to
• net cash provided by operating activities
• Increase in accounts receivable (30,000)
• Increase in accounts payable
  4,000 (26,000)
• Net cash provided by operating activities
  9,000
• Cash flows from investing activities
• Purchase of equipment (10,000)
• Cash flows from financing activities
• Issuance of Common Stock 50,000
• Payment of cash dividends (15,000)
• Net cash provided by financing activities
  35,000
• Net increase in cash 34,000

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YEAR TWO
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Illustration 13-13
Second-Year Operations
COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31
29
Illustration 13-13
Second-Year Operations
COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31
1998
1997
Change
30
Illustration 13-14
Second-Year Operations
COMPUTER SERVICES COMPANY Income Statement For
the Year Ended December 31, 1998

• Revenues 507,000
• Operating expenses 261,000
• Depreciation expenses 15,000
• Loss on sale of equipment 3,000 279,000
• Income from operations 228,000
• Income tax expense 89,000
• Net income 139,000

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Illustration 13-14
Second-Year Operations

• Additional Information
• (a) In 1998 the company declared and paid a
  15,000 cash dividend.
• (b) The company obtained land through the
  issuance of 130,000 of long-term bonds.
• (c) An office building costing 160,000 was
  purchased for cash equipment costing 25,000 was
  also purchased for cash.
• (d) During 1998 the company sold equipment with a
  book value of 7,000 (cost 8,000 less
  accumulated depreciation 1,000) for 4,000 cash.

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Determine the Net Increase or Decrease in Cash

• Cash increased 22,000 (56,000-34,000)

33
Determine Net Cash Provided/Used By Operating
Activities

• Depreciation expense - During 1998 Computer
  Services Company reported depreciation expense of
  15,000.
• Depreciation and other charges that do not
  require the use of cash, such as amortization of
  intangible assets are added to net income.

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Illustration 13-16
Computer Services Company Statement of Cash
Flows (Partial)For the Year Ended December 31,
1998
Cash flows from operating activities Net Income

139,000 Adjustments to reconcile net income
to net
cash provided by operating
activities Depreciation expense
15,000
INDIRECT METHOD
35
Determine Net Cash Provided/Used By Operating
Activities

• Loss on Sale of Equipment - Computer Services
  Company reported a 3,000 loss on the sale of
  equipment (book value 7,000 less cash proceeds
  4,000).
• The loss reduced net income but did not reduce
  cash.
• The 3,000 loss is added to net income in
  determining net cash provided by operating
  activities.

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Illustration 13-16
Computer Services Company Statement of Cash
Flows (Partial)For the Year Ended December 31,
1998
Cash flows from operating activities Net Income

139,000 Adjustments to reconcile net income
to net
cash provided by operating
activities Depreciation expense
15,000 Loss on sale of equipment
3,000
INDIRECT METHOD
37
Determine Net Cash Provided/Used By Operating
Activities

• Accounts Receivable - Accounts receivable
  decreases during the period because cash receipts
  are higher than revenues reported on an accrual
  basis. The decrease of 10,000 must be added to
  net income.

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Illustration 13-13
Second-Year Operations
COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31
39
Illustration 13-16
Computer Services Company Statement of Cash
Flows (Partial)For the Year Ended December 31,
1998
Cash flows from operating activities Net Income

139,000 Adjustments to reconcile net income
to net
cash provided by operating
activities Depreciation expense
15,000 Loss on sale of equipment
3,000 Decrease in accounts receivable 10,000
INDIRECT METHOD
40
Determine Net Cash Provided/Used By Operating
Activities

• Prepaid Expenses - Prepaid expenses increase
  during a period because cash paid for expenses is
  greater than expenses reported on an accrual
  basis.
• The increase of 4,000 in prepaid expenses must
  be deducted from net income.

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Illustration 13-13
Second-Year Operations
COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31
42
Illustration 13-16
Computer Services Company Statement of Cash
Flows (Partial)For the Year Ended December 31,
1998
Cash flows from operating activities Net Income

139,000 Adjustments to reconcile net income
to net
cash provided by operating
activities Depreciation expense
15,000 Loss on sale of equipment
3,000 Decrease in accounts receivable
10,000 Increase in prepaid expenses (4,000)
INDIRECT METHOD
43
Determine Net Cash Provided/Used By Operating
Activities

• Accounts Payable - The increase of 55,000 in
  accounts payable must be added to net income.

