Statement of Cash Flows and Articulation
Chapter 5

 

 

In Chapter 4 we emphasized the importance of the income statement.  However, the income statement prepared as it is using accrual accounting is not without potential drawbacks.    Accrual net income does not necessarily equal cash inflow and the statement of cash flows may give a more accurate picture of economic performance of a company.  Remember that positive net income on the income statement is meaningless unless the corporation can translate earnings into cash inflows.  Since most companies use accrual accounting, the only place one can discover what really has happened to cash is the statement of cash flows.

 

The authors present several examples of companies whose income statements need to be tempered by reported results on the statement of cash flows:

          Circle K – When a company reports large noncash expenses, it may give a
          more depressing picture of performance than warranted

 

          Home Depot – Though reported earnings are positive, operations may be
          actually consuming rather than generating cash

 

          Knowledgeware – When accounting assumptions are stretched, the income
          statement may report overly optimistic results

 

The statement of cash flows reports cash inflows and outflows on one page.  Cash flows are divided into three categories:  Operating, investing, and financing.  The three categories provide information relating to the following:

Operating activities – Transactions which affect net income
Investing activities – Transactions in property, plant, and equipment

Financing – Transactions which affect debt and equity activities

 

In preparing a statement of cash flows the definition of cash includes both cash (currency and bank account balances) and cash equivalents.  Cash equivalents are short term highly liquid instruments maturing in 90 day or less, i.e, T bills and other short term highly liquid financial instruments.

 

Exhibit 5-2 provides examples of major cash inflows (receipts) and cash outflows (payments) by category.  Note that operating activities include revenue and expense transactions which go to make up net income.  Investing activities include transactions involving the purchase and sale of land, buildings, equipment, and other assets not held for resale.  Financing activities include transactions whereby cash is obtained from or repaid to owners and creditors.

 

Successful companies ordinarily report large cash inflows from operating activities and large cash outflows in investing activities.  Financial activities can show either an inflow or an outflow depending where the company is in its life cycle.  A young expanding company typically requires large cash inflows from financing activities.  As a company matures, it realizes sufficient cash inflows from operating activities to pay dividends and to pay down debt.  Thus a successful maturing company may have a large cash outflow in financing activities.

 

Non-cash investing and financing activities are reported in a separate schedule on the statement of cash flows.  They are transactions arising when firms make investments that do not require cash and/or obtain financing other than cash, i.e., firm issues stock to acquire a building.  See Page 227.

 

The statement of cash flows reconciles the beginning and ending amounts of cash and cash equivalents.  There are two methods of preparing the statement of cash flows:  (1) the direct method, and (2) the indirect method.  The vast majority of publicly traded firms use the indirect method.    The only difference between the two methods is how cash flows from operating activities are calculated.  Cash flows from investing and financing activities are calculated identically in both methods.  Of course, both methods report the same amount of net cash flow from operating activities and the same amount of overall cash flow. 

 

On Page 229-232 the authors present a simple example which is used to show the calculation of operating cash flows by (1) the direct method and (2) the indirect method.  Essentially the accrual net income figure of $15 will be converted to a  cash inflow figure of $53.  To accomplish this, each income statement item must be converted to a cash figure. 

 

Thus sales of $150 computed using accrual accounting must be converted to a cash figure.  Since the balance of accounts receivable increased from beginning to end of the year, some of the sales ($60-40) must have been on credit.  Thus cash inflow from sales is $150 - $20 = $130.

 

Cost of Goods Sold on the income statement is reported as $80.  In converting this accrual figure to cash we must calculate the amount of cash paid for inventory during the year.  Since Inventory decreased from beginning to end of the year (from $100 to $75), then some of the Cost of Goods Sold must have been taken from Inventory.  Thus Cash paid for inventory is $80-$25 = $55.

 

Wage Expense is reported as $25 on the income statement.  However, the Wages Payable Account increased from $7 at the beginning of the year to $10 at the end of the year.  Thus cash wage expense must be $25-3 = $22. 

 

Since Depreciation Expense did not involve a cash payment, it is eliminated in calculating cash flow using the direct method.  An operating activities cash flow statement using the direct method appears on Page 230.

 

The indirect method begins with reported net income and adjusts this accrual figure to a cash figure.  An operating activities cash flow statement using the indirect method appears on Page 231. 

 

Depreciation must be added back to net income as Depreciation has been deducted in arriving at net income of $15 (Page 229) but Depreciation does not involve an outflow of cash.  Next because accounts receivable increased during the year (meaning some sales did not result in cash but in an increase in A/R), the sales figure on the income statement must be decreased by $20 ($60-40).   Since Inventory decreased ($100-75) during the year, less cash was used to purchase inventory than the Cost of Goods Sold figure of $80.  We must therefore add $25 to convert our accrual net income figure to a cash basis.  Wage Expense is reported as $25 on the income statement.  However, since Wages Payable increased ($10-$7) during the year some of the wage expense was not paid in cash.  Thus $3 needs to be added to reported net income as a result of the increase in payables. 

 

Beginning on Page 233 the authors present a complete statement of cash flows.  They suggest a six step approach in preparing a statement of cash flows as follows:

1.     Compute how much the cash balance has changed during the year

2.    Convert the income statement from accrual to cash basis

3.    Analyze long-term assets to identify the cash flow effects of investing activities

4.    Analyze the long term debt and stockholders’ equity accounts to determine the cash flow effect of financing activities

5.    Make certain that the total net cash flow operating, investing, and financing activities combined is equal to the net increase or decrease in cash (Step 1)

6.    Prepare any supplemental disclosures including any noncash investing and financing activities

 

Note Step 2 above requires the following:

          Eliminate all non-cash expenses

          Eliminate gains or losses associated with investing or financing activities (the
             cash flow from these transactions will be reported in the investing or
             financing activities section of the statement of cash flows)
          Adjust for changes in the balances of current assets and current liabilities

 

Several cash flow ratios are introduced.  The cash flow to net income ratio is computed by dividing cash from operations by net income.  This ratio, which generally has a value of >1.0, reflects the extent to which accrual accounting  adjustments have been included in computing net income

 

The cash flow adequacy ratio is computed by dividing cash from operating activities by cash required by investing activities.  This ratio indicates the degree to which a business is generating cash to pay for new equipment or for acquisitions.  The cash times interest earned ratio is computed by dividing cash before interest and taxes by cash paid for interest The ratio indicates the degree of risk for creditors in not receiving the required interest payments.

 

Articulation relates to the fact that the financial statements tie together with one another and are an integrated set of reports of a company’s performance and economic health.  See Exhibit 5-11.

 

The cash flow statement is an excellent tool to analyze whether operating, investing, and financial plans are feasible.  Projected cash flow statements are valuable tools for management, investors, and creditors.  See Exhibit 5-13.