Topic 5- The Statement of Cash Flows PDF

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Review of Key Points 1.

The statement of cash flows provides information that is not readily apparent by looking at just the balance sheet and the income statement. Operating cash flow is particularly useful in selected cases when net income does not give an accurate reflection of a company's performance. A cash flow statement is an important companion to the income statement. When non-cash expenses are high, earnings give an overly pessimistic view of a company's performance; cash flow from operations may give a better picture. In addition, the operations of rapidly growing companies can consume cash even when reported net income is positive. Finally, the cash flow statement provides a reality check in situations where companies have an incentive to bias the accrual accounting assumptions. The cash flow statement offers a one-page summary of the results of a company's operating, investing, and financing activities for the period. A pro forma, or projected, cash flow statement is an excellent tool to analyze whether a company's operating, investing, and financing plans are consistent and workable.

2.

Cash flows are partitioned into three categories—operating, investing and financing. In normal circumstances, a company has positive cash from operations and negative cash from investing activities. Whether cash from financing activities is positive or negative typically depends on how fast a company is growing. The three sections of a cash flow statement are: operating, investing, and financing. Significant non–cash investing and financing transactions must also be disclosed. o

Operating. For purposes of preparing a cash flow statement, operating activities are those activities that enter into the calculation of net income. Net cash provided by operating activities is the "bottom line" of the cash flow statement.

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Investing. The primary investing activities are the purchase and sale of land, buildings, and equipment.

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Financing. Financing activities involve the receipt of cash from, and the repayment of cash to, owners and creditors.

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Non-cash investing and financing transactions include the purchase of long-term assets in exchange for the issuance of debt or stock.

Most companies generate positive cash flow from operations. Cash from investing activities is usually negative, reflecting the fact that most companies are using cash to expand or enhance long-term assets. Positive cash flow from financing activities can be a sign of a young, rapidly expanding company in need of external financing. Negative cash flow from financing activities might be exhibited by a mature company. 3.

Preparing a statement of cash flows is a simple process if one has access to the record of a company's detailed cash transactions. One simply scans the list of cash transactions and sorts them into operating, investing, and financing items. With access to detailed cash account information, preparation of a statement of cash flows is easy because no accrual assumptions are necessary.

4.

When detailed cash flow information is not available, a statement of cash flows can be prepared using knowledge of how the three primary financial statements articulate. Operating cash flow can be reported using either the direct or the indirect method. In the absence of detailed cash account information, a company's cash inflows and outflows can be inferred through a careful analysis of each account contained in the balance sheet and the income statement. The six steps for preparing a statement of cash flows in this way are as follows: o

Compute the change in the cash balance.

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Convert the income statement from an accrual-basis to a cashbasis summary of operations.

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

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Analyze the short-term and long-term debt and the stockholders' equity accounts to determine the cash flow effects of any financing transactions.

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Prepare the formal statement of cash flows.

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Disclose any significant investing or financing transactions that did not involve cash.

The direct method of reporting cash from operating activities is easy to understand. The indirect method is more difficult to understand but it is useful because it highlights the reasons for the difference between net income and cash from operations. 2. Knowledge of how the three primary financial statements tie together allows one to forecast how interactions among management decisions might affect a company's future financial position. A projected cash flow statement can be constructed using information from a projected balance sheet and income statement. The cash flow projection allows a company to plan ahead as far as timing of new loans, stock issuances, long-term asset acquisitions, and so on. Projected cash flow statements also allow potential lenders to evaluate the likelihood that the loan will be repaid and allow potential investors to evaluate the likelihood of receiving cash dividends in the future....