Understanding Financial

Statements 2 – Statement of
Cash Flows
Lecture 3

1
Learning Objectives
1. Distinguish between cash basis and accrual basis
accounting.
2. Explain the importance of cash to a business.
3. Identify the purposes of the statement of cash flows.
4. Distinguish among operating, investing, and financing
activities.
5. Understanding how to read and interpret the statement
of cash flows.
6. Identify the limitations of the statement of cash flows.

2
 Learning objective 1

Distinguish between cash basis and accrual basis accounting.

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Measuring Cash Flows
? Profits in the financial statements are calculated on
“accrual basis” rather than “cash basis”.

? Thus profits are not equal to cash.

Accrual- vs. Cash-Basis Accounting

Cash Basis Accounting

∙ Revenue recorded only when cash is received.

∙ Expense recorded only when cash is paid.
∙ Ignores receivables, payables and depreciation because no
cash involved.
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Accrual- vs. Cash-Basis Accounting

Accrual Basis Accounting

Accrual basis is the principle of recording revenues when

earned and expenses when incurred, rather than when cash is
received or paid.
• Thus sales revenue recorded in the income statement includes both
cash and credit sales.

Treatment of long-term assets: Asset acquisitions (that will

last more than one year, such as equipment) are not recorded
as an expense but are written off every year as depreciation
expense.
 Accrual- vs. Cash-Basis Accounting
Suppose you work during the end-of-semester holidays mowing lawns.
Most of your customers pay you immediately after you cut their grass.
A few ask you to send them an invoice at the end of each month.
It is now 31 December and you have collected $900 from cash-paying
customers. Your remaining customers owe you $300. How much
service revenue would you have under the
(a) cash basis? $900
(b) accrual basis? $900 + $300 = $1,200
Which method of accounting provides more information about your
lawn-service business? Explain your answer.
The accrual basis: (1) it considers all revenue earned, including
revenue earned on account; (2) also keeps a record of
receivables from customers. The cash basis ignores both your
receivables and the revenue you earned on account.
 Learning objective 2

Explain the importance of cash to a business.

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Importance of cash to a business
Which would you prefer?

1) Your shop makes a profit of RM30,000 this year and, at

the end of the year, your assets consists of only
inventory costing RM10,000 and you owe your suppliers
RM10,000.
OR
2) Your shop makes a profit of RM8,000 this year but you
have RM5,000 in cash, RM2,000 in inventory, no debtors
and you owe RM3,000 to your trade creditors.

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Importance of cash to a business
? It takes cash to pay the bills.
? Income and expenses generate cash receipts and cash
payments.
? Net income is good, but need cash to pay the bills
and run the business operations.
? Important for business to ensure there is sufficient
cash funds available as and when needed.
? Cash is king!

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 Learning objective 3

Identify the purposes of the statement of cash flows.

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Accrual Accounting Does Not Follow Cash Flows
? Because we use accrual accounting, the income statement
and the balance sheet do not reflect actual cash flows
(cash receipts and cash payments).
? There are two common approaches to measuring a firm’s
cash flows:
1) Using the conventional accountant’s presentation called a
Statement of Cash Flows.
? This method of presenting cash flows focuses on identifying the
sources and uses of cash that explain the change in a firm’s cash
balance reported in the balance sheet.
2) Calculate a firm’s free cash flows and financing cash
flows.

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TIMING OF THE FINANCIAL STATEMENTS

Income
Statement

Balance Statement of
Balance
Sheet Stockholders’
Sheet
Equity

Statement
of Cash
Flows

31 Dec 2019 For the year ended 31Dec 31 Dec 2020

(A point in time) 2020 (A period of time) (A point in time)

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Statement of Cash Flows
• Reports why cash increased or decreased during the
period
• Covers a period of time

• Communicating link between the Income Statement and

cash reported on the Balance Sheet

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Purposes of the statement of cash flows

1. Predict future cash flows

▪ Past cash receipts and payments help predict future cash flows.