44
Illustration 13-13
Second-Year Operations
COMPUTER SERVICES COMPANY Comparative Balance
Sheet December 31
1998
1997
Change
45
Illustration 13-16
Computer Services Company Statement of Cash
Flows (Partial)For the Year Ended December 31,
1998
Cash flows from operating activities Net Income

139,000 Adjustments to reconcile net income
to net
cash provided by operating
activities Depreciation expense
15,000 Loss on sale of equipment
3,000 Decrease in accounts receivable
10,000 Increase in prepaid expenses
(4,000) Increase in accounts payable 55,000
79,000 Net cash provided by operating 218,000
activities
INDIRECT METHOD
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Determine Net Cash Provided/Used By Operating
Activities

• Study the balance sheet to determine changes in
  noncurrent assets.
• Changes in each noncurrent account are analyzed
  using selected transaction data to determine the
  effect, if any, the changes had on cash.

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Determine Net Cash Provided/Used By Investing
and Financing Activities

• Land - Land of 130,000 was purchased through the
  issuance of long-term bonds.
• Although the exchange of bonds payable for land
  has no effect on cash, it is a significant
  noncash investing and financing activity that
  must be disclosed.

48
Determine Net Cash Provided/Used By Investing
and Financing Activities

• Building - An office building was acquired using
  cash of 160,000.
• This transaction is a cash outflow reported in
  the investing activities section.

49
Determine Net Cash Provided/Used By Investing
and Financing Activities

• Equipment - The equipment account increased
  17,000.
• The additional information provided, reveals that
  this was a net increase resulting from two
  transactions
• (1) a purchase of equipment for 25,000
• (2) sale of equipment costing 8,000 for 4,000.
  
• The purchase of equipment should be shown as a
  25,000 outflow of cash and the sale of equipment
  should be shown as a cash inflow of 4,000.

50
Determine Net Cash Provided/Used By Investing
and Financing Activities

• Bonds Payable - The bonds payable account
  increased by 130,000. The issuance of bonds for
  land is a noncash transaction reported in a
  separate schedule at the bottom of the statement
  of cash flows.

51
Determine Net Cash Provided/Used By Investing
and Financing Activities

• Retained Earnings - Retained Earnings increased
  by 124,000.
• The increase is a net of
• (1) Net income of 139,000 that increased
  Retained Earnings and
• (2) dividends of 15,000 that decreased Retained
  earnings.
• Net income is converted to net cash provided by
  operations.
• Payment of the dividend is a cash outflow that is
  reported as a financing activity.

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Illustration 13-16
Computer Services Company Statement of Cash
Flows (Partial)For the Year Ended December 31,
1998
Net cash provided by operating 218,000
activities - continued Cash flows from
investing activities Purchase of building
(160,000) Purchase of equipment
( 25,000) Sale of equipment
4,000 Net cash used by investing act.
(181,000) Cash flows from financing
activities Payment of cash dividends
15,000 Net Cash used by financing act.
( 15,000) Net Increase in cash
22,000 Cash at beginning of period
34,000 Cash at end of
period 56,000 Noncash investing and financing
act. Issuance of bonds payable to buy
land 130,000
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Free Cash Flow

• In the statement of cash flows, cash from
  operations is intended to indicate the
  cash-generating capability of the company.
• Statement of Cash flows fails to take into
  account that a company must invest in new fixed
  assets to maintain its current level of
  operations and it must maintain dividends at
  current levels to satisfy investors.

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Free Cash Flow

• Cash Provided By Operations
• Capital Expenditures
• Dividends Paid
  
• Free Cash Flow

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Assessing Liquidity, Solvency, and Profitability
Using Cash Flows

• Rather than using numbers from the income
  statement for assessment purposes, we use numbers
  from the statement of cash flows.

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Liquidity

• Liquidity is the ability of a business to meet
  its immediate obligations.
• One measure of liquidity is the current ratio.
• A disadvantage of the current ratio is that it
  uses year-end balances of current assets and
  current liabilities (may not be representative of
  a company's position during most of the year.)

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Current Cash Debt Coverage Ratio

• A ratio that partially corrects this is the
  current cash debt coverage ratio.
• Cash provided by operations
• Average current liabilities
• Since cash from operations involves the entire
  year rather than a balance at one point in time,
  it is often considered a better representation of
  liquidity on the average day.

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Solvency

• Solvency is the ability of a firm to survive over
  the long term.
• One measure of solvency is the debt to total
  assets ratio.
• A measure of solvency that uses cash figures is
  the cash debt coverage ratio.
• Cash Provided By Operations
• Average Total Liabilities
• This ratio measures a company's ability to repay
  its liabilities from cash generated from
  operations.

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Profitability

• Profitability refers to a company's ability to
  generate a reasonable return.
• Accrual-based ratios that measure profitability
  are gross profit rate, profit rate margin, and
  return on assets.
• A cash-based measure of performance is the cash
  return on sales ratio.

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Cash Return on Sales Ratio

• Indicates the company's ability to turn sales
  into dollars for the firm.
• A low cash return on sales ratio should be
  investigated because it might indicate the firm
  is recognizing sales that are not really sales -
  that is, sales it will never collect.

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Cash Return on Sales Ratio

• Cash From Operations
• Net Sales

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