Cash Flow Statement - Introduction

A cash flow statement is important to your business because it can be used to

assess the timing, amount and predictability of future cash flows and it can be
the basis for budgeting.

A cash flow statement can answer the questions,

“Where did the money come from?” and “Where did
it go?”

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Cash Flow Statement

What is a Cash Flow Statement ?

For your business, the cash flow statement may be the most important
financial statement you prepare. It traces the flow of funds (or working
capital) into and out of your business during an accounting period. For a
small business, a cash flow statement should probably be prepared as
frequently as possible. This means either monthly or quarterly.

An annual statement is a must for any

business.

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Cash Flow Statement

Purpose of Cash Flow Statement

The cash flow statement’s primary purpose is to provide information
regarding a company’s cash receipts and cash payments. The statement
complements the income statement and balance sheet.

It is important to note cash flow is not the same as net income.

Cash flow is the movement of money into and out of your company,
and it can be affected by several noncash transactions.

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History of Cash Flow Statement

Historical View
The cash flow statement became a requirement for publicly traded
companies in 1987. There are various rules governing how information is
reported on cash flow statements, as determined by generally accepted
accounting principles (GAAP).
While your business may not be a public company, a
cash flow statement is still important to measure and
track the flow of cash into and out of your business

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An Overview

The cash flow statement explains the change during the period in cash and
cash equivalents. Cash includes currency on hand and demand deposits.
Cash equivalents are short-term, highly liquid investments that are readily
convertible to cash.
Statement No. 95 requires that
cash receipts and payments be
classified as operating, investing
and financing activities.

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An Overview

The cash flow statement will summarize the cash flows so that net cash
provided or used by each of the three types of activities is reported.
Beginning and ending cash must be reconciled based on the net effect of
these activities.

Here is an example of what a cash flow statement might look like.

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 Operating Activities

Indirect OR direct
xx
xx

Net cash provided by operating Activities xx

+
Investing Activities xx
xx A supplement schedule
of non-cash investing
Net cash provided by Investing Activities xx
+ and financing activities
Financing Activities xx xx
xx
xx
Net cash provided by Financing Activities xx
xx
+ Cash at the Beginning of the period xx

Cash at the End of the period xx

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Component of Cash Flow

1 Operating Activities
The statement provides information about the cash generated from a
company’s daily operating activities. Operating activities are those which
produce either revenue or are the direct cost of producing a product or
service.

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Component of Cash Flow

1 Operating Activities
Operating activities which generate cash inflows include customer
collections from sales of their primary products or services, receipts of
interest and dividends, and other operating cash receipts.

Operating activities which create cash outflows include payments to

suppliers, payments to employees, interest payments, payment of income
taxes and other operating cash payments.

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Component of Cash Flow

2 Investing Activities
Investing activities include buying and selling noncurrent assets which
will be used to generate revenues over a long period of time; or buying
and selling securities, lending money and receiving loan payments would
also be considered investing activities.

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Component of Cash Flow

3 Financing Activities
Financing activities include borrowing and repaying money, issuing stock
(equity) and paying dividends.

For example, if you borrow funds to purchase equipment

or pay off a loan, the cash flow statement will enable you
to determine how much cash was either generated or used
as a result of those transactions.

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Component of Cash Flow

Income Flows and Cash Flows

The income statement and balance sheet are based on accrual accounting
which was developed based on the principle of matching. The matching
principle states that revenues generated and the expenses incurred to generate
those revenues should be reported in the same income statement.

This emphasizes the cause-and-effect association between revenue and

expense.

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Component of Cash Flow

Income Flows and Cash Flows

Many revenues and expenses result from accruals and allocations that do not
affect cash. A company can operate at a profit and continually be short of
cash. It can also generate huge inflows of cash from operations and still
report a loss.

The statement of cash flows can explain how these situations might occur.
Answers to these questions cannot be found in the other financial statements.

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Component of Cash Flow

Income Flows and Cash Flows

There are two types of items that cause differences between income flows
and outflows: noncash income or expense and nonoperating income or
expense.
An example of a noncash item on the income statement would be
• Depreciation or amortization
• A gain on the sale of an asset.
These transactions must be reported on a cash flow statement in order to
properly determine the true effect of conducting business on cash.

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Constructing the statement
Information used to
prepare a cash flow
statement is taken from
the income statement
for the current year.