2. Evaluate management decisions

▪ Report on managers’ investments. Wise investments help
companies prosper. Unwise investments cause businesses to suffer
financially.

3. Predict ability to pay debts and dividends

▪ Report where cash came from and how the cash was spent. This
information helps investors and creditors predict whether the
business can pay its debts and dividends.

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Cash Equivalents

On a Statement of Cash Flows, cash means more than cash

on hand and cash in the bank. Cash includes cash
equivalents.
? Highly liquid investments
? Can convert into cash quickly
? Examples:
? Money-market investments
? Investments in government bonds

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 Learning objective 4

Distinguish among operating, investing, and financing cash

flows

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Sources and Uses of Cash
? Sources
Cash inflow
? Decrease in asset account – occurs when we “sell” something
? Accounts receivable, inventory, and net fixed assets
? Increase in liability or equity account
? Accounts payable, other current liabilities, and common stock

? Uses
Cash outflow
? Increase in asset account – occurs when we “buy” something
? E.g., inventory, equipment
? Decrease in liability or equity account
? E.g., to pay notes payable and long-term debt

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Knowing When a Change in the Balance Sheet is
a Source or Use of Cash

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Basic Cash Flow Activities
Operating
Activities Investing
Income Statement Items Activities Financing
Generally Long-Term Activities
Asset Items
Generally Long-term
Liability and Equity
Items

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 Anchor Co. Bhd.
Statement of Cash Flows
For the Year Ended 31 December 2018
Cash flows from operating activities: RM’000 RM’000
Receipts:
2
Collections from customers
71
1
Interest received on bills receivable
0
Dividends received on investments in shares 9
2
Total cash receipts
90
Payments:
(1
To suppliers
33)
(5
To employees
8)
(1
For interest
6)
(1
For income tax
5)
(2
Total cash payments
22)
6
Net cash provided by operating activities
8
Cash flows from investing activities:
(3
Acquisition of non-current assets
06)
(1
Loan to another company
1)
Proceeds from sale of non-current assets 62 21
Operating Activities
? Most important category
? Reflects day-to-day transactions

? Create revenues, expenses, gains, and losses

? Transactions that make up net profit
? Also affect current assets and current liabilities on the
Balance Sheet

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 Cash Flows from Operating Activities
Typical cash inflows Typical cash outflows
What are some of the What are some of the
typical cash inflows from typical cash outflows from
operating activities?` operating activities?
Sales of goods Purchases of
and services inventory
Interest Payments of
revenue wages and
other expenses
Dividend
revenue Tax payments
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Investing Activities

? Transactions that increase and decrease non-current

assets
? Purchase and sales of plant assets including:
Computers, land, buildings, and equipment

? Includes loans receivable

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 Cash Flows from Investing Activities
Typical cash inflows Typical cash outflows
What are some of the typical What are some of the
cash inflows from investing typical cash outflows
activities? from investing
activities?
Sales of fixed
assets Purchase of
fixed assets
Sale of
long-term Purchase of
investments long-term
investments
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Financing Activities

? Increases and decreases in non-current liabilities and

owner’s equity
? Issuing shares and paying dividends
? Selling bonds
? Borrowing money and paying off loans
? Note: payment to long-term creditors include principal payments only.
Payment of interest is an operating activity.

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 Cash Flows from Financing Activities
Typical cash inflows Typical cash outflows
What are some of the What are some of the
typical cash inflows from typical cash outflows from
financing activities? financing activities?
Issuing bonds Paying cash
and long-term dividends
notes payable Repaying debt
Issuing Share
preferred and buy-backs
ordinary shares
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 Reporting Cash Flows
Increases in Cash Decreases in Cash

Operating Operating
(receipts from (payments for
revenues) expenses)

Investing Investing
(receipts from sales of (payments for acquiring
noncurrent assets) noncurrent assets)

Financing Financing
(receipts from issuing (share buy-backs, dividends, and
equity and debt securities) redemption of debt securities)
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Noncash Investing and Financing
? Investing and financing activities that do not affect cash.
Some examples are:
? Acquire land by issuing a note payable
? Retire debt by issuing shares
? Convert preference shares to ordinary shares

? Reported in a separate schedule or in a note that

accompanies the Statement of Cash Flows.

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Operating, Investing & Financing Activities
and the Balance Sheet

Operating
cash flows

Current
Current assets
liabilities
Non-current
Investing cash Non-current liabilities Financing
flows assets cash flows
Owners’ equity

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 Learning objective 5

Understanding how to read and interpret the statement of cash

flows.

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Format for Operating Activities
? Indirect method
? Starts with net income and adjusts it to net cash provided by
operating activities
? Used by most companies

? Direct method
? Restates Income Statement in terms of cash
? Shows cash receipts and payments from operating activities

Both methods result in the

same amount of cash flow
from operations

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Statement of Cash Flows – Indirect Method
? Calculates cash flows from changes in account
balances

? Changes divided into three major categories

? Operating Activity – includes net income and changes in
most current accounts (CA & CL)
? Investment Activity – includes changes in fixed assets
? Financing Activity – includes changes in notes payable,
long-term debt, and equity accounts, as well as dividends

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Income Statement Conversion:
From Accrual to Cash Basis
Cash Flow from Operations: Six Steps
1. Add back depreciation.
2. Subtract (add) any increase (decrease) in accounts
receivable.
3. Subtract (add) any increase (decrease) in inventory.
4. Subtract (add) any increase (decrease) in other current
assets.
5. Add (subtract) any increase (decrease) in accounts payable
6. Add (subtract) any increase (decrease) in other accrued
expenses.
Depreciation Expenses
? Depreciation is a noncash expense which recognizes the
cost of non-current assets used up or allocated to each
accounting period.

? Depreciation reduces net income in the Income

Statement but it does not reduce the Cash amount on
the Balance Sheet.

? Therefore, to go from net income to cash flows, we must

remove depreciation by adding it back to net income.

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36
Cash flow from
operations
Cash flow from
operations
The Indirect Method Statement of Cash Flows

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Format of Stmt of CF – Indirect Method

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The Direct Method
? Provides clearer information about cash receipts and
payments

? Only operating activities presentation is different from the

indirect method
? Net cash flow from operating activities is the same amount of
cash as that prepared using the indirect method
? Investing and Financing sections always prepared using direct
method

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The Direct Method Stmt of Cash Flows

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Format of Stmt of CF – Direct Method
Statement of Cash Flows (partial)
Cash flows from operating activities
Receipts:
Collections from customers
Interest received
Dividends received on investments
Total cash receipts
Payments:
To suppliers
To employees
For interest and income taxes
Total cash payments
Net cash provided by operating activities
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Cash Flow from Operating Activities
? Shows whether operating activities are generating
positive cash flows or not.
? As net profit is an accrual accounting measure, it does not
indicate a net cash inflow.
? A company that reports a net profit may still have a net cash
outflow from operating activities and a decrease in its Cash
balance.
? A company that reports a net loss can have a net cash inflow
from operating activities and an increase in its Cash balance.

? Important for this to be net cash inflow for a business to

remain viable.

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 Classifying items in the cash flow statement
An analysis of comparative balance sheets, the current year’s income
statement, and the general ledger accounts of Darcy Corp. uncovered
the following items. Assume all items involve cash unless there is
information to the contrary.

(a) Payment of interest on notes payable (h) Issuance of shares in the company.
(b) Exchange of land for patent. (i) Amortization of patent.
(c) Sale of building at book value. (j) Issuance of bonds for land.
(d) Payment of dividends. (k) Purchase of land.
(e) Depreciation. (l) Conversion of bonds into shares.
(f) Receipt of dividends on investment in (m) Loss on sale of land.
shares. (n) Retirement of bonds.
(g) Receipt of interest on notes receivable.

