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Chapter 13
Statement of Cash Flows

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 Statement of Cash Flow: Introduction
Cash flow is particularly important for large companies like
PepsiCo, Inc. as it continuously seeks to expand its markets. As is
true for many companies, recent annual reports for Pepsi includes
three–year comparative statements of cash flows. These
statements present cash flows in three major categories: operating
activities, investing activities, and financing activities. For a recent
three–year period, Pepsi’s statements show $9.4 to $10.6 billion
positive cash flows from operations each year. This cash was used
for many purposes, including capital spending, repayment of debt,
repurchasing the company’s common stock, and paying dividends
to stockholders. Efficiently managing cash flows of this magnitude
is an important responsibility of the company’s management team
and is critical for the company’s continued success.

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 Purpose of the Statement
The objective of a statement of cash flows is to provide
information about the cash receipts and cash payments of a
business entity during the accounting period.
In a statement of cash flows, information about positive and
negative cash flows is classified in terms of the company’s:
• Operating activities.
• Investing activities.
• Financing activities.

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 Benefits
The statement of cash flows assists investors, creditors, and others in
assessing such factors as:
• The company’s ability to generate positive cash flows in future periods.
• The company’s ability to meet its obligations and to pay dividends.
• The company’s need for external financing.
• Reasons for differences between the amount of net income and the
related net cash flows from operating activities.
• Both the cash and noncash aspects of the company’s investment and
financing transactions for the period.
• Causes of the change in the amount of cash and cash equivalents
between the beginning and the end of the accounting period.

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 Classification of Cash Flows: Operating

The operating activities section of the statement of cash

flows includes the cash effects of those transactions reported
in the continuing operations section of the income statement.
Cash flows from operating activities include the following:

Cash Receipts Cash Payments

Collections from customers for Payments to suppliers of merchandise and
sales of goods and services services, including payments to employees
Interest and dividends received Payments of interest
Other receipts from operations; Payments of income taxes
for example, proceeds from Other expenditures relating to operations: for
settlement of litigation example, payments in settlement of
litigation

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 Classification of Cash Flows: Investing

Cash flows relating to investing activities present the cash

effects of transactions involving plant assets, intangible
assets, and investments. They include the following:

Cash Receipts Cash Payments

Cash proceeds from selling Payments to acquire investments
investments and plant and and plant and intangible assets
intangible assets
Cash proceeds from collecting Amounts paid to borrowers
principal amounts on loans
Sale of investment Purchase of investments

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 Classification of Cash Flows: Financing

Cash flows classified as financing activities include the

following items that result from debt and equity financing
transactions:

Cash Receipts Cash Payments

Proceeds from both short–term Repayment of amounts borrowed
and long–term borrowing (excluding interest payments)
Cash received from owners (for Payments to owners, such as cash
example. from issuing stock dividends
or sale of treasury stock) Purchase of treasury shares

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 FASB’s Position on Interest & Dividends

A case can be made that interest and dividend receipts are related
to investing activities, and that interest payments are related to
financing activities. The Financial Accounting Standards Board (F A
SB) considered this point of view but decided instead to require
companies to present interest and dividend receipts and interest
payments as operating activities. The F ASB position reflects the
fact that cash flows from operating activities should include the
cash effects of the revenue and expense transactions included in
the income statement. Because dividend and interest revenue and
interest expense enter into the determination of net income, the
related cash flows are presented as operating activities in the
statement of cash flows. Payments of dividends, however, do not
enter into the determination of net income. Therefore, dividend
payments are classified as financing activities.

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 International Case In Point
International Case In Point
Both the Financial Accounting Standards Board in the United
States and the International Accounting Standards Board require
companies to present a statement of cash flows organized into
three categories: operating activities, investing activities, and
financing activities. One difference in these two sets of financial
reporting standards is the classification of interest received on
investments and interest paid on debt financing. As you have
learned in this chapter. the F ASB requires these to be presented
as part of operating cash flows. IASB standards, on the other
hand, allow interest received to be classified as either operating or
investing and interest paid to be classified as either operating or
financing.

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 Cash and Cash Equivalents
For purposes of preparing a statement of cash flows, cash is
defined as including both cash and cash equivalents.
Cash equivalents are short–term, highly liquid investments
that will mature within 90 days from the acquisition date.
Examples include:
• Money market funds.
• Commercial paper.
• Treasury bills.

