Financial Reporting and Analysis – Dr.

Michael Lee

CLASS 3

STATEMENT OF CASH FLOWS

Learning Objectives

• Explain the purpose and relevance of the statement of cash flows

• Define and identify operating, investing, and financing activities
• Understand the difference between net income and cash flow from operations
• Prepare a statement of cash flows
• Prepare a summary analysis of the statement of cash flows
• Analyse a statement of cash flows

Introduction
The statement of cash flows is the most challenging of the required corporate financial statements to read
and interpret. This statement is also critically important in assessing a firm’s financial performance. Cash
flow from operating activities – one of the key figures on the statement of cash flows – has been a major
element in bankruptcies. No single reported figure on any set of financial statements can be relied on as
a predictor of future performance or as a measure of historical performance. But there are important
items that should always be assessed, and cash flow from operations, as well as related components of a
cash flow statement, are among those elements.

The statement of cash flows shows the actual cash flowing in and flowing out during an accounting period
from all the firm’s operations as well as from its other activities including from borrowings and investing.

Companies in financial difficulties can have:

• Positive net income and negative cash flow from operations
• Negative net income and positive cash flow from operations
• Erratic pattern in net income and cash flows over several years

Statement of cash flows are segregated by operating activities, investing activities and financing activities.
Adjustments made to net income in order to calculate cash flow from operations should be examined to
determine why cash flow from operations is positive or negative.

Basic Principles
Fundamental to interpreting the information presented in a statement of cash flows is an explanation of
how the statement is prepared as well as further discussion of cash flow from operations as an analytical
tool in evaluating financial performance.

The statement of cash flows is a way of showing changes in the balance sheet accounts since a balance
sheet shows amounts at the end of each accounting period.

Definitions
Cash includes cash and highly liquid short-term marketable securities also called cash equivalents (e.g.,
bills, certificates, notes, bonds, commercial paper). *Some companies will separate marketable securities
into two accounts: (1) cash and cash equivalents and (2) short –term investments. When this occurs, the
short-term investments are classified as investment activities.

Operating activities include delivering or producing goods for sale and providing services and the cash
effects of transactions and other events that enter into the determination of income.

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Investing activities include: (1) acquiring and selling or otherwise disposing of (a) securities that are not
cash equivalents and (b) productive assets that are expected to benefit the firm for long periods of time;
and (2) lending money and collecting on loans.

Financing activities include borrowing from creditors and repaying the principal and obtaining resources
from owners and providing them with a return on investment.

Operating Activities
Inflows Outflows
• Cash from sales of goods or services • Payments for purchase of inventory
• Returns on equity securities (dividends) • Payments for operating expenses (salaries,
• Returns on interest-earning assets (interest) rent etc.)
• Payments for purchases from suppliers other
than inventory
• Payments to lenders (interest)
• Payment for taxes

Investing Activities
Inflows Outflows
• Cash from sales of property, plant and • Purchases of property, plant and equipment
equipment loans (principal) to others
• Cash collections from loans (principal) to • Purchases of debt or equity securities of other
others entities*
• Cash from sales of debt or equity securities of
other entities (except securities traded as
cash equivalents)*
• Cash from sale of a business segment

Financing Activities
Inflows Outflows
• Proceeds from borrowing • Repayment of debt principal
• Proceeds from issuing the firm’s own equity • Repurchase of a firm’s own shares
securities • Payment of dividends

Total Inflows less Total Outflows = Change in cash for the accounting period

*Cash flows from purchases, sales and maturities of trading securities are classified based on the nature
and purpose for which the securities were acquired.

Indirect Method
The indirect method applies to the calculation of cash flows from operating activities only. Calculating
cash flows from investing and financing activities are the same for the indirect method and direct method.

Step 1: Classify balance sheet items by cash flow categories: cash, operating, investing and financing.

Step 2: For cash flow from operating activities, the following is used.

Inflow Outflow
Minus Asset account Plus Asset account
Plus Liability account Minus Liability account
Plus Equity account Minus Equity account

Not all of the following adjustments are used for all companies.

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Net income*
Noncash/nonoperating revenue and expense included in income:
+ Depreciation, amortisation, depletion expense for period
+ Increase in deferred tax liability
- Decrease in deferred tax liability
+ Decrease in deferred tax asset
- Increase in deferred tax asset
- Increase in investment account from equity income**
+ Decrease in investment account from equity income***
- Gain on sale of assets
+ Loss on sale of assets
Cash provided (used) by current assets and liabilities
+ Decrease in accounts receivable
- Increase in accounts receivable
+ Decrease in inventory
- Increase in inventory
+ Decrease in prepaid expenses
- Increase in prepaid expenses
+ Decrease in interest receivable
- Increase in interest receivable
+ Increase in accounts payable
- Decrease in accounts payable
+ Increase in accrued liabilities
- Decrease in accrued liabilities
+ Increase in income tax payable
- Decrease in income tax payable
+ Increase in deferred revenue
- Decrease in deferred revenue
Net cash flow from operating activities

*before extraordinary items and discontinued operations

**amount by which equity income exceeds cash dividends received
***amount by which cash dividends received exceed equity income recognised

Step 3: Calculate cash flow from investing activities.

Step 4: Calculate cash flow from financing activities.

Step 5: Calculate the change in cash.

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Direct Method
Step 2: For cash flow from operating activities, the following is used.

Sales - Increase in accounts receivable

+ Decrease in accounts receivable = Cash collections from
+ Increase in deferred revenue customers
- Decrease in deferred revenue
Cost of goods sold + Increase in inventory
- Decrease in inventory = Cash paid to
- Increase in accounts payable suppliers
+ Decrease in accounts payable
Salary expense - Increase in accrued salaries payable = Cash paid to
+ Decrease in accrued salaries payable employees
Other operating - Depreciation, amortisation, depletion expense
expenses for period = Cash paid for other
+ Increase in prepaid expenses operating expenses
- Decrease in prepaid expenses
- Increase in accrued operating expenses
+ Decrease in accrued operating expenses
Interest revenue - Increase in interest receivable = Cash revenue from
+ Decrease in interest receivable interest
Interest expense - Increase in accrued interest payable = Cash paid for interest
+ Decrease in accrued interest payable
Investment income - Increase in investment account from equity
income* = Cash revenue from
+ Decrease in investment account from equity dividends
income**
Tax expense - Increase in deferred tax liability
+ Decrease in deferred tax liability = Cash paid for taxes
- Decrease in deferred tax asset
+ Increase in deferred tax asset
- Increase in income taxes payable
+ Decrease in income taxes payable
- Decrease in prepaid tax
+ Increase in prepaid tax
Net cash flow from operating activities

*amount by which equity income recognised exceeds cash dividends received

**amount by which cash dividends received exceed equity income recognised