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 Classifying items in the cash flow statement
(a) Payment of interest on notes payable (h) Issuance of shares in the company.
(b) Exchange of land for patent. (i) Amortization of patent.
(c) Sale of building at book value. (j) Issuance of bonds for land.
(d) Payment of dividends. (k) Purchase of land.
(e) Depreciation. (l) Conversion of bonds into shares.
(f) Receipt of dividends on investment in (m) Loss on sale of land.
shares. (n) Retirement of bonds.
(g) Receipt of interest on notes receivable.

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 Anchor Co. Ltd
Statement of Cash Flows
For the Year Ended 31 December 2018
Cash flows from operating activities: RM’000 RM’000
Receipts:
2
Collections from customers
71
1
Interest received on bills receivable
0
Dividends received on investments in shares 9
2
Total cash receipts
90
Payments:
(1
To suppliers
33)
(5
To employees
8)
(1
For interest
6)
(1
For income tax
5)
(2
Total cash payments
22)
6
Net cash provided by operating activities
8
Cash flows from investing activities:
(3
Acquisition of non-current assets
06)
(1
Loan to another company
1)
Proceeds from sale of non-current assets 62 47
 Anchor Co. Ltd
Statement of Cash Flows
For the Year Ended 31 December 2018
Cash flows from operating activities: RM’000 RM’000
Receipts:
2
Collections from customers 1. Which category of cash
71
Interest received on bills receivable
1 flows (operating,
0 investing and financing)
Dividends received on investments in shares 9
2 provided the majority
Total cash receipts
90 of cash flows? Which
Payments: category had the
(1
To suppliers
33)
greatest outflows?
(5
To employees
8) 1. Identify the primary
(1 cash receipts and cash
For interest
6)
(1 payments during the
For income tax
5) year.
(2
Total cash payments
22)
6
Net cash provided by operating activities
8
Cash flows from investing activities:
(3
Acquisition of non-current assets
06)
(1
Loan to another company
1)
Proceeds from sale of non-current assets 62 48
Using Cash Flows to Evaluate a Company

Free Cash Flow

Free cash flow describes the cash remaining from operations

after adjustment for capital expenditures and dividends.
Capital expenditures are needed to maintain the company’s level
of operations.
Dividends are required to satisfy investors.

❖ FCF can be used to acquire new assets, for share buy-backs,

repay debt, or to pay dividends.
Free Cash Flows
? the amount of cash available from operations after the firm
pays for the investments it has made in operating working
capital and fixed assets.
? This cash is available to distribute to the firm’s creditors and
owners.
? Specifically, a company’s free cash flows result from two
activities:
1) After-tax cash flows from operations are the cash flows a firm
generates from day-to-day operations after taxes are paid, but before
any investments in working capital or long-term assets are made. Think
of it as the cash flows of a business if it were not getting larger or
smaller in size. (You should note that when computing free cash flows,
the term cash flows from operations is not the same as in the
statement of cash flows.)
2) Asset investments, which include investments in (1) a company’s net
operating working capital and (2) its long-term assets.
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Computing Free Cash Flows
Free cash flows = After-tax cash flows
from operations

Increase in net Decrease in

─ operating or + net operating
working capital working capital

Increase in
─ long-term or + Decrease in
assets long-term assets

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Computing Free Cash Flows
? Involves 3 steps:
1) Compute the after-tax cash flows from operations by
converting the income statement from an accrual basis to a
cash basis. (You should note when computing free cash flows,
the term cash flows from operations is not the same as in the
statement of cash flows.)
2) Calculate the increase or decrease in the firm’s investment in
net operating working capital.
3) Compute the increase or decrease in investments made in
long-term assets, including fixed assets and other long-term
assets such as intangible assets.

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53
Step 1: Determine the after-tax cash flows from
operations

$9,7
Operating income (EBIT)
07
1,97
+ Depreciation expense
6
(2,1
─ Income tax expense
26)
$9,
= After tax cash flows from operations
557

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Step 2: Calculate the change in the net operating
working capital

Change in Change in Change in

NOWC = current assets ─ non-interest-bearing
current liabilities
▶ Non-interest-bearing current liabilities is any short-term liability that
does not require the firm to pay interest on the loan. This typically
includes accounts payable (credit provided by suppliers) and any
accrued operating expenses, such as accrued wages.

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Step 3: Compute the change in long-term assets
? The final step involves computing the change in gross
fixed assets (not net fixed assets) and other long-term
assets.
? Again returning to Coca-Cola’s balance sheet, we can see
that the total investment in long-term assets was $2.262
billion:

57
Computing the Firm’s Free Cash Flows
? We now have the three pieces to compute Coca-Cola’s
free cash flows: (1) after-tax cash flows from operations,
(2) changes (investments) in net operating working
capital, and (3) changes (investments) in long-term assets.
As shown below (expressed in $ millions), the firm’s free
cash flows are $5.107 billion.

58
Interpreting the Firm’s Free Cash Flows
? Coca-Cola’s free cash flows in 2014 were positive in the
amount of $5.361 billion.
? Positive free cash flows are distributed to the firm’s
investors.
? Negative free cash flows require that investors infuse
money into the business.
? Investors in this context includes both lenders and
shareholders.
? Any money coming from or paid to investors is called
financing cash flows.

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Computing Financing Cash Flows

60
Computing Financing Cash Flows
? The firm
▪ Paid $483 million in interest and $5.350 billion in dividends.
▪ Borrowed (increased) $4.815 billion in short-term
interest-bearing debt and borrowed (increased) $258 million of
its long-term interest-bearing debt.
▪ Received $878 million by issuing new common stock.
▪ Spent $5.479 billion to repurchase outstanding common stock.

? Add it all up and Coca-Cola distributed a net amount of

$5.361 billion to its creditors and shareholders.

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Interpreting the Financing Cash Flows
? Coca-Cola’s free cash flows exactly equal its financing
cash flows. They will always be equal. The firm’s free cash
flows, if positive, will be the amount distributed to the
investors; and if the free cash flow is negative, it will be
the amount that the investors provide to the firm to
cover the shortage in free cash flows.
? Based on our review of Coca-Cola’s free cash flows and
financing cash flows, we know that the company had
significant positive cash flows from operations ─ more
than enough to cover its investments and distribute large
sums of money to its investors.

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 Learning objective 6

Identify the limitations of the statement of cash flows.

63
 Limitations of the statement of cash flows
1. Past cash flows reported
• Overcome to some extent by looking at comparative
statements from previous years to look for trends. Should
not over-rely on one period’s stmt.
2. Non-cash transactions and events not reported
• E.g. debt-equity swaps, financing non-current asset
purchases by long-term debt, use of finance leases, barter
transactions don’t affect current period cash flow
statement.
3. Liquidity/solvency
• Stmt of cash flows only goes some way in enabling users
to establish liquidity/solvency position of an entity.

64
Limitations of the statement of cash flows
3. Management manipulation
• E.g. prepayment, delaying cash payments, postponing
acquisition of large investments, deferring debenture
issues, barter, finance leasing
• Effect of these practices felt in subsequent periods

4. Cost
• Direct method of converting accrual-basis revenues and
expenses to cash flows from operating activities require
additional costs to produce required information. As such,
many companies prefer the indirect method.

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Example of financial statements of a construction
and property development company
? Refer to Ho Hup Construction Company Berhad Annual
Report 2017, pp74-82. Notes to the statements are in
pp83-160.

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Self-learning Activities
? Atrill, P. & McLaney, E., 2017, Accounting and Finance for
Non-Specialists, 10th ed, Harlow, England: Pearson, Ch 3, 4
&5

? Dyson, J. R. & Franklin, E., 2017. Accounting for

Non-Accounting Students. 9th ed. Harlow, England:
Pearson. Ch 4, 5 & 7

? Your own research of other sources

? Attempt the tutorial and online review questions