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 Cash versus Accrual Information
• The items in an income statement and a statement of
financial position (balance sheet) represent the balances of
specific general ledger accounts.
• However, the captions used in the statement of cash flows
do not correspond to specific ledger accounts because a
company’s general ledger is usually maintained on the
accrual basis of accounting, not on a cash basis.
• The most logical to prepare the statement of cash flows by
examining the income statement and the changes during
the period in all of the balance sheet accounts except for
Cash itself.

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 Preparing a Statement of Cash Flows:
Direct Method
In order to begin preparing the statement of cash flows, we
need the following information:
• Income statement.
• Comparative balances at the beginning and end of the
period.
• Additional detailed information about the changes
occurring during the period in certain balance sheet
accounts.

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 Allison Corporation: Income Statement

Access the text alternative for slide images.

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 Allison Corporation: Balance Sheet

Access the text alternative for slide images.

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 Allison Corporation: Additional
Information
To assist in the preparation of the statement of cash flows,
the additional information related to changes in certain
balance sheet accounts will be divided into the following
categories:
• Operating activities.
• Investing activities.
• Financing activities.

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 Allison Corporation: Operating Activities
• Accounts receivable increased by $30,000 during the year.
• Dividend revenue is recognized on the cash basis, but interest revenue
is recognized on the accrual basis. Accrued interest receivable
decreased by $1,000 during the year.
• Inventory increased by $10,000 and accounts payable increased by
$15,000 during the year.
• During the year, short–term prepaid expenses increased by $3,000
and accrued expenses payable (other than for interest or income
taxes) decreased by $6,000. Depreciation for the year amounted to
$40,000.
• The accrued liability for interest payable increased by $7,000 during
the year.
• The accrued liability for income taxes payable decreased by $2,000
during the year.

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 Allison Corporation: Investing Activities

• Analysis of the Marketable Securities account shows debit

entries of $65,000, representing the cost of securities
purchased, and credit entries of $44,000, representing the cost
of securities sold. (No marketable securities are classified as
cash equivalents.)
• Analysis of the Notes Receivable account shows $17,000 in
debit entries, representing cash loaned by Allison Corporation to
borrowers during the year, and $12,000 in credit entries,
representing collections of notes receivable. (Collections of
interest were recorded in the Interest Revenue account and are
considered cash flows from operating activities.)
• Allison’s plant asset accounts increased by $116,000 during the
year.

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 Allison Corporation: Financing Activities

• During the year, Allison Corporation borrowed $45,000

cash by issuing short–term notes payable to banks. Also,
the company repaid $55,000 in principal amounts due on
these loans and other notes payable. (Interest payments
are classified as operating activities.)
• The company issued bonds payable for $100,000 cash.
• The company issued 1,000 shares of $10 par value capital
stock for cash at a price of $50 per share.
• Cash dividends declared and paid to stockholders
amounted to $40,000 during the year.

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 Allison Corporation: Cash and Cash
Equivalents
Cash and cash equivalents as shown in Allison Corporation’s
balance sheets amounted to $20,000 at the beginning of the
year and $55,000 at year–end–a net increase of $35,000.
Key Point
Using this information, we will now illustrate the steps in
preparing Allison Corporation’s statement of cash flows and a
supporting schedule disclosing the noncash investing and
financing activities.

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 Cash Received from Customers
If accounts receivable increase during the year, credit sales
will have exceeded collections of cash from accounts
receivable.
• We deduct the increase in accounts receivable from net
sales to determine the amount of cash received during the
year.
If accounts receivable decrease, collections of these
accounts will have exceeded credit sales.
• We add the decrease in accounts receivable to net sales to
determine the amount of cash received during the year.

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 Allison Corporation: Cash Received from
Customers
The relationship between cash received from customers and
net sales is summarized as follows:
+ Decrease in Accounts Receivable 
Cash received Net  
=  or 
from Customers Sales  
 − Increase in Accounts Receivable 
For Allison Corporation, we can compute the cash received
from customers as follows:

Net sales (accrual basis) $900,000

Less: Increase in accounts receivable 30,000
Cash received from customers $870,000

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 Interest and Dividends Received
Dividend revenue is recorded on the cash basis.
• The $3,000 shown in the income statement also
represents the amount of cash received as dividends.
Interest revenue is recognized on the accrual basis.
• We have already shown how to convert one type of
revenue, net sales, from the accrual basis to the cash
basis.
• We use the same approach to convert interest revenue
from the accrual basis to the cash basis.

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 Allison Corporation: Interest and
Dividends Received
Our formula for converting net sales to the cash basis may be
modified to convert interest revenue to the cash basis as follows:
+ Decrease in Interest Receivable 
Interest Interest  
=  or 
Received Revenue  
− Increase in Interest Receivable 
We compute Allison Corporation’s interest received as follows:
Interest revenue (accrual basis) $6,000
Add: Decrease in accrual interest receivable 1,000
Interest received (cash basis) $7,000

We then combine interest and dividends received as follows:

Interest received (cash basis) $ 7,000
Dividends received (cash basis) 3,000
Interest and dividends received $10,000

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 Cash Payments for Merchandise and
Expenses
• The next item in the statement of cash flows, “Cash paid to
suppliers and employees,” includes all cash payments for
purchases of merchandise and for operating expenses
(excluding interest and income taxes).
• Payments of interest and income taxes are listed as
separate items in the statement.
• The relationship between cash payments for merchandise
and the cost of goods sold depends on the changes during
the period in two related balance sheet accounts: inventory
and accounts payable to suppliers of merchandise.

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 Allison Corporation: Cash Paid for
Merchandise
We compute cash payments for purchases as follows:

+ Increase in Inventory  + Decrease in Accounts Payable 

Cash Payments 
Cost of   
=  or  and  or 
for Purchases Goods Sold   −Increase in Accounts Payable 
− Decrease in Inventory   

We compute Allison Corporation’s cash payments for purchases of merchandise

as follows:

Cost of goods sold $500,000

Add: Increase in inventory 10,000
Net Purchases (accrual basis) $510,000
Less: Increase in accounts payable to suppliers 15,000
Cash payments for purchases of merchandise $495,000

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 Cash Payments for Expenses 1

Expenses shown on the income statement may differ from

cash payments made during the period.
In converting accrual basis expenses to the cash basis, we
deduct the following noncash expenses:
• Depreciation expense.
• Amortization of intangible assets.
• Unfunded portion of postretirement benefits expense.
• Amortization of bond discount.

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 Cash Payments for Expenses 2

A second type of difference arises from short–term timing

differences between the recognition of expenses and the
actual cash payments.
Expenses are recorded in accounting records when the
related goods or services are used.
However, the cash payments for these expenses might
occur:
1. In an earlier period.
2. In the same period.
3. In a later period.

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 Cash Payments for Expenses (concluded)

1. If cash payment is made in advance, the payment creates

an asset, termed a prepaid expense, or, in our formula, a
“prepayment.” To the extent that prepaid expenses
increase over the year, cash payments exceed the
amount recognized as expense.
2. If payment is made in the same period, the cash payment
is equal to the amount of expense.
3. If payment is made in a later period, the payment reduces
a liability for an accrued expense payable. To the extent
that accrued expenses payable decrease during the year,
cash payments exceed the amount recognized as
expense.

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 Allison Corporation: Cash Payments for
Expenses
The relationship between cash payments for expenses and accrual-basis
expenses is summarized as follows:
 Decrease in 
 Increase in  + Related Accrued 
+ Related   
 Depreciation     Liabilities 
 and Other   Prepayments   
Cash Payments      or 
= Expenses   and  or  and  
for Expenses  − Noncash   Decrease in   Increase in 
 Expenses    − Related Accrued 
− Related   
 Prepayments   Liabilities 
   

We may compute the Allison Corporation’s cash payments for operating

expenses as follows:
Operating expenses (Including depreciation) $300,000
Less: Noncash expenses (depreciation) 40,000
Subtotal $260,000
Add: Increase In short-term prepayments $3,000
Decrease In accrued liabilities 6,000 9,000
Cash payments for operating expenses $269,000

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 Allison Corporation: Cash Paid to
Suppliers and Employees
• The caption used in our cash flow statement, “Cash paid to
suppliers and employees,” includes cash payments for
both purchases of merchandise and for operating
expenses.
• This cash outflow may now be computed by combining the
two previous calculations.

