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lectureweek4.docxCash Flows
Introduction
The Statement of Cash Flows is the third basic financial statement that is presented with the Balance Sheet and the Income Statement on a periodic basis. By reviewing the changes in cash due to operations, investing activities, and financing activities, the analyst can better ascertain how cash was generated and spent.
The Statement of Cash Flows
The statement of cash flows was developed in the 1970s and 1980s as a reaction to the need for management to reconcile net income to available cash. Many managers questioned how a company could report a profit, but have no money, or report a loss and still have cash available; the statement of cash flows was developed to explain how the income statement related to the available cash. The statement of cash flows can help managers and business owners to understand the sources and uses of cash, and predict future cash requirements so that needs may be met.
The cash flow statement focuses attention on a firm's ability to generate cash internally, its management of current assets and current liabilities, and the details of its investments and its external financing (Libby, Libby, & Short, 2004). It is designed to help both managers and analysts answer important cash-related questions such as these:
Will the company have enough cash to pay its short-term debts to suppliers and other creditors without additional borrowing?
Is the company adequately managing its accounts receivable and inventory?
Has the company made necessary investments in new productive capacity?
Did the company generate enough cash flow internally to finance necessary investment, or did it rely on external financing?
Is the company changing the makeup of its external financing?
These questions and others can be answered through the preparation and examination of the statement of cash flows.
Operating, Investing, and Financing Activities
The statement of cash flows has three main sections: (a) cash flows from operating activities, which are related to earning income from normal, recurring operations; (b) cash flows from investing activities, which are related to the acquisition and sale of productive assets; and (c) cash flows from financing activities, which are related to external financing of the enterprise. The net cash inflow or outflow for the year is the same amount as the increase or decrease in cash and cash equivalents for the year on the balance sheet. Cash equivalents are highly liquid investments with original maturities of less than three months. The operating activities section of the statement of cash flows can be prepared using either the direct or indirect method; the investing and financing activities sections are always prepared directly.
Direct Method of Determining Cash Flows from Operating Activities
The direct method for reporting cash flows from operating activities separates all of the operating transactions that result in either a debit or credit into categories of cash inflows and cash outflows. The most common inflows are cash received from customers, and interest and dividends received on investments. The most common outflows are cash paid for the purchase of services and goods for resale, salaries and wages, income taxes, and interest on liabilities. The cash flows from operating activities section of the statement of cash flows is prepared by adjusting each item on the income statement from an accrual basis to a cash basis.
Indirect Method of Determining Cash Flows from Operating Activities
The indirect method for reporting cash flows from operating activities involves a conversion of net income to net cash flow from operating activities. To convert net income to net cash flows from operating activities, the following steps are used:
1. Start with net income for the period, found on the income statement.
2. Adjust net income for non-cash expenses (typically depreciation and amortization). Since depreciation and amortization expenses decrease net income, but do not use cash, they are added back to net income in the conversion.
3. Add back losses or subtract out gains that resulted from investing activities. Gains and losses will be included in the investing activities section of the statement of cash flows, and are factored out of the operating activities section.
4. Adjust for changes in each of the individual current assets (other than cash and short-term investments), which reflect differences in the timing of accrual basis net income and cash flows. All increases in the identified current assets are included in the conversion by decreasing cash flows, and all decreases in the identified current assets are reflected by increasing cash flows.
5. Adjust for changes in each of the current liabilities (other than short-term debt to financial institutions and current maturities of long-term debt, which relate to financing), which reflect differences in the timing of accrual basis net income and cash flows. All increases in the identified current liabilities are included in the conversion by increasing cash flows, and all decreases in the identified current liabilities are reflected by decreasing cash flows.
6. The sum of the net income, depreciation and amortization adjustment, gain and loss adjustment, adjustments for changes in current assets, and adjustments for changes in current liabilities, will result in the cash flows from operating activities for the period.
Financial Accounting Standards Board (FASB) Statement No. 95 requires that when the indirect method is used, additional disclosures must be made, such as the interest and income taxes paid by the company, so that the user of the financial statements may approximate the direct method of determining cash flows from operating activities (Kieso, Weygandt, & Warfield, 2004).