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Constructing the statement

Information used to prepare a cash

flow statement is taken from
balance sheets for the past two
years.

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Constructing the statement

The cash flow statement follows an activity format and is divided into three
sections: operating, investing and financing activities. Generally, the
operating activities are reported first, followed by the investing and finally,
the financing activities.

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Page 19
Constructing the statement

Two methods of calculating and reporting the net cash flow from
operating activities. Both methods result in identical figures for net cash
flow from operating activities because the underlying accounting concepts
are the same.

1. The Direct method reports 2. The Indirect method reconciles net

gross cash inflows and income with net cash flow from
gross outflows from operating activities by adjusting net
operating activities. income for deferrals, accruals, and
items that effect investing and
financing cash flows.
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Constructing the statement

In-Direct Method

The second method used to calculate the Cash Flows from Operating
Activities is referred to as the Indirect Method. Using the Indirect Method,
cash flows from Operating Activities are reported by adjusting net income
for revenues, expenses, gains, and losses that appear on the income
statement but do not influence cash.

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Constructing the statement

We will take net income and make adjustments for three types of items, which
are:
1. Eliminate non-cash items (Depreciation)
2. Subtract investing and financing activity events (Gain and losses)
3. Add back the effect of any operating activities that were not included
on the income statement but did have a cash effect and subtract the
effect of any events that are included in the income statement, but did
not have a cash effect. This includes the adjustments that must be made
to Receivables, payables and inventory and similar items.

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Constructing the statement

Steps of preparing operating activities under indirect method

1. Add all depreciation and amortization expenses back to net income
2. Add all losses on the income statement back to net income
3. Subtract all gains on the income statement from net income
4. Add and subtract the changes in balance sheet accounts that are related
to operating activities
5. In addition to the above adjustments, the amounts for income taxes
paid and interest paid need to be disclosed in a supplemental schedule
under indirect method.

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Constructing the statement
Net Income “Accrual Base”
In-Direct Method +/- Non – Cash Items
Reconciliation Method + Depreciation and Amortization of Assets
- Amortization of Premium and + Discount
+ Losses and - Gains

+/- Change in Working Capital Current Liabilities

Current Assets + Decrease In Assets + Increase In Liabilities
- Increase
Increase In In Assets - Decrease In Liabilities
Assets Decrease In
Decrease In Increase In
Liabilities
Assets Liabilities
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Page 25
Page 26
Constructing the statement
The net income for Hudson Co. was $3 million for the years ended Dec
31,2005. Additional information is as follows:
Depreciation on fixed assets $1,500,000
Gain from the cash sale of land 200,000
Increase in accounts payable 300,000
Dividends paid on preferred stick 400,000

The net cash provided by operating activities in the statement of cash

flows for the year ended Dec 31,2005 should be:
o $4,200,000 o $4,500,000 o $4,600,000 o $4,800,000

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Constructing the statement
The net cash provided by operating activities in the statement of cash
flows for the year ended Dec 31,2005 should be:
o $4,200,000 o $4,500,000 o $4,600,000 o $4,800,000

Amortization (as well as depreciation) is always added back to net

income in the Indirect Method. = 4800000

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Constructing the statement
Lino Co. has provided the following 2005 current account balances for the
preparation of the annual statement of cash flow:
Jan 1 Dec 31
Accounts receivable $23,000 $29,000
Allowance for doubtful accounts 800 1,000
Prepaid rent expenses 12,400 8,200
Accounts payable 19,400 22,400
Lino’s 005 net income is $150,000. Net cash provided by operating
activities in the statement of cash flow should be.
o $151,400 o $151,000 o $148,600 o $145,400

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Constructing the statement
Net cash provided by operating activities in the statement of cash
flow should be.

o $151,400 o $151,000 o $148,600 o $145,400

Net income is $150,000 and the adjustments are: 1) minus $6,000 for the decrease
in accounts receivable; 2) plus $200 for the increase in the allowance for doubtful
debts (this operates as a liability account); 3) plus $4,200 for the decrease in prepaid
rent expense; 4) plus $3,000 for the increase in accounts payable. This gives us an
answer of $151,400.

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Constructing the statement

The cash flow statement follows an activity format and is divided into three
sections: operating, investing and financing activities. Generally, the
operating activities are reported first, followed by the investing and finally,
the financing activities.