Cash payments for purchases of merchandise $495,000

Cash payments for operating expenses 269,000
Cash payments to suppliers and employees $764,000

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 Allison Corporation: Cash Payments for
Interest and Taxes
To determine the amount of interest actually paid, we subtract from total
interest expense the portion that has been financed through an increase
in the liability for interest payable. The computation is as follows:
Interest expense $35,000
Less: Increase in related accrued liability 7,000
Interest paid $28,000

Incurring income tax expense increases the tax liability; making cash
payments to tax authorities reduces it. If the liability decreased over the
year, cash payments to tax authorities must have been greater than the
income tax expense for the current year. The amount of the cash
payments is determined as follows:
Income tax expense $36,000
Add: Decrease in related accrued liability 2,000
Income tax paid $38,000

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 Allison Corporation: Review of Operating
Activities
Cash flows from operating activities:

Cash received from customers $ 870,000

Interest and dividends received 10,000
Cash provided by operating activities $ 880,000
Cash paid to suppliers and employees $(764,000)
Interest paid (28,000)
Income taxes paid (38,000)
Cash disbursed for operating activities (830,000)
Net cash flows from operating activities $ 50,000

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 Cash Flows from Investing Activities
Much information about investing activities can be obtained
simply by looking at the changes in the related asset
accounts during the year.
• Debit entries in these accounts represent purchases of the
assets, or cash outlays.
• Credit entries represent sales of the assets, or cash
receipts.
However, credit entries in asset accounts represent the cost
(or book value) of the assets sold.
• To determine the cash proceeds from these transactions,
we must adjust the amount of the credit entries for any
gains or losses recognized on the sales.

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 Allison Corporation: Purchases and Sales
of Securities
• The $65,000 in debit entries represents purchases of
marketable securities.
• The $44,000 in credit entries represents the cost of marketable
securities sold during the period.
• However, the income statement shows that these securities
were sold at a $4,000 loss.
• Thus the cash proceeds from these sales amounted to only
$40,000 ($44,000 cost, minus $4,000 loss on sale).
• In the statement of cash flows, these investing activities are
summarized as follows:
Purchases of marketable securities $(65,000)
Proceeds from sales of marketable securities 40,000

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 Allison Corporation: Loans Made and
Collected
Debit entries in the Notes Receivable account represent new
loans made during the year.
Credit entries indicate collections of the principal amount on
outstanding notes (loans).
• (Interest received is credited to the Interest Revenue
account and is included among the cash receipts from
operating activities.)

Loans made to borrowers $(17,000)

Collections on loans 12,000

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 Your Turn: You as a Sales Manager
Assume you are a regional sales manager for Wiggins Foods. Inc..
a distributor of bulk food products to schools, nursing homes.
hospitals. prisons, and other institutions. Recently, the purchasing
agent for Baggins Preschools. Inc., tells you the company will
likely have to forgo its normal monthly order because of cash flow
problems. The purchasing agent tells you other companies are
helping it through the cash flow squeeze and asks if your company
could loan the payment to Baggins. The purchasing agent
suggests you could record the sale as revenue and increase notes
receivable (rather than accounts receivable) by the same amount.
Baggins is one of your largest customers. Without its order, you
will not meet your sales goals for the month–so you are tempted to
say yes. However, on reflection you wonder if it might be unethical
for the company to lend its customer money to finance purchases.
What should you do?
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 Allison Corporation: Cash Paid to Acquire
Plant Assets
• Allison Corporation purchased plant assets during the year
for $200,000, paying $160,000 in cash and issuing a long–
term note payable for the $40,000 balance.
• Notice that only the $160,000 cash payment appears in the
statement of cash flows.
• The noncash aspects of these transactions are shown in a
supplementary schedule, as follows:
Supplementary Schedule of Noncash Investing and
Financing Activities
Purchases of plant assets $200,000
Less: Portion financed through issuance of long-term debt 40,000
Cash paid to acquire plant assets $160,000

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 Allison Corporation: Proceeds from Sales
of Plant Assets
• An analysis of the plant asset accounts shows net credit
entries totaling $44,000 in the year.
• These net credit entries represent the book value of plant
assets sold during the year.
• However, the income statement shows that these assets
were sold at a gain of $31,000.
• Therefore, the cash proceeds from sales of plant assets
amounted to $75,000, as follows:

Book value of plant assets sold $44,000

Add: Gain on sales of plant assets 31,000
Proceeds from sales of plant assets $75,000

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 Allison Corporation: Review of Investing
Activities
Cash flows from investing activities:

Purchases of marketable securities $ (65,000)

Proceeds from sales of marketable securities 40,000
Loans made to borrowers (17,000)
Collections on loans 12,000
Purchases of plant assets (160,000)
Proceeds from sales of plant assets 75,000
Net cash flows from Investing activities $(115,000)

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 Cash Flows from Financing Activities
Cash flows from financing activities are determined by analyzing
the debit and credit changes recorded during the period in the
related liability and stockholders’ equity accounts.
Cash flows from financing activities are more easily determined
than those relating to investing activities, because financing
activities seldom involve gains or losses.
The debit or credit changes in the balance sheet accounts usually
are equal to the amounts of the related cash flows.
• Credit changes in such accounts as Notes Payable and the
accounts for long–term debt and paid–in capital usually indicate
cash receipts.
• Debit changes indicate cash payments.

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 Allison Corporation: Short–Term
Borrowing Transactions
• Cash inflows and outflows related to borrowing activities
should be reported separately.
• Presenting both positive and negative cash flows is
referred to as presenting gross cash flows rather than
presenting net cash flows.
• Allison Corporation’s cash flows from borrowing
transactions can be summarized as follows:

Proceeds from short-term borrowing $45,000

Payments to settle short-term debts (55,000)

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 Allison Corporation: Proceeds from
Issuing Bonds Payable and Capital Stock
Allison Corporation received cash of $100,000 by issuing
bonds payable.
• This amount was determined by summing the credit
entries in the Bonds Payable account.
• The Bonds Payable account included no debit entries
during the year, so we know that no cash was paid to retire
bonds.
Allison Corporation issued capital stock for $50,000.
• The proceeds from issuing stock are equal to the sum of
the credit entries made in the Capital Stock and Additional
Paid-in Capital accounts ($10,000 + $40,000).

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 Allison Corporation: Cash Dividends Paid
to Stockholders
Allison Corporation declared and paid cash dividends of
$40,000 during the year.
• If dividends are both declared and paid during the same
year, the cash payments are equal to the related debit
entries in the Retained Earnings account.
• If the balance sheet includes a liability for dividends
payable, the amounts debited to Retained Earnings
represent dividends declared during the period, which may
differ from the amount of dividends paid.
• To determine cash dividends paid, we adjust the amount of
dividends declared by adding any decrease (or subtracting
any increase) in the Dividends Payable account over the
period.
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 Allison Corporation: Review of Financing
Activities
Cash flows from financing activities:

Proceeds from short–term borrowing $ 45,000

Payments to settle short–term debts (55,000)
Proceeds from issuing bonds payable 100,000
Proceeds from issuing capital stock 50,000
Dividends paid (40,000)
Net cash flows from financing activities $100,000

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 Relationship between the Balance Sheet
and the Statement of Cash Flows
• The first asset appearing in the statement of financial
position (balance sheet) is Cash and Cash Equivalents.
• The statement of cash flows explains in great detail the
change in this one asset from one balance sheet date to
the next.
• The last three lines in the statement of cash flows illustrate
this relationship, as shown in our Allison Corporation
example:

Net increase (decrease) in cash and cash equivalents $35,000

Cash and cash equivalents, beginning of year 20,000
Cash and cash equivalents, end of year $55,000

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 Case in Point
Successful companies sometimes experience reductions in cash. Often
these reductions are intentional in order to more productively use the
company's cash in different ways. For example, in the year ending June
30,2021, Procter & Gamble Company reported a decrease in cash of
$5.8 billion. Does this mean that the company was experiencing extreme
financial difficulty? Not necessarily. In that same year, operations
provided almost $18 billion to support a wide range of activities. The
overall decline in cash in 2021 including paying cash dividends to
stockholders, retiring debt, and purchasing treasury stock. Another
important consideration is how the change in cash in any one year
compares to that of other years. In the case of P&G, in the previous year,
cash increased by almost $12 billion.
Lessons to be learned from this example are twofold. First, a decrease in
cash does not necessarily signal financial problems, and second, a
company's cash position may change in ways very different from its net
income.

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 Direct Method of Preparing the Statement
of Cash Flows
• In determining cash flows from operating activities for
Allison Corporation, we have followed what is commonly
referred to as the direct method.
• To this point in our study of the statement of cash flows, we
have emphasized the direct method because we consider
it to be the more informative and more readily understood
approach.
• The direct method is recommended by the FASB, although
companies are permitted to use either the direct or indirect
method.

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 Direct Method versus Indirect Method
Direct Method Indirect Method
Provides readers with the Begins with net income from
nature and dollar amount of: the income statement.
• Specific positive cash • Essentially works
flows (inflows). backward from net income
• Specific negative cash to cash flow.
flows (outflows). • Reaches the same net
cash provided by
operating activities as the
direct method.

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 Direct Method: Illustration
Direct Method
Cash flows from operating activities:
Cash received from customers $ 870,000
Interest and dividends received 10,000
Cash provided by operating activities $880,000
Cash paid to suppliers and employees $(764,000)
Interest paid (28,000)
Income taxes paid (38,000)
Cash disbursed for operating activities (830,000)
Net cash provided by operating activities $ 50,000

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 Indirect Method: Illustration

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 Reconciling Net Income with Net Cash
Flows
• In order to prepare the statement of cash flows using the
indirect method, adjustments are required to reconcile net
income with net cash flows.
• The nature and dollar amounts of these adjustments are
determined using a worksheet or a computer program;
they are not entered in the company’s accounting records.
• Necessary adjustments include:
1. Adjusting for noncash expenses.
2. Adjusting for timing differences.
3. Adjusting for nonoperating gains and losses.

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 Supplementary Schedule for Direct
Method
The FASB requires companies using the direct method to
meet an additional reporting requirement.
• They are required to provide a supplementary schedule
showing the computation of net cash flows from operating
activities by the indirect method.
The majority of companies use the indirect method.
• No supplementary schedule is required because the
information is already presented in the body of the
statement.

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 The Indirect Method: Summary of
Adjustments 1

Net Income
Adds:
• Depreciation.
• Decrease in accounts receivable.
• Decrease in inventories.
• Decrease in prepaid expenses.
• Increase in accounts payable.
• Increase in accrued expenses payable.
• Increase in deferred income taxes payable.
• Nonoperating losses deducted in computing net income.

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 The Indirect Method: Summary of
Adjustments 2

Deduct:
• Increase in accounts receivable.
• Increase in inventories.
• Increase in prepaid expenses.
• Decrease in accounts payable.
• Decrease in accrued expenses payable.
• Decrease in deferred income taxes payable.
• Nonoperating gains added in computing net income.

Net Cash Provided by (used in) operating activities.

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 Net Cash Flow From Operating Activities

Creditors and investors are particularly interested in net cash

flow from operating activities. It answers questions such as:
• Is the amount large enough to meet ongoing cash needs to
pay employees and suppliers, service long–term debt, and
provide for necessary replacements of plant assets?
• Will additional debt or equity financing be required in the
future?
• Is the amount of cash generated by operations sufficient to
sustain the recent amount of dividends to stockholders, or
even increase that amount?

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 Free Cash Flow
Analysts sometimes compute an amount called free cash
flow, a metric that is often cited in the financial literature. It
represents the cash flow available to management for
discretionary purposes, after the company has met all of its
basic obligations relating to business operations. While
different analysts may calculate free cash flow in different
ways, it is often calculated by subtracting from net cash from
operating activities the cash used to purchase plant assets
and pay dividends to stockholders. Both of these are
considered necessary expenditures of cash that will typically
recur each year.

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 Your Turn: You as a Financial Analyst 1

You are working for the same stock market research firm as in Chapter 12, but
unlike your previous boss (who tended to focus on growth and relative value, both
based on reported earnings), your new boss focuses primarily on free cash flow
and dividends in choosing stocks. Your new boss Is Interested in stocks where
free cash flow equals at least 50 percent of cash flow from operations. He also
wants dividends to be 25 percent or more of cash flow from operations. You are
considering the same stocks as before: Home Depot, Intel, Coca–Cola, and
Amazon. Your new boss provides you with the following information that he has
taken from recent financial statements and asks you to recommend which stocks
are consistent with his investment criteria.
In Millions

Cash Flow from Net Capital

Company Operations (CFO) Expenditures Dividends
Home Depot $18,839 $2,2632 $6,451
Intel 33,145 16,213 5,576
Coca-Cola 9,231 728 5,437
Amazon 30,723 13,427

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 Your Turn: You as a Financial Analyst 2

He also tells you that a potential new client is going to be calling you this
afternoon. This potential client Is an elderly widow and experienced investor who
Is quite wealthy. She Is Interested in learning why the relative levels of free cash
flow and dividends are Important metrics. She also doesn't understand why all
firms don't pay dividends. Your boss tells you to be prepared to answer this
prospective client's questions.

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 Managing Cash Flows: Cash Budgets
Cash budgets serve many purposes. Among the most
important are:
• Assisting managers to plan and coordinate their activities
in advance.
• Providing managers with advance notice of the resources
at their disposal and the results they are expected to
achieve.
• Providing targets useful in evaluating performance.
• Providing advance warnings of potential cash shortages.

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 What Priority Should Managers Give to
Increasing Net Cash Flows?
• Creditors and investors look to a company’s cash flows to
protect their investment and provide future returns.
• Trends in key cash flows (such as from operations and free
cash flow) affect a company’s credit rating, stock price, and
access to additional investment capital.
• For these reasons, management is under constant
pressure to improve the key measures of cash flow.

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 Short–Term Results versus Long-Term
Growth
Often, short–term operating results can be improved at the
expense of long–term growth.
• For example, reducing expenditures for developing new
products may increase earnings and net cash flows in the
current period.
• Over time, this strategy may lessen the company’s
competitiveness and long–term profitability.
Key Point
Many of the most successful products took many years to
develop and test before they contributed positive cash flows
to the company.

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 One–Time Boosts to Cash Flows
Some strategies can increase the net cash flows of the
current period, but without having much effect on future cash
flows.
Such strategies include:
• Collecting receivables more quickly.
• Reducing the size of inventory.

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 Strategies for Permanent Improvements in
Cash Flow
Several strategies may improve cash flows in both the short
and long term.
1. Deferring income taxes.
2. Peak pricing.
3. Effective product mix.

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 A Worksheet for Preparing a Statement of
Cash Flows 1

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 A Worksheet for Preparing a Statement of
Cash Flows 2

1. The following information also is used in the preparation

of the worksheet:
2. Net income for the year amounted to $250,000. Cash
dividends of $140,000 were declared and paid.
3. Auto’s only noncash expense was depreciation, which
totaled $60,000.
4. Marketable securities costing $15,000 were sold for
$35,000 cash, resulting in a $20,000 nonoperating gain.
5. The company purchased plant assets for $100,000,
making a $30,000 cash down payment and issuing a
$70,000 mortgage note payable for the balance of the
purchase price.

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 Statement of Cash Flows

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 Supplementary Information
Supplementary Schedule: Noncash Investing and
Financing Activities

Purchases of plant assets $ 100,000

Less: Portion financed by issuance of long-term debt 70,000
Cash paid to acquire plant assets $ 30,000

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 Learning Objective Summary LO13–1
LO13–1: Explain the purposes and uses of a statement of
cash flows. The primary purpose of a statement of cash
flows is to provide information about the cash receipts and
cash payments of the entity and how they relate to the
entity’s operating, investing, and financing activities.
Investors, creditors, and other users of financial statements
rely on this information to assess the liquidity of a business
and to evaluate its ability to generate positive cash flows in
future periods, pay dividends, and finance growth.

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 Learning Objective Summary LO13–2
LO13–2: Describe how cash transactions are classified
in a statement of cash flows. Cash flows are classified as
(1) operating activities, (2) investing activities, or (3) financing
activities. Cash from operating activities generally include the
cash effects of those items included in determining net
income. Investing activities include the purchase and
disposal of noncurrent assets. Financing activities include the
cash effects of debt and equity financing.

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 Learning Objective Summary LO13–3
LO13–3: Compute the major cash flows relating to
operating activities. The major operating cash flows are (1)
cash received from customers, (2) cash paid to suppliers and
employees, (3) interest and dividends received, (4) interest
paid, and (5) income taxes paid. These cash flows are
computed by converting the income statement amounts for
revenue, cost of goods sold, and expenses from the accrual
basis to the cash basis. This is done by adjusting the income
statement amounts for changes occurring over the period in
related balance sheet accounts.

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 Learning Objective Summary LO13–4
LO13–4: Compute the cash flows relating to investing and financing
activities. Cash flows from investing and financing activities are
determined by examining the entries in the related asset and liability
accounts, along with any related gains or losses shown in the income
statement. Debit entries in asset accounts represent purchases of assets
(an investing activity). Credit entries in asset accounts represent the cost
of assets sold. The amount of these credit entries are adjusted by any
gains or losses recognized on these sales transactions to determine the
appropriate amount of cash flows.
Debit entries to liability accounts represent repayment of debt, while
credit entries represent borrowing. Both types of transactions are
classified as financing activities. Other financing activities include the
issuance of stock (indicated by credits to the paid–in capital accounts)
and payment of dividends (indicated by a debit change in the Retained
Earnings account).

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 Learning Objective Summary LO13–5
LO13–5: Distinguish between the direct and indirect
methods of reporting operating cash flows. The direct
and indirect methods are alternative formats for reporting net
cash flows from operating activities. The direct method
shows the specific cash inflows and outflows comprising the
operating activities of the business. By the indirect method,
the computation begins with accrual–based net income and
makes adjustments necessary to arrive at net cash flows
from operating activities. Both methods result in the same
dollar amount of net cash flows from operating activities.
When the direct method is used, a reconciliation of net
income to net cash from operating activities must be
disclosed.

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 Learning Objective Summary LO13–6
LO13–6: Explain why net income differs from net cash flows
from operating activities. Net income differs from net operating
cash flows for several reasons. Net income includes noncash
expenses, such as depreciation and the amortization of intangible
assets. These expenses, which require no cash outlays when they
are recognized, reduce net income but do not require cash
payments in the same accounting period. Another reason net
income and net cash flows from operations differ is the many
timing differences that exist between the accrual recognition of
revenues and expenses in the income statement and receipt or
payment of cash that results from the same transactions. Finally,
nonoperating gains and losses enter into the determination of net
income, but the related cash flows are classified as investing or
financing activities, not operating activities.

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 Learning Objective Summary LO13–7
LO13–7: Compute net cash flows from operating
activities using the indirect method. The indirect method
uses net income (as reported in the income statement) as
the starting point in the computation of net cash flows from
operating activities. Adjustments to net income necessary to
arrive at net cash flows from operating activities can be
described in three categories: noncash expenses, timing
differences, and nonoperating gains and losses. Adjustments
reconcile net income (accrual basis) to net cash flows from
operating activities. For this reason, the indirect method is
sometimes referred to as the reconciliation method.

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 Learning Objective Summary LO13–8
LO13–8: Discuss the likely effects of various business
strategies on cash flows. Various business strategies are
available that may improve a company’s cash flows.
Predicting how a particular business strategy will affect cash
flows is difficult. Management should take care to not make
changes that improve short–term cash flows at the expense
of greater long–term cash flows. An informed user of a
company’s financial statements should understand the
direction in which a strategy is likely to affect cash flows–both
in the short term and over a longer term.

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 Learning Objective Summary LO13–9
LO13–9: Explain how a worksheet may be helpful in
preparing a statement of cash flows. flows. A worksheet is
a useful tool for converting accrual information to the cash–
based information as an aid in preparing the statement of
cash flows. In the top portion of the worksheet, entries are
made summarizing the changes in each noncash account. In
the bottom half, offsetting entries are made to represent the
cash effects of the transactions summarized in the top
portion. The entries in the bottom half of the worksheet are
classified into the same categories as in a statement of cash
flows–operating, investing, and financing. The statement of
cash flows then is prepared from the data in the bottom
portion of the worksheet.

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