Cash Flows from Investing Activities
Investing activities reported on the cash flow statement include cash payments to acquire fixed assets and short- and long-term investments, and cash proceeds from the sale of fixed assets and short- and long-term investments.
Cash Flows from Financing Activities
Cash inflows from financing activities include cash proceeds from issuance of short- and long-term debt and common stock. Cash outflows include cash principal payments on short- and long-term debt; cash paid for the repurchase of the company's stock, and cash dividend payments. Cash payments associated with interest are a cash flow from operating activities.
Supplemental Disclosures
Outside of the basic format of the statement, a company is also required to disclose the following:
Cash paid for taxes
Cash paid for interest
A reconciliation of net income to cash provided/used by operations if the direct method is used for operating activities
A schedule of non-cash investing and financing activities
The supplemental disclosures on the statement of cash flows are considered important items for the user of the financial statements, as they will indicate major expenditures that might not otherwise be exposed.
Analysis of the Statement of Cash Flows
The statement of cash flows provides insight into where cash comes from and how a firm spends it. Typically, investors and creditors prefer to see that a company is generating much of its cash from operating activities. Cash outflows from investing activities indicate that the company is investing in long-term assets, which may indicate growth. Cash inflows from financing activities mean that the firm is raising capital through borrowing or selling stock.
Quite often, management cannot directly control cash from operations since sales and collections rely upon customers. However, the investing and financing activities represent active management decisions to purchase or sell assets, enter into long-term debt, sell or purchase the company's stock, or pay cash dividends. The statement of cash flows can indicate management's intentions through a careful examination of the cash flows from investing and financing activities sections.
In addition to reviewing the actual statement of cash flows, the accountant or analyst should calculate cash flow ratios to get a better picture of how an organization is managing its cash. The statement of cash flows, combined with the other financial statements and a detailed ratio analysis, can lead the user to a better understanding of the financial health of the firm, as well as its goals and objectives.
Analysis of Cash Flow Ratios
Cash flow ratios are highly scrutinized by present and potential creditors. The statement of cash flows, in conjunction with ratio analysis, can indicate whether a borrower will be able to repay funds if borrowed.
Free Cash Flow
Free cash flow (Cash flow from operating activities - Capital expenditures - Cash dividends) measures the cash remaining from operations after the company makes investments in new assets and pays out the expected dividends to stockholders (Kimmel, Weygandt, & Kieso, 2009). Free cash flow gives the analyst a better idea of how much cash truly is available from cash flows from operations, looking at the statement of cash flows alone.
Quality of Income Ratio
Quality of income ratio (Cash flow from operating activities / Net income) measures the portion of income that was generated in cash. A higher quality of income ratio indicates greater ability to finance operating and other cash needs from operating cash inflows. A higher ratio also indicates that it is less likely that the company is using aggressive revenue recognition policies to increase net income.
Capital Acquisition Ratio
The capital acquisition ratio (Cash flow from operating activities / Cash paid for property, plant, and equipment) reflects the portion of purchases of property, plant, and equipment financed from operating activities without the need for outside debt or equity financing or the sale of other investments or fixed assets. A high ratio benefits the company because it provides the company with opportunities for strategic acquisitions (Libby et al., 2004).
Conclusion
The statement of cash flows is important for all stakeholders: management, employees, creditors, and stockholders. Without sufficient cash, a company would cease to exist. While viewing only cash transactions ignores accrual accounting, it also eliminates the smoothing of earnings accomplished by the careful selection of certain accounting methods.
References
Kieso, D., Weygandt, J., & Warfield, T. (2004). Intermediate accounting (11th ed.). Hoboken, NJ: John Wiley & Sons.
Kimmel, P., Weygandt, J., & Kieso, D. (2009). Accounting: Tools for business decision making (3rd ed.). Hoboken, NJ: John Wiley & Sons, Inc.
Libby, R., Libby, P., & Short, D. (2004). Financial accounting (4th ed.). Boston, MA: McGraw-Hill/Irwin.