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Constructing the statement

Calculation of Investing Activities

Investing activities are the changes to the cash position created by the buying
or selling of non-current assets. This includes selling and replacing
equipment that wears out or acquiring a new building or land to facilitate
growth in a company.
It can also include the purchase or sale of
stocks, bonds and securities. Lending
money and receiving loan payments are also
considered investing activities.

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Constructing the statement

Calculation of Investing Activities

When calculating the cash inflows or outflows from investing activities, it is
important that you remember we are only interested in the amount of cash
involved (received/Paid) in the transaction.

It is important to note that Information

regarding the gain or loss on the transaction or the
book value of the item bought or sold is not the
amount that we are interested in.
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Constructing the statement

Knox Co. sold a fixed assets that had an original cost of $20,000 and
accumulated depreciation of $12,000 at the time of the sale. Knox realized a
gain of $5,000 on the sale.
Although the amount of cash
received from the sale is not ($20,000 Cost - $12,000 Accumulated Depreciation).
provided in the information,
we can calculate this Since the asset was sold at $5,000 gain
This $13,000 is the amount that is presented on the
SCF. The $5,000 gain will be an adjustment in the
operating section through elimination
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Constructing the statement

Knox Co. sold a fixed assets that had an original cost of $20,000 and
accumulated depreciation of $12,000 at the time of the sale. Knox realized a
gain of $5,000 on the sale.
et Sale Price $13,000
Although the amount of cash
Asset book value $8,000
received from the sale is not
provided in the information,
we can calculate this Gain on Sale $5,000
This $13,000 is the amount that is presented on the
SCF. The $5,000 gain will be an adjustment in the
operating section through elimination
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Constructing the statement

It is important to note that In reporting investing and financing

activities, we should not net together cash paid and cash received
amounts, even if they are for the same item. This means that the SCF
should have separate lines for “Cash paid to purchase equipment” and
“ Cash received from the sale of equipment”

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Constructing the statement
Karr Co. reported net income of $300,000 for 2005. Changes occurred
in several balance sheet accounts as follows:
Equipment $25,000 Increase
Accumulated Depreciation 40,000 increase
Notes Payable 30,000 Increase
Additional information:
• During 2005, Karr sold equipment costing $25,000, with
accumulated depreciation of $12,000 for a gain of $5,000
• In December 2005, Karr purchased equipment costing $50,000
with $20,000 in cash and a 12% note payable of $30,000
• Depreciation expense for the year was $52,000
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Constructing the statement
In Karr’s 2005 statement of Cash
flows, net cash provided by
operating activities is:

o $340,000 o 347,000

o 352,000 o 357,000

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Constructing the statement
In Karr’s 2005 statement of Cash flows, net cash provided by
operating activities is:
o $340,000 o 347,000 o 357,000 o 352,000
Net income was $300,000. The change in the equipment account is an investing
activity and not relevant to operating activities by itself. we need depreciation
expense, not accumulated depreciation. Because of disposals, the change in
accumulated depreciation may not be equal to the depreciation expense. In the
additional information, we find out that equipment was sold for a $5,000 gain. This
gain must be subtracted from net income.The last item tells us that depreciation
expense was $52,000, and this is the amount that we need add back to net income.
Adding it all together we get $347,000.

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Constructing the statement
In Karr’s 2005 statement of cash
flows, net cash used in investing
activities is

o $2,000 o $12,000

o $18,000 o $20,000

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Constructing the statement
In Karr’s 2005 statement of cash flows, net cash used in investing
activities is
o $2,000 o $12,000 o $20,000 o $18,000

The cash received from the sale is $18,000. We know this because the original cost
was $25,000 and the accumulated depreciation was $12,000. This means that the
book value at the time of the sale was $13,000. If it was sold for a gain of $5,000,
that means that the cash received was $18,000 ($13,000 + $5,000). For the
purchase, the amount of cash paid was $20,000. In total the amount of cash used
was $2,000.

