THE STATEMENT OF CASH FLOWS

The statement of cash flows shows the sources and uses of cash, which is a basis
for cash flow analysis for financial managers. The statement aids him/her in
answering vital questions like “where was money obtained?’’ and “where was
money put and for what purpose?” The following provides a list of more specific
questions that can be answered by the statement of cash flows and cash flow
analysis:
1. Is the company growing or just maintaining its competitive position?
2. Will the company be able to meet its financial obligations?
3. Where did the company obtain funds?
4. What use was made of net income?
5. How much of the required capital has been generated internally?
6. How was the expansion in plant and equipment financed?
7. Is the business expanding faster than it can generate funds?
8. Is the company’s dividend policy balance with its operating policy?
9. Is the company’s cash position sound and what will it have on the market price
of stock?
Cash is vital to the operation of every business. How management utilizes the flow
of cash can determine a firm’s success or failure. Financial managers must control
their company’s cash flow so that bills can be paid on time and extra dollars can be
put into the purchase of inventory and new equipment or invested to generate
additional earnings.
FASB Requirements
Management and external interested parties have always recognized the need for a
cash flow statement. Therefore, in recognition of the fact that cash flow information
is an integral part of both investment and credit decisions, the Financial Accounting
Standards Board (FASB) has issued Statement No. 95, “Statement of Cash Flows.”
This pronouncement requires that enterprises include a statement of cash flows as
part of the financial statements. A statement of cash flows reports the cash
receipts, payments, and net change in on hand resulting from the operating,
investing and financing activities of an enterprise during a given period. The
presentation reconciles beginning and ending cash balances.
Accrual Basis of Accounting
Under Generally Accepted Accounting Principles (GAAP), most companies use the
accrual basis of accounting. This method requires that revenue be recorded when
earned and that expenses be recorded when incurred. Revenue may include credit
sales that have not yet been collected in cash and expenses incurred that may not
have been paid in cash. under the accrual basis of accounting, net income will
generally not indicate the net cash flow from operating activities. To arrive at net
cash flow from operating activities, it is necessary to report revenues and expenses
on a cash basis. This is accomplished by eliminating those transactions that did not
result in a corresponding increase or decrease in cash on hand.
EXAMPLE 2.7 During 19x1,the Eastern Electric Supply Corporation earned
$2,100,000 in credit sales, of which $100,000 remained of the end of the calendar
year. Cash that was actually by the corporation in 19x1 can follows:
Credit $2,100,000
Less: Credit at year 100,OOO
----------------
Actual cash collected $2,000,000
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A statement of cash flows focuses only on transactions involving the cash receipts
and disbursements of a company.
As previously stated, the statement of cash flows classifies receipts and cash
payments into operating, investing, and financing activities.
Operating Activities
Operating activities include all transactions that are not investing or financing. They
only relate to income statement items. Thus cash from the sale of goods or
services, including the collection or sale of trade accounts and notes receivable
from customers, interest received on loans, and dividend income are to be treated
as cash from operating activities, Cash paid to acquire materials for the
manufacture of goods for resale, rental payments to landlords, payments to
employees as compensation, and interest paid to creditors are classified for
operating activities.
Investing Activities
Investing activities include cash inflows from the sale of property, plant, and
equipment used in the production of goods and services, debt instruments or equity
of other entities, and the collection of principals on loans made to other enterprises.
Cash outflows under this category may result from the purchase of plant other
productive assets, debt instruments of other entities, the making of loans to other
enterprises.
Financing Activities
The financing activities of an enterprise involve the sale of a company’s own
preferred and stock, bonds, other short- or borrowings. Cash outflows classified as
financing the repayment of short- and debt, the of treasury stock, and the payment
of cash dividends.
EXAMPLE 2.8 The basic form of the statement of cash flows for Long Beach
Corporation in Example 2.6 is illustrated below.
Long Corporation
Statement Cash Flows
For the Year Ended December 31, 19X1
(In Millions Dollars)

Cash flows from operating activities:

Net income 182
Add (deduct) to reconcile net
income to net cash flow
Depreciation 23
Increase in accounts payable 9
Increase in other liabilities 24
Increase in accounts receivable (35)
Increase in inventory (86)
------
Net cash by operating activities 117

Cash flows from investing activities:

Cash paid to purchase fixed assets (225)
Sale of marketable securities 28
-------
Net cash provided by investing activities (197)

Cash flows from financing activities:

Decrease in notes payable (36)
Issuance of long-term debt 54
Sale of common stock 78
Cash paid for dividends (40)
-----
Net cash used in financing activities 56
------
Net decrease in cash and cash equivalents (24)
Cash at the beginning of the year 51
------
Cash and cash equivalents at the end of the year 27**
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**This amount should be equal to the cash and cash equivalents balance in your
statement of financial position.