Topic 10

Analysis of Cash Flows

Basic Elements of the Statement of
Cash Flows
• Uses a concept of cash that includes not only
cash but also short-term, highly liquid
investments
– Referred to as the cash and cash equivalent focus
• Explains the changes in focus accounts
Basic Elements of the Statement of
Cash Flows—Continued
• Uses of the statement of cash flows
– Internal (management) users
• Determine dividend policy
• Evaluate cash generated by operations
• Review investing and financing policy
– External users
• Determine a firm’s ability to increase dividends
• Determine a firm’s ability to pay debt from operations
• Determine the percentage of cash from operations in relation
to the cash from financing
Structure of the Statement of Cash
Flows
Cash Flows from Operating Activities
Add: Cash Flows from Investing Activities
Add: Cash Flows from Financing Activities
Change in Cash

Beginning Cash Balance

Add: Change in cash
Ending Cash Balance

Supplemental disclosure: Noncash investing

and financing activities
Operating Activities
Include the cash effects of events that enter into
the determination of net income
• Cash inflows from • Cash outflows for
– Sale of goods or payments
services – For acquisitions of
– Returns on loans inventory
(interest) – To employees
– Return on equity – For taxes
securities (dividends) – For interest expenses
– For other expenses
Investing Activities
Lending and collecting money and acquiring and
selling investments and long-term assets
• Cash inflows from • Cash outflows for
– Receipts from loans – Loans to other entities
collected – Investment in debt or
– Sales of debt or equity equity securities of
securities of other other entities
corporations – Purchase of property,
– Sale of property, plant, plant, and equipment
and equipment
Financing Activities
Include cash flows relating to liability and owners’
equity
• Cash inflows from • Cash outflows for
– Sale of equity – Payment of dividends
securities – Reacquisition of
– Sale of bonds, capital stock
mortgages, notes, and – Payment of amounts
other short- and long- borrowed
term borrowings
Presentation of Cash Flows From
Operations
• Direct method
– Converts the income statement from accrual basis to
a cash basis
– Encouraged by SFAS No. 95
– Supplemental information required
• Reconciliation of net income to cash provided by operations
• Indirect method
– Adjusts net income for items that affected net income
but did not affect cash
– Supplemental information required
• Cash paid for income taxes and for interest
Exhibit 10-1—Statement of Cash
Flows: Direct Method
Exhibit 10-1—Statement of Cash
Flows: Direct Method
Exhibit 10-1—Statement of Cash
Flows: Indirect Method
Exhibit 10-1—Statement of Cash
Flows: Indirect Method
Financial Ratios and the
Statement of Cash Flows
• Traditional ratios related income statement
item(s) to a balance sheet item(s)
• Statement of cash flows became a required
statement in 1987
• Cash flow financial ratios were slowly developed
– Operating cash flow to current maturities of debt
– Operating cash flow to total debt
– Operating cash flow per share
– Operating cash flow to cash dividends
Operating Cash Flow to Current
Maturities of Debt
• Indicates a firm’s ability to meet its current
maturities of debt
• Higher ratio indicates better liquidity

Operating Cash Flow

Current Maturities of Long-Term Debt and Current Note Payable
Operating Cash Flow to Total Debt
• Indicates a firm’s ability to cover total debt with
the yearly operating cash flow
• The higher the ratio, the better the firm’s ability
to carry its total debt
• Conservative approach is to include all possible
balance sheet debt

Operating Cash Flow

Total Debt
 Operating Cash Flow per Share
• Indicates the funds flow per common share
outstanding
• Higher than earnings per share as depreciation
is not deducted

 Operating Cash  Operating Cash Flow  Preferred Dividends

 Flow per Share  =
  Diluted Weighted Average Common
Shares Outstanding
Operating Cash Flow per Share—
Continued
• A better indication of a firm’s ability to make
capital expenditure decisions and pay dividends
than is earnings per share
• Does not reflect firm’s profitability
– Firms are prohibited from reporting this on financial
statements
Operating Cash Flow to Cash
Dividends
• Indicates a firm’s ability to cover cash dividends
with the yearly operating cash flow
• Higher the ratio, the better the firm’s ability to
cover cash dividends

Operating Cash Flows

Cash Dividends
Alternative Cash Flow
• No standard definition of cash flow
• Alternative definition
– Net income plus depreciation expense
• Less useful than the net cash flow from operating activities
Procedures to Develop the
Statement of Cash Flows
• Analyze all balance sheet accounts other than
cash and cash equivalents.
Increase Decrease
Current assets Operating outflow Operating inflow
Noncurrent assets Investing outflow Investing inflow
Current liabilities Operating inflow Operating outflow
Long-term liabilities Financing inflow Financing outflow
Stockholders’ equity Financing inflow Financing outflow
Procedures to Develop the
Statement of Cash Flows
• Three techniques used to prepare the statement
of cash flows
– The visual method
• Determine change in cash and cash equivalents
• Compute the net change in all other balance sheet accounts
• Classify as operating, investing, and financing
– The T-account method
– The worksheet method
Procedures to Develop Operating
Cash Flows: Direct Approach
• Operating section describes income statement
accounts in terms of receipts or payments
• Cash receipts
– From customers
– From other operating sources
• Cash payments
– For merchandise
– To employees
– For other operating expenses
Procedures to Develop Operating
Cash Flows: Indirect Approach
• Begin with net income
• Add or deduct adjustments to change accrual
basis net income to cash basis net income
– Changes in current noncash assets
– Changes in noncash assets go in the inverse
direction of changes in cash
– Changes in current liabilities
– Changes in noncash liabilities go in the same
direction of changes in cash
Procedures to Develop Operating
Cash Flows: Indirect Approach
• Adjust net income (loss) for noncash expenses
(like depreciation expense) and noncash
revenues
• Eliminate non cash gains and losses that relate
to investing and financing activities