The statement of cash flows reports the cash receipts, cash payments, and net change in

cash resulting from operating, investing, and financing activities during a period.

Usefulness--- generate future cash flows, to pay dividends and meet obligations, the
reasons for the difference between net income and net cash provided by operating
activities, cash investing and financing transactions during the period. Cash generating
ability of a company.

Classifications--

1. Operating activities: transactions that create revenues and expenses. Enter into
determination of net income.
2. Investing activities: acquiring and disposing of investments, property, plant,
equipment; lending money and collecting the loans.
3. Financing activities: obtaining cash from issuing debt and repaying the ammounts
borrowed; obtaining cash from stockholders, and paying dividends.
Note:

• Operating activities involve income statement items.

Receipts of investment revenue (interest and dividends) included as operating activities as

Non-cash activities:

1. Direct issuance of common stock to purchase assets. (The company gives shares
(equity) instead of paying cash.)
2. Conversion of bonds into common stock. (A debt obligation is converted into equity
without paying cash.)
3. Direct issuance of debt to purchase assets. (Instead of paying cash, the company
issues a note or bond to acquire the asset.)
4. Exchanges of plant assets. (One asset is exchanged for another without using cash.)
These activities are not included in the statement. Rather, in either separate schedule at
the bottom of cash flows statement or in a separate note or supplementary schedule to the
financial statements. To satisfy full disclosure principle.

Format
Cash flows statement is prepared from three other financial statements, not adjusted trial
balance.
Three sources are Comparative balance sheets, Current income statement,
additional information (needed to determine how cash was provided or used)

For first step, 2 methods. Both methods arrive at same amount. they differ in how they
arrive.

1. Indirect Method

A great majority of companies use this method. Easier, less costly to prepare, focuses on
the difference of net income and net cash flow from operating activities.
Step1:

For accrual basis, there are expenses recorded but not paid yