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Managerial Accounting

Weygandt, Kieso, & Kimmel

Prepared by Karleen Nordquist.. The College of St. Benedict... and St. Johns University...
with contributions by Dr. Jessica J. Frazier.. and Philip Li... Eastern Kentucky University.

John Wiley & Sons, Inc.

Chapter 11

Statement of Cash Flows

Chapter 11
Statement of Cash Flows
After studying this chapter, you should be able to:
1 Indicate the primary purpose of the statement of cash flows. 2 Distinguish among operating, investing, and financing activities. 3 Explain the impact of the product life cycle on a companys cash flows. 4 Prepare a statement of cash flows using one of two approaches: (a) the indirect method or (b) the direct method. 5 Use the statement of cash flows to evaluate a company.

Preview of Chapter 11
The Statement of Cash Flows: Purpose and Format

STATEMENT OF CASH FLOWS

Purpose Classifications Significant Noncash Activities Format Corporate Life Cycle Usefulness Preparation

Preview of Chapter 11
Section 1: Indirect Method
Determining Net Increase/ Decrease in Cash Determining Net Cash Provided/ Used by Operating Activities Determining Net Cash Provided/ Used by Investing and Financing Activities Summary of Indirect Method

STATEMENT OF CASH FLOWS

Preview of Chapter 11

Section 2: Direct Method

STATEMENT OF CASH FLOWS

Determining Net Increase/ Decrease in Cash Determining Net Cash Provided/ Used by Operating Activities Determining Net Cash Provided/ Used by Investing and Financing Activities

Preview of Chapter 11

Using Cash Flows to Evaluate a Company

STATEMENT OF CASH FLOWS

Free Cash Flow Capital Expenditure Ratio Assessing Liquidity, Solvency, and Profitability

Study Objective 1

Indicate the primary purpose of the statement of cash flows.

The Primary Purpose of the Statement of Cash Flows


The primary purpose of the statement of cash
flows is to provide information about cash receipts, cash payments, and the net change in cash resulting from the operating, investing, and financing activities of a company during the period. These activities involving cash are reported in a format that reconciles the beginning and ending cash balances.

The Primary Purpose of the Statement of Cash Flows


Reporting the causes of changes in cash is useful
because investors, creditors, and other interested parties want to know what is happening to a company's most liquid resource its cash. The statement of cash flows provides answers to the following important questions about an enterprise: Where did the cash come from during the period? What was the cash used for during the period? What was the change in the cash balance during the period?

Study Objective 2

Distinguish among operating, investing, and financing activities.

Classification of Cash Flows


The statement of cash flows classifies cash
receipts and cash payments into

operating, investing, and financing activities.

Operating Activities
Operating activities include the cash effects of
transactions that create revenues and expenses and thus enter into the determination of net income. Operating activities is the most important category because it shows the cash provided or used by company operations. Cash provided by operations is generally considered to be the best measure of whether a company can generate sufficient cash to continue as a going concern and to expand.

Investing Activities
Investing activities include purchasing and disposing of investments and productive long-lived assets using cash, and lending money and collecting the loans.

Financing Activities
Financing activities include obtaining cash from issuing debt and repaying the amounts borrowed and obtaining cash from stockholders and paying them dividends.

Typical Cash Receipts and Payments Classified by Activity


Operating activities Cash inflows: From sale of goods or services From returns on loans (interest received) and on equity securities (dividends received) Cash outflows: To suppliers for inventory To employees for services To government for taxes To lenders for interest Illustration 11-1a To others for expenses

Typical Cash Receipts and Payments Classified by Activity


Investing activities Cash inflows: From sale of property, plant, and equipment From sale of debt or equity securities of other entities From collection of principal on loans to other entities Cash outflows: To purchase property, plant, and equipment To purchase debt or equity securities of other entities To make loans to other entities
Illustration 11-1b

Typical Cash Receipts and Payments Classified by Activity


Financing activities Cash inflows:

From sale of equity securities (company's own stock) From issuance of debt (bonds and notes)

Cash outflows:

To stockholders as dividends
To redeem long-term debt or reacquire capital stock
Illustration 11-1c

Operating Activities
Some cash flows relating to investing or
financing activities are classified as operating activities. For example, receipts of investment revenue (interest and dividends) and payments of interest to lenders are classified as operating activities because these items are reported in the income statement.

Operating Activities
As a general rule: Operating activities involve income
determination (income statement) items. Investing activities involve cash flows resulting from changes in investments and long-term asset items. Financing activities involve cash flows resulting from changes in long-term liability and stockholders' equity items.

Significant Noncash Activities


Not all of a company's significant activities
involve cash. Four examples of significant noncash activities are: Issuance of common stock to purchase assets Conversion of bonds into common stock Issuance of debt to purchase assets Exchanges of plant assets

Significant Noncash Activities


Significant noncash financing and investing
activities are not reported in the body of the statement of cash flows. Rather, they are reported either in a separate schedule at the bottom of the statement of cash flows or in a separate note or supplementary schedule to the financial statements. This reporting of these significant noncash activities in a separate note or supplementary schedule satisfies the full disclosure principle.

Format of the Statement of Cash Flows


The three activities (operating, investing, and
financing), plus the significant noncash investing and financing activities make up the general format of the statement of cash flows. The cash flows from operating activities section always appears first, followed by the investing activities, and the financing activities sections. The individual inflows and outflows form investing and financing activities are reported separately. The reported operating, investing, and financing activities result in net cash provided or used by each activity.

Format of the Statement of Cash Flows


The net cash provided or used by each activity is totaled
to show the net increase (decrease) in cash for the period. The net increase (decrease) in cash for the period is then added or subtracted from the beginning-of-period cash balance to obtain the end-of-period cash balance. Any significant noncash investing and financing activities are (usually) reported in a separate schedule at the bottom of the statement.

Format of the Statement of Cash Flows


Company Name Statement of Cash Flows Period Covered Cash flows from operating activities (List of individual items) Net cash provided (used) by operating activities Cash flows from investing activities (List of individual items) Net cash provided (used) by investing activities Cash flows from financing activities (List of individual items) Net cash provided (used) by financing activities Net increase (decrease) in cash Cash at beginning of period Cash at end of period Noncash investing and financing activities (List of individual noncash transactions) XX XXX

XX
XXX

XX XXX XXX XXX XXX

XXX

Illustration 11-2

Study Objective 3

Explain the impact of the product life cycle on a companys cash flows.

The Corporate Life Cycle


All products go through a series of phases called the
product life cycle. The phases (in order of their occurrence) are often referred to as the introductory phase, growth phase, maturity phase, and decline phase. We can characterize a company as being in one of these four phases because the majority of its products are usually in a particular phase. The phase a company is in affects its cash flows.

Corporate Life Cycle: Introductory Phase


The introductory phase occurs when the company is
purchasing fixed assets and beginning to produce and sell. When a company is in the introductory stage, one would expect that it will be spending considerable amounts to purchase productive assets, but will not be generating much (if any) cash from operations. To support asset purchases the company may have to issue stock or debt. One would expect cash from operations to be negative, cash from investing to be negative, and cash from financing to be positive.

Corporate Life Cycle: Growth Phase


During the growth phase, the company is striving to
expand its production and sales. Cash from operations continues to be less than net income during this phase because inventory must be purchased for future projected sales. Cash needed for asset acquisitions will continue to exceed cash provided by operations, requiring that the company make up the deficiency by issuing new stock or debt. Thus, the company continues to show negative cash from investing and positive cash from financing in this phase.

Corporate Life Cycle: Maturity Phase


In the maturity phase, sales and production
level off. Cash from operations and net income are approximately the same. Cash generated from operations exceeds investing needs. Thus, in the maturity phase the company can actually start to retire debt or buy back stock.

Corporate Life Cycle: Decline Phase


During the decline phase, sales of the product fall
due to a weakening in consumer demand. During this phase, cash from operations decreases. Cash from investing might actually become positive as the firm sells off excess assets, and cash from financing may be negative as the company buys back stock and retires debt.

Usefulness of the Statement of Cash Flows


Many investors believe cash flow is less susceptible to
management manipulation and fraud than traditional accounting measures such as net income. Although reliance on cash flows to the exclusion of accrual accounting is inappropriate, comparing cash from operations to net income can reveal important information about the quality of reported net income that is the extent to which net income provides a good measure of actual performance.

Usefulness of the Statement of Cash Flows


The information in a statement of cash flows should help investors, creditors and others evaluate these aspects of the firm's financial position: The entity's ability to generate future cash flows. The entity's ability to pay dividends and meet obligations. The reasons for the difference between net income and net cash provided (used) by operating activities. The cash investing and financing transactions during the period.

Preparing the Statement of Cash Flows


The statement of cash flows is prepared differently from other basic financial statements. First, because the statement requires detailed information concerning the changes in account balances that occurred between two periods of time, an adjusted trial balance does not provide the data necessary for the statement. Second, the statement of cash flows deals with cash receipts and payments. The accrual concept is not used in the preparation of a statement of cash flows.

Preparing the Statement of Cash Flows


The information to prepare the statement of cash flows usually comes from three sources: Comparative balance sheet. (Indicates the
amount of change in assets, liabilities, and stockholders equities from the beginning to the end of the period.)

Current income statement. (Helps in determining


cash provided or used by operations.)

Additional information.

(Includes transaction data that helps determine how cash was provided or used.)

Preparing the Statement of Cash Flows: Steps


Preparing the statement of cash flows involves the following steps: 1 Determine the net increase/decrease in cash. 2 Determine the net cash provided/used by operating activities. 3 Determine the net cash provided/used by investing and financing activities.

Preparing the Statement of Cash Flows: Indirect and Direct Methods


In order to determine the cash provided/used by
operating activities, net income must be converted from an accrual basis to a cash basis. This conversion may be done by either of two methods: indirect or direct. Both methods arrive at the same total amount for net cash provided by operating activities. The investing and financing sections are identical under both methods.

The Indirect Method


The indirect method is used extensively in
practice. Most companies favor the indirect method for the following three reasons: it is easier to prepare, it focuses on the differences between net income and net cash flow from operating activities, and it tends to reveal less company information to competitors.

The Direct Method


Others favor the direct method, which is more
consistent with the objective of a statement of cash flow because it shows operating cash receipts and payments. The FASB prefers the direct method but allows the use of either method. When the direct method is used, the net cash flow from operating activities as computed using the indirect method must also be reported in a separate schedule.

Study Objective 4a

Prepare a statement of cash flows using the indirect method

Statement of Cash Flows Indirect Method


Transactions of Computer Services Company for two
years will be used to explain and the illustrate the indirect method of preparing the statement of cash flows. Computer Services Company started operations on January 1, 1999, when it issued 50,000 shares of $1 par value common stock for $50,000 cash. The company rented its office space and furniture, and performed consulting services throughout the first year. Information needed to prepare the 1999 statement of cash flows is shown on the following two slides.

Statement of Cash Flows Indirect Method


Computer Services Company Comparative Balance Sheet December 31
Assets Cash Accounts receivable Equipment Total Dec. 31, 1999 $34,000 30,000 10,000 $74,000 Jan. 1, 1999 $ -0-0-0$ -0Change Increase/Decrease $34,000 increase 30,000 increase 10,000 increase

Liabilities and Stockholders Equity Accounts payable $ 4,000 Common stock 50,000 Retained earnings 20,000 Total $74,000

$ -0-0-0$ -0-

$ 4,000 increase 50,000 increase 20,000 increase

Illustration 11-5

Statement of Cash Flows Indirect Method


Computer Services Company Income Statement For the Year Ended December 31, 1999
Revenues Operating expenses Income before income taxes Income tax expense Net income $85,000 40,000 45,000 10,000 $35,000

Additional information: (a)Examination of selected data indicates that a dividend of $15,000 was declared and paid during the year. (b)The equipment was purchased at the end of 1999. No depreciation was taken in 1999.

Illustration 11-6

Step 1: Determining the Increase/Decrease in Cash


Determining the increase/decrease in cash
during the year is a simple computation. As shown on the comparative balance sheet, Computer Services had no cash on hand at the beginning of 1999 and a balance of $34,000 at the end of 1999. Therefore, cash increased by $34,000.

Step 2: Determining Net Cash Provided/Used by Operating Activities


To determine net cash provided/used by operating
activities under the indirect method, net income is adjusted for income items that did not affect cash. Accrual basis net income is converted to cash basis. This process is graphically illustrated on the next slide. Net income must be converted because earned revenues may include credit sales that have not been collected in cash and incurred expenses that may not have been paid in cash. A useful starting point in identifying the needed adjustments to net income is the current asset and current liability accounts.

Net Income Versus Net Cash Provided by Operating Activities


Accrual Basis of Accounting
Earned Revenues

Cash Basis of Accounting

Net Income

Adjustments to Reconcile Net Income to Net Cash Provided/Used by Operations

Net Cash Provided/Used by Operating Activities

Incurred Expenses
Illustration 11-7

Step 2: Determining Net Cash Provided/Used by Operating Activities


Operations of the period led to revenues. Not all of these revenues resulted in an increase in cash, however. When accounts receivable increase during the year, revenues on an accrual basis are higher than revenues on a cash basis. Computer Services Company had revenues of $85,000 during its first year of operation, but collected only $55,000 in cash. On an accrual basis, revenue was $85,000, but on a cash basis, only $55,000 of revenue was received during the period. To convert net income to net cash provided by operating activities, the $30,000 increase in accounts receivable must be deducted from net income.

Step 2: Determining Net Cash Provided/Used by Operating Activities


Operations of the period also led to expenses. Not all of these expenses resulted in a decrease in cash. When accounts payable increase during the year, expenses on an accrual basis are higher than expenses on a cash basis. Computer Services shows $40,000 of operating expenses on its income statement. However, since accounts payable increased by $4,000 during the year, only $36,000 of those expenses were paid in cash ($40,000 - $4,000). To convert net income to net cash provided by operating activities, the $4,000 increase in accounts payable must be added to net income.

T-account Analysis of Accounts


The T-accounts shown below may help illustrate the preceding discussion.
Accounts Receivable
Balance, Jan. 1 Revenues Balance, Dec. 31 0 85,000 30,000 Receipts from customers 55,000

Cash amounts for statement of cash flows


Accounts Payable
Payments to creditors 36,000 Balance, Jan. 1 Operating expenses Balance, Dec. 31 0 40,000 4,000

Accrual amounts on income statement


Illustrations 11-8 & 9

Step 2: Determining Net Cash Provided/Used by Operating Activities


For Computer Services, the changes in accounts
receivable and accounts payable were the only changes in current assets and current liability accounts. Therefore, any other revenues or expenses reported in the income statement were received or paid in cash, and no other adjustment of net income is necessary. The operating activities section of the statement of cash flows for Computer Services Company is shown on the next slide.

Step 2: Determining Net Cash Provided/Used by Operating Activities

Computer Services Company Partial Statement of Cash Flows - Indirect Method For the Year Ended December 31, 1999
Cash flows from operating activities Net income $ 35,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(30,000) Increase in accounts payable 4,000 (26,000) Net cash provided by operating activities $ 9,000

Illustration 11-10

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


To find net cash provided/used by investing and financing activities, determine the changes in the noncurrent accounts on the balance sheet. Those changes are then analyzed using selected transaction data to determine the effect, if any, the changes had on cash. Computer Service Company's three noncurrent accounts are Equipment, Common Stock, and Retained Earnings, all three of which had increases during the year.

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities No transaction data are given for the increases in
Equipment of $10,000, and Common Stock of $50,000. When other explanations are lacking, assume any differences involve cash. The increase in equipment is assumed to be a purchase of equipment for $10,000 cash. This purchase is reported as a cash outflow in the investing activities section. The increase of common stock is assumed to result from the issuance of common stock for $50,000 cash. It is reported as an inflow of cash in the financing section.

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


The reasons for the net increase of $20,000 in the Retained Earnings account are determined by analysis. First, net income increased retained earnings by $35,000. Second, the additional information indicates that a cash dividend of $15,000 was declared and paid. The $35,000 increase due to net income is reported in the operating activities section. The cash dividend paid is reported in the financing activities section.

Statement of Cash Flows 1999


Computer Services Company Statement of Cash Flows - Indirect Method For the Year Ended December 31, 1999
Cash flows from operating activities Net income $ 35,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(30,000) Increase in accounts payable 4,000 (26,000) Net cash provided by operating activities 9,000 Cash flows from investing activities Purchase of equipment (10,000) Net cash used by investing activities (10,000) Cash flows from financing activities Issuance of common stock 50,000 Payment of cash dividends (15,000) Net cash provided by financing activities 35,000 Net increase in cash 34,000 Cash at beginning of period 0 Cash at end of period $34,000

Illustration 11-12

Statement of Cash Flows 1999


Computer Services Company's statement of cash
flows for 1999 on the previous slide shows that operating activities provided $9,000 cash; investing activities used $10,000 cash; and financing activities provided $35,000 cash. The increase in cash of $34,000 reported in the statement of cash flows agrees with the increase of $34,000 shown as the change in the cash account in the comparative balance sheet.

Second Year of Operations 2000


The comparative balance sheet, income statement, and additional information for Computer Services Companys second year of operation are presented on the next two slides.

Statement of Cash Flows Indirect Method


Computer Services Company Comparative Balance Sheet December 31
Assets Cash Accounts receivable Prepaid expenses Land Building Acc Depr - building Equipment Acc Depr - equipment Total 2000 $ 56,000 20,000 4,000 130,000 160,000 (11,000) 27,000 (3,000) $383,000 1999 $34,000 30,000 0 0 0 0 10,000 0 $74,000 Illustration 11-13 Change Increase/Decrease $ 22,000 increase 10,000 decrease 4,000 increase 130,000 increase 160,000 increase 11,000 increase 17,000 increase 3,000 increase

Liabilities and Stockholders Equity Accounts payable $ 59,000 Bonds payable 130,000 Common stock 50,000 Retained earnings 144,000 Total $383,000

$4,000 0 50,000 20,000 $74,000

$ 55,000 increase 130,000 increase 0 change 124,000 increase

Statement of Cash Flows Indirect Method


Computer Services Company Income Statement For the Year Ended December 31, 1999
Revenues Operating expenses Depreciation expense Loss on sale of equipment Income from operations Income tax expense Net income $507,000 $261,000 15,000 3,000

279,000 228,000 89,000 $139,000

Additional information: (a)In 2000 the company declared and paid a $15,000 cash dividend. (b)The company obtained land through the issuance of $130,000 of long-term bonds. (c)An office building costing $160,000 was purchased for cash; equipment costing $25,000 was also purchased for cash. (d)During 2000 the company sold equipment with a book value of $7,000 (cost $8,000 less accumulated depreciation $1,000) for $4,000 cash. Illustration 11-14

Step 1: Determining the Increase/Decrease in Cash


As shown on the comparative balance sheet,
Computer Service Companys cash increased $22,000 ($56,000 - $24,000) during 2000.

Step 2: Determining Net Cash Provided/Used by Operating Activities


Once again, to determine net cash provided/used by operating activities under the indirect method, net income is adjusted for income items that did not affect cash.

Explanations for the adjustments to net income for


Computer Services Company in 2000 are discussed on the following four slides.

Step 2: Determining Net Cash Provided/Used by Operating Activities


Accounts Receivable: Accounts receivable decreases
during the period because cash receipts are higher than revenues reported on an accrual basis. The decrease of $10,000 must be added to net income. Prepaid Expenses: Prepaid expenses increase during a period because cash paid for expenses is greater than expenses reported on an accrual basis. Cash payments have been made in current period, but expenses have been deferred to future periods. The increase of $4,000 in prepaid expenses must be deducted from net income.

Step 2: Determining Net Cash Provided/Used by Operating Activities


Accounts Payable: Like the increase in 1999, the 2000 increase of $55,000 in accounts payable must be added to net income to convert to net cash provided by operating activities.

Step 2: Determining Net Cash Provided/Used by Operating Activities


Depreciation Expense: During 2000 Computer Services Company reported depreciation expense of $15,000. An analysis of the accumulated depreciation accounts reveals that $11,000 related to the building and $4,000 related to the equipment. Depreciation and other charges that do not require the use of cash, such as amortization of intangible assets are added to net income.

Step 2: Determining Net Cash Provided/Used by Operating Activities


Loss on Sale of Equipment: Computer Services
Company reported a $3,000 loss on the sale of equipment (book value $7,000 less cash proceeds $4,000). The loss reduced net income but did not reduce cash. Thus, the $3,000 loss is added to net income in determining net cash provided by operating activities. As a result of the previous adjustments, net cash provided by operating activities is $218,000.

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


Once again, to find net cash provided/used by investing and financing activities, determine the changes in the noncurrent accounts on the balance sheet. Those changes are then analyzed using selected transaction data to determine the effect, if any, the changes had on cash.

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


Land: Land of $130,000 was purchased through the
issuance of long-term bonds. Although the exchange of bonds payable for land has no effect on cash, it is a significant noncash investing and financing activity that must be disclosed. Building: An office building was acquired using cash of $160,000. This transaction is a cash outflow reported in the investing activities section.

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


Equipment: The Equipment account increased
$17,000. The additional information provided, reveals that this was a net increase resulting from two transactions: (1) a purchase of equipment for $25,000, and (2) a sale of equipment costing $8,000 for $4,000. These are investing activities. The purchase of equipment should be shown as a $25,000 outflow of cash, and the sale of equipment should be shown as a cash inflow of $4,000.

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


Bonds Payable: The Bonds Payable account
increased by $130,000 when bonds were issued to acquire land. As indicated earlier this is a noncash investing and financing activity reported in a separate schedule at the bottom of the statement of cash flows.

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


Retained Earnings: Retained Earnings increased by
$124,000. The increase is the result of (1) net income of $139,000 that increased RE, and (2) dividends of $15,000 that decreased RE. Net income is converted to net cash provided by operations in the operating activities section. Payment of the dividends is a cash outflow that is reported as a financing activity. Computer Services Companys cash flow statement for 2000 is shown on the next slide.

Computer Services Company Statement of Cash Flows - Indirect Method For the Year Ended December 31, 2000
Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 15,000 Loss on sale of equipment 3,000 Decrease in accounts receivable 10,000 Increase in prepaid expenses (4,000) Increase in accounts payable 55,000 Net cash provided by operating activities Cash flows from investing activities Purchase of building (160,000) Purchase of equipment (25,000) Sale of equipment 4,000 Net cash used by investing activities Cash flows from financing activities Payment of cash dividends (15,000) Net cash provided by financing activities Net increase in cash Cash at beginning of period Cash at end of period Noncash investing and financing activities: Issuance of bonds payable to purchase land $139,000

79,000 218,000

(181,000)

(15,000) 22,000 34,000 $ 56,000 $130,000

Illustration 11-18

Summary of Conversion to Net Cash Provided by Operating Activities - Indirect Method


As shown in the previous illustrations, the statement of cash flows prepared by the indirect method starts with net income and adds or deducts items not affecting cash, to arrive at net cash provided by operating activities. The additions and deductions consist of changes in specific current assets and current liabilities, and noncash charges reported on the income statement.

Study Objective 4b

Prepare a statement of cash flows using the direct method.

Statement of Cash Flows Direct Method


Transactions of Juarez Company for two years will be
used to explain and the illustrate the direct method of preparing the statement of cash flows. Juarez Company began business on January 1, 1999, when it issued 300,000 shares of $1 par value common stock for $300,000 cash. The company rented its office and sales space, as well as its equipment. Information needed to prepare the 1999 statement of cash flows is shown on the following two slides.

Statement of Cash Flows Direct Method


Juarez Company Comparative Balance Sheet December 31
Assets Cash Accounts receivable Inventory Prepaid expenses Land Total Dec. 31, 1999 $159,000 15,000 160,000 8,000 80,000 $422,000 Jan. 1, 1999 $ -0-0-0-0-0$ -0Change Increase/Decrease $159,000 increase 15,000 increase 160,000 increase 8,000 increase 80,000 increase

Liabilities and Stockholders Equity Accounts payable $ 60,000 Accrued expenses payable 20,000 Common stock 300,000 Retained earnings 42,000 Total $422,000

$ -0-0-0-0$ -0-

$ 60,000 increase 20,000 increase 300,000 increase 42,000 increase

Illustration 11-21

Statement of Cash Flows Direct Method


Juarez Company Income Statement For the Year Ended December 31, 1999
Revenues from sales Cost of goods sold Gross profit Operating expenses Income before income taxes Income tax expense Net income $780,000 450,000 330,000 170,000 160,000 48,000 $112,000

Additional information: (a)Dividends of $70,000 were declared and paid in cash. (b)The accounts payable increase resulted from the purchase of merchandise.

Illustration 11-22

Step 1: Determining the Increase/Decrease in Cash


Determining the increase/decrease in cash
during the year is a simple computation. As shown on the comparative balance sheet, Juarez Company had no cash on hand at the beginning of 1999 and a balance of $159,000 at the end of 1999. Therefore, cash increased by $159,000.

Step 2: Determining Net Cash Provided/Used by Operating Activities


To determine net cash provided/used by operating
activities under the direct method, adjust each item in the income statement from the accrual basis to the cash basis. An efficient way to apply the direct method is to analyze the revenues and expenses reported in the income statement in the order in which they are listed and then determine the cash receipts and cash payments related to these revenues and expenses. Only major classes of operating cash receipts and cash payments are reported in the operating activities section, as illustrated on the next slide.

Major Classes of Cash Receipts and Payments


Cash Receipts

Cash Payments
To suppliers

Net Cash Provided by Operating Activities

From sales of goods and services to customers

To employees

From receipts of interest on loans and dividends on investments

For operating expenses

Net Cash Provided/Used by Operating Activities

For interest

For taxes
Illustration 11-23

Step 2: Determining Net Cash Provided/Used by Operating Activities


Operations of the period led to revenues. Not all of these revenues resulted in an increase in cash, however. When accounts receivable increase during the year, revenues on an accrual basis are higher than revenues on a cash basis. Juarez Company had revenues of $780,000 during its first year of operation. To determine cash receipts from customers, it is necessary to consider the change in accounts receivable during the year. Specifically, the increase in accounts receivable is deducted from sales revenues. For Juarez, accounts receivable increased $15,000. Thus, cash receipts from customers were $765,000 ($780,000 revenue - $15,000 increase in accounts receivable).

Step 2: Determining Net Cash Provided/Used by Operating Activities


The relationships among cash receipts from customers,
revenues from sales, and changes in accounts receivable are shown below.
Cash receipts from customers

Revenues from sales

+ Decrease in accounts receivable or - Increase in accounts receivable Illustration 11-26

Cash receipts from customers may also be determined


from an analysis of the Accounts Receivable account as shown below.
Accounts Receivable
Balance, Jan. 1 Revenues from sales 0 780,000 Receipts from customers 765,000

Balance, Dec. 31

15,000 Illustration 11-25

Step 2: Determining Net Cash Provided/Used by Operating Activities


To determine cash payments to suppliers, it is first necessary to find purchases for the year. To find purchases, cost of goods sold is adjusted for the change in inventory. When inventory increases during the year, it means that purchases this year exceed cost of goods sold. As a result, the increase in inventory is added to cost of goods sold to arrive at purchases. In 1999, Juarez Companys Cost of Goods Sold was $450,000 and its inventory increased $160,000. Purchases, therefore are $610,000 ($450,000 + 160,000).

Step 2: Determining Net Cash Provided/Used by Operating Activities


After purchases are computed, cash payments to suppliers are determined by adjusting purchases for the change in accounts payable. When accounts payable increase during the year, purchases on an accrual basis are higher than purchases on a cash basis.

In 1999, Juarez Companys Accounts Payable increased by


$60,000. Thus, cash payments to suppliers were $550,000 ($610,000 purchases - $60,000 increase in accounts payable).

Step 2: Determining Net Cash Provided/Used by Operating Activities


The relationships among cash payments to suppliers,
cost of goods sold, changes in inventory, and changes in accounts payable are shown below.
Cash payments to suppliers

Cost of goods sold

+ Increase in inventory or - Decrease in inventory

+ Decrease in accounts payable or - Increase in accounts payable Illustration 11-30

Cash payments to suppliers may also be determined


from an analysis of the Accounts Payable account as shown below.
Accounts Payable
Payments to suppliers 550,000 Balance, Jan. 1 Purchases Balance, Dec. 31 0 610,000 60,000

Illustration 11-29

Step 2: Determining Net Cash Provided/Used by Operating Activities


To determine the cash paid for operating expenses, the income statement amount must be adjusted for any changes in prepaid expenses and accrued expenses payable. When prepaid expenses increase, accrual basis operating expenses are lower than cash basis operating expenses. Similarly, when accrued expenses payable increases, accrual basis operating expenses are higher than cash basis operating expenses. Juarez Companys cash payments for operating expenses are computed as shown below.
Operating Expenses Add: Increase in prepaid expenses Deduct: Increase in accrued expenses payable Cash payments for operating expenses $170,000 8,000 (20,000) $158,000

Illustration 11-31

Step 2: Determining Net Cash Provided/Used by Operating Activities


The relationships among cash payments for operating
expenses, changes in prepaid expenses, and changes in accrued expenses payable are shown below.
Cash payments for operating expenses + Increase in prepaid expense or - Decrease in prepaid expense + Decrease in accrued expenses payable or - Increase in accrued expenses payable

Operating Expenses

Illustration 11-31

Step 2: Determining Net Cash Provided/Used by Operating Activities


The income statement for Juarez Company shows
income tax expense of $48,000. This amount equals the cash paid because the comparative balance sheet indicates no income taxes payable at either the beginning or the end of the year. All of the revenues and expenses on the 1999 income statement have now been adjusted to a cash basis. The operating activities section of the statement of cash flows for Juarez Company is shown on the next slide.

Step 2: Determining Net Cash Provided/Used by Operating Activities

Juarez Company Partial Statement of Cash Flows - Direct Method For the Year Ended December 31, 1999
Cash flows from operating activities Cash receipts from customers $765,000 Cash payments: To suppliers $550,000 For operating expenses 158,000 For income taxes 48,000 756,000 Net cash provided by operating activities $ 9,000

Illustration 11-10

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


To find net cash provided/used by investing and financing activities, determine the changes in the noncurrent accounts on the balance sheet. Those changes are then analyzed using selected transaction data to determine the effect, if any, the changes had on cash. Juarez Company's three noncurrent accounts are Land, Common Stock, and Retained Earnings, all three of which had increases during the year.

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


No transaction data are given for the increase in Land
of $80,000. When other explanations are lacking, assume any differences involve cash. The purchase of land for $80,000 cash is reported as a cash outflow in the investing activities section. The increase of common stock results from the issuance of common stock for $300,000 cash. It is reported as an inflow of cash in the financing section.

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


The reasons for the net increase of $42,000 in the Retained Earnings account are determined by analysis. First, net income increased retained earnings by $112,000. Second, the additional information indicates that a cash dividend of $70,000 was declared and paid. The adjustment of revenues and expenses to arrive at net cash provided by operations was done in step 2 earlier. The cash dividend paid is reported in the financing activities section.

Statement of Cash Flows 1999


Juarez Company Statement of Cash Flows - Direct Method For the Year Ended December 31, 1999
Cash flows from operating activities Cash receipts from customers $765,000 Cash payments: To suppliers $550,000 For operating expenses 158,000 For income taxes 48,000 756,000 Net cash provided by operating activities 9,000 Cash flows from investing activities Purchase of land (80,000) Net cash used by investing activities (80,000) Cash flows from financing activities Issuance of common stock 300,000 Payment of cash dividends (70,000) Net cash provided by financing activities 230,000 Net increase in cash 159,000 Cash at beginning of period 0 Cash at end of period $159,000

Illustration 11-35

Statement of Cash Flows 1999


Juarez Company's statement of cash flows for
1999 on the previous slide shows that operating activities provided $9,000 cash; investing activities used $80,000 cash; and financing activities provided $230,000 cash. The increase in cash of $159,000 reported in the statement of cash flows agrees with the increase of $159,000 shown as the change in the cash account in the comparative balance sheet.

Second Year of Operations 2000


The comparative balance sheet, income statement, and additional information for Juarez Companys second year of operation are presented on the next two slides.

Statement of Cash Flows Direct Method


Juarez Company Comparative Balance Sheet December 31
Assets Cash Accounts receivable Inventory Prepaid expenses Land Equipment Acc Depr - equipment Total 2000 $191,000 12,000 130,000 6,000 180,000 160,000 (16,000) $663,000 1999 $159,000 15,000 160,000 8,000 80,000 0 0 $422,000

Illustration 11-36
Change Increase/Decrease $ 32,000 increase 3,000 decrease 30,000 decrease 2,000 decrease 100,000 increase 160,000 increase 16,000 increase

Liabilities and Stockholders Equity Accounts payable $ 52,000 Accrued expenses payable 15,000 Income taxes payable 12,000 Bonds payable 90,000 Common stock 400,000 Retained earnings 94,000 Total $663,000

$60,000 20,000 0 0 300,000 42,000 $422,000

$ 8,000 decrease 5,000 decrease 12,000 increase 90,000 increase 100,000 increase 52,000 increase

Statement of Cash Flows Direct Method


Juarez Company Income Statement For the Year Ended December 31, 1999
Revenues from sales Cost of goods sold Operating expenses Depreciation expense Loss on sale of equipment Income before income taxes Income tax expense Net income $975,000 $660,000 176,000 18,000 1,000

855,000 120,000 36,000 $84,000

Additional information: (a)In 2000 the company declared and paid a $32,000 cash dividend. (b)Bonds were issued at face value for $90,000 in cash. (c)Equipment costing $180,000 was purchased for cash. (d)Equipment costing $20,000 was sold for $17,000 cash when the book value of the equipment was $18,000. (e)Common stock of $100,000 was issued to acquire land. Illustration 11-37

Step 1: Determining the Increase/Decrease in Cash


As shown on the comparative balance sheet,
Juarez Companys cash increased $32,000 ($191,000 - $159,000) during 2000.

Step 2: Determining Net Cash Provided/Used by Operating Activities


Once again, to determine net cash provided/used by
operating activities under the direct method, adjust each item in the income statement from the accrual basis to the cash basis.

Explanations for the adjustments to revenues and


expenses for Juarez Company in 2000 are discussed on the following five slides.

Step 2: Determining Net Cash Provided/Used by Operating Activities


Cash Receipts from Customers: Revenues from sales
were $975,000. Since accounts receivable decreased $3,000 cash receipts from customers were greater than sales revenues. Cash receipts from customers were $978,000 ($975,000 + $3,000). Cash Payments to Suppliers: For 2000, purchases are computed using cost of goods sold of $660,000 and the decrease in inventory of $30,000. Purchases are then adjusted by the decrease in accounts payable of $8,000. Cash payments to suppliers were $638,000 ($660,000 - $30,000 + $8,000).

Step 2: Determining Net Cash Provided/Used by Operating Activities


Cash Payments for Operating Expenses: Operating
expenses for 2000 were $176,000. This amount is then adjusted for changes in prepaid expenses and accrued expenses payable. Prepaid expenses decreased $2,000 during the year. This means that $2,000 was allocated to expenses, but cash payments did not increase by that amount. Accrued expenses payable decreased $5,000. As a result, cash payments were $5,000 higher than reported for operating expenses. Cash payments for operating expenses were $179,000 ($176,000 - $2,000 + 5,000).

Step 2: Determining Net Cash Provided/Used by Operating Activities


Depreciation Expense: Depreciation expense is not
shown on a statement of cash flows under the direct method because it is a noncash charge. If the amount for operating expenses had included depreciation, operating expenses must be reduced by the amount of depreciation to determine cash payment for operating expenses. Other charges to expense that do not require the use of cash, such as the amortization of intangible assets and depletion expense are treated in the same manner as depreciation.

Step 2: Determining Net Cash Provided/Used by Operating Activities


Loss on Sale of Equipment: The loss on sale of
equipment of $1,000 is also a noncash charge. The loss on sale of equipment reduces net income, but it does not reduce cash. Thus, the loss on sale of equipment is not reported on a statement of cash flows prepared using the direct method.

Step 2: Determining Net Cash Provided/Used by Operating Activities


Cash Payments for Income Taxes: Income tax
expense on the income statement was $36,000. Income taxes payable, however, increased $12,000, which means that $12,000 of the income taxes have not been paid. Cash payments for income taxes were therefore $24,000 ($36,000 - $12,000).

The relationships among cash payments for income


taxes, income tax expense and changes in income taxes payable is shown below.
Cash payments for income taxes + Decrease in income taxes payable or - Increase in income taxes payable Illustration 11-42

Income tax expense

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


Once again, to find net cash provided/used by investing and financing activities, determine the changes in the noncurrent accounts on the balance sheet. Those changes are then analyzed using selected transaction data to determine the effect, if any, the changes had on cash.

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


Land: Land increased $100,000. The additional
information indicates that common stock was issued to purchase the land. Although the exchange of common stock for land has no effect on cash, it is a significant noncash investing and financing activity that must be disclosed.

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


Equipment: The Equipment account increased
$160,000 in 2000. The additional information provided, reveals that this was a net increase resulting from two transactions: (1) a purchase of equipment for $180,000 cash, and (2) a sale of equipment costing $20,000 for $17,000 cash when its book value was $18,000. These are investing activities. The purchase of equipment should be shown as a $180,000 outflow of cash, and the sale of equipment should be shown as a cash inflow of $17,000. The two amounts should be shown separately, not netted.

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


Bonds Payable: The Bonds Payable account
increased by $90,000 when bonds were issued for cash. This inflow of cash will be shown as a financing activity on the statement of cash flows. Common Stock: The Common Stock account increased $100,000. As indicated earlier, land was acquired from this stock issuance. This is a significant noncash financing and investing transaction that must be disclosed.

Step 3: Determining Net Cash Provided/Used by Investing & Financing Activities


Retained Earnings: Retained Earnings increased by
$52,000. The increase is the result of (1) net income of $84,000 that increased RE, and (2) dividends of $32,000 that decreased RE. Net income is not reported on the cash flows statement under the direct method. Payment of the dividends is a cash outflow that is reported as a financing activity. Juarez Companys cash flow statement for 2000 is shown on the next slide.

Juarez Company Statement of Cash Flows - Direct Method For the Year Ended December 31, 2000
Cash flows from operating activities Cash receipts from customers Cash payments: To suppliers $638,000 For operating expenses 179,000 For income taxes 24,000 Net cash provided by operating activities Cash flows from investing activities Purchase of equipment (180,000) Sale of equipment 17,000 Net cash used by investing activities Cash flows from financing activities Issuance of bonds payable 90,000 Payment of cash dividends (32,000) Net cash provided by financing activities Net increase in cash Cash at beginning of period Cash at end of period Noncash investing and financing activities: Issuance of common stock to purchase land

$978,000

841,000 218,000

(163,000)

58,000 32,000 159,000 $ 191,000


$100,000

Illustration 11-44

Study Objective 5

Use the statement of cash flows to evaluate a company.

Using Cash Flows to Evaluate a Company


Traditionally, the ratios most commonly used by investors and creditors have been based on accrual accounting. In this section, some cash-based ratios that are gaining increased acceptance among analysts are introduced.

Using Cash Flows To Evaluate A Company


Microsoft Corporations 1998 statement of cash flows provides information for the computations of these measures:
Microsoft Corporation Partial Statement of Cash Flows For the Year Ended 1998 ($ in millions)
Net cash provided by operating activities Cash flows from investing activities Additions to PP&E Other assets Short-term investments Net cash used by investing activities Net cash provided by financing activities $6,880

$ (656) (190) (6,426) (7,272) 554

Illustration 11-46

Free Cash Flow


In the statement of cash flows, cash from operations
is intended to indicate the cash-generating capability of the company. However, cash from operations fails to take into account that a company must invest in new fixed assets just to maintain its current level of operations and it must at least maintain dividends at current levels to satisfy investors. Free cash flow is the term used to describe the cash left from operations after adjustment for capital expenditures.

Free Cash Flow


Free cash flow is often computed with the following formula (alternative definitions also exist):
Net Cash Provided by Operating Activities

Capital Expenditures

Dividends Paid

Free Cash Flow


Illustration 11-45

Microsofts free cash flow is calculated as shown below. (In as much detail as is available.)
Net cash provided by operating activities Less: Expenditures on PP&E Dividends paid Free cash flow $6,880 (656) 0 $6,224

Illustration 11-47

Capital Expenditure Ratio


Another indicator of a company's ability to generate
sufficient cash to finance new fixed asset purchases is the capital expenditure ratio. It is computed with the formula shown below. Once again, Microsoft is used as an example.
Net Cash Provided by Operating Activities

Capital Expenditures

= =

Capital Expenditure Ratio

$6,880

$656

10.49 times

Microsofts ratio of 10.49 times suggests that it


could have purchased 10 times as much PP&E as it did without requiring any outside financing.

Assessing Liquidity, Solvency, and Profitability Using Cash Flows


Chapter 12 will present ratios used to
analyze a company's liquidity, solvency, and profitability using accrual-based numbers from the income statement and balance sheet. In this chapter we introduce ratios that are cash-based rather than accrualbased. These ratios use numbers from the statement of cash flows instead of the income statement.

Assessing Liquidity, Solvency, and Profitability Using Cash Flows


Many analysts are critical of accrualbased numbers because they feel that the adjustment process allows too much management discretion. One disadvantage to the cash-based measures is that, unlike the more commonly employed accrual-based measures, there are no readily available published industry averages for comparison.

Assessing Liquidity, Solvency, and Profitability Using Cash Flows


In the following discussion, Microsoft will be
analyzed with cash-based ratios. The following information will be needed in addition to the cash flow information provided earlier:
($ in millions) 1998 Current liabilities $ 5,730 Total liabilities 5,730 Sales 14,484 1997 $ 3,610 3,610 11,358

Illustration 11-49

Liquidity
Liquidity is the ability of a business to meet its
immediate obligations. You may be familiar with one measure of liquidity called the current ratio. (It will also be covered in Chapter 12.) Current ratio equals current assets divided by current liabilities. A disadvantage of the current ratio is that it uses year-end balances of current assets and current liabilities, which may not be representative of a company's position during most of the year.

Current Cash Debt Coverage Ratio


A ratio that partially corrects this problem is the
current cash debt coverage ratio, computed by dividing cash flow from operations by average current liabilities. Because cash from operations involves the entire year rather than a balance at one point in time, it is often considered a better representation of liquidity on the average day.

Current Cash Debt Coverage Ratio


The current cash debt coverage ratio for Microsoft and Oracle (for comparison purposes) are given below. Each company's current ratio is also shown for comparative purposes.
Net Cash Provided by Operating Activities
($ in millions)

Average Current Liabilities

=
=

Current Cash Debt Coverage Ratio


Current ratio

Microsoft

$6,880

($5,730 + $3,610)/2

1.47 times

2.77:1 1.74.1

Oracle

.73 times

Microsofts net cash provided by operations is nearly 1- times its average current liabilities. Oracles ratio of .73 times, though not a cause for concern, is substantially lower than Microsofts.

Solvency
Solvency is the ability of a firm to survive over the
long term. A measure of solvency that uses cash figures is the cash debt coverage ratio: the ratio of cash provided by operations to total debt as represented by average total liabilities. This ratio measures a company's ability to repay its liabilities from cash generated from operations.

Cash Debt Coverage Ratio


The cash debt coverage for Microsoft and Oracle for 1998 are given below. The debt to total assets ratio (an accrual-based solvency ratio) is also shown for comparison purposes.
Net Cash Provided by Operating Activities
($ in millions)

Average Total Liabilities

=
=

Cash Debt Coverage Ratio

Debt to total assets

Microsoft Oracle

$6,880

($5,730 + $3,610)/2

1.47 times .56 times

26% 49%

Microsoft has no long-term obligations so its cash debt coverage ratio is the same as its current cash debt coverage ratio. Oracle has long-term debt so its ratios are not as good as Microsofts. Neither company has a solvency problem, however.

Profitability
Profitability refers to a company's ability to
generate a reasonable return. Chapter 12 will introduce accrual-based ratios that measure profitability, such as gross profit rate, profit rate margin, and return on assets, if they are not already familiar to you. A cash-based measure of performance is the cash return on sales ratio.

Cash Return on Sales Ratio


The cash return on sales ratio is computed by
dividing cash from operations by sales. The cash return on sales ratio indicates the company's ability to turn sales into dollars. A low cash return on sales ratio should be investigated because it might indicate the company is recognizing sales that are not really sales that is, sales it will never collect.

Cash Debt Coverage Ratio


The cash return on sales ratios for Microsoft and Oracle for 1998 are given below. Illustration 11-52
Net Cash Provided by Operating Activities
($ in millions)

Net Sales

Cash Return on Sales Ratio

Microsoft Oracle

$6,880

$14,484

48% 22%

Oracles cash return on sales ratio of 22% is substantially less than Microsofts at 48%. This indicates that Microsoft is more efficient in turning sales into cash. Yet Oracles cash return on sales ratio is quite respectable.

Copyright
Copyright 1999 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that named in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Chapter 11
Statement of Cash Flows