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Constructing the statement
Alp Co. had the following activities during 2005:
• Acquired 2,000 shares of the common stock of Maybel, Inc.
(classified as available for sale) for $26,000
• Sold common stock of rate motors (classified as available for
sale) for $35,000 when the carrying value was $33,000
• Acquired a $50,000, 4-years certificate of deposit from a bank.
(during the year, interest of $3,750 was paid to Alp.)
• Collected dividends of $1,200 on stock investments
In Alp’s 2005 statement of cash flow, net cash used in investing
activities is o $37,250 o $38,050 o $39,800 o $41,000

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Constructing the statement
In Alp’s 2005 statement of cash flow, net cash used in investing
activities is
o $37,250 o $38,050 o $39,800 o $41,000

The first item is an investing activity and a cash outflow of $26,000. The second
item is also an investing activity and it generated a cash inflow of $35,000 (we do
not care about the carrying value, gain or loss in the investing section, just the
cash received). The third item is also investing, but only the $50,000 relating to
the purchase of the CD. The interest is an operating activity. The fourth item is an
operating activity. In total, the investing cash flows were an outflow of $41,000.

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Constructing the statement

Calculation of Financing Activities

Financing activities on a cash flow statement reflect borrowing money and
repaying money, issuing stock, and paying dividends. Again, we are
interested only in the amount of cash in the transaction.

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Constructing the statement

The financing activities

section of the cash flow
statement can be reduced to
the following formula:

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Constructing the statement

As you can see, this section of

the cash flow statement is
registering inflows of cash from
loans received and loans
repaid, and other cash inflows
from outsiders and owners. If
you have paid dividends or
taken money from the
business, it should be reported
here

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Constructing the statement
The following information was taken from the accounting records of
Johnson corporation for the year ended December 31, 2017:
Proceeds from issuance of preferred stock $8,000,000
Dividends paid on preferred stock 800,000
Bonds payable converted to common stock 4,000,000
Payment for purchase of machinery 1,000,000
Proceeds from sale of plant building 2,400,000
2% Stock dividends on common stock 600,000
Gain on sale of plant building 400,000
The net cash flows from investing and financing activities that
should be presented, respectively
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Constructing the statement

o $1,400,000 and 7,200,000

o $1,400,000 and 7,800,000

o $1,800,000 and 7,800,000

o $1,800,000 and 7,200,000

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Constructing the statement

o $1,400,000 and 7,200,000 The investing activities are: 1) payment for the
purchase of machinery (−$1,000,000), and 2)
the sale of a plant building (+$2,400,000).
o $1,400,000 and 7,800,000 These give a net cash flows from investing
activities of $1,400,000. The two financing
o $1,800,000 and 7,800,000 activities are: 1) issuing stock (+$8,000,000),
and 2) dividends paid on the stock (−$800,000).
These give a net cash flows from financing
o $1,800,000 and 7,200,000 activities of $7,200,000.

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Constructing the statement
Question: Three years ago, James Company purchased stock in Zebra Inc. at a cost of
$100,000.The stock was sold for $150,000 during the current fiscal year. The result of
this transaction should be shown in the investing activities section of James’s
statement of cash flows as
a) Zero
b) $50,000
c) $100,000
d) $150,000

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Benefits of the Statement of Cash Flows

• The statement of cash flows provides the most information about cash and
how the company receives and spends cash. It helps users to assess the
ability of the company to generate positive future cash flows to meet its
obligations as they come due and to pay dividends.
• It helps users to assess the reasons for differences between net income and net
cash inflows and outflows.

• It helps users to assess the effect of investing and financing transactions on the
company’s financial position.

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Benefits of the Statement of Cash Flows

• It helps users to assess the company’s need for external financing. A negative
operating cash flow and a positive financing cash flow indicate the company is
financing its operations with either debt or equity. An examination of the financing
section of the statement will reveal whether debt or equity is being used.

• Lenders can use it to assess the ability of a company to repay a loan.

• Investors can use it to determine if the company will be able to continue to pay its
current level of dividends in the future or whether it might even be able to increase
its dividend.

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Limitations of the Statement of Cash Flows

• The statement of cash flows shows only how much cash was received and paid out for
operating, investing, and financing activities. For the information on a statement of cash
flows to be fully utilized, it often needs to be interpreted in the context of other
information in the other financial statements. For example, a positive operating cash
flow may have been achieved by not paying the payables when due. To recognize past
due payables, the balance sheet and income statement are also needed.

• The indirect method of preparing the operating cash flows section of the SCF does not
show the sources and uses of operating cash individually but shows only adjustments to
accrual-basis net income, a limitation that can cause a user to have difficulty in using the
information presented

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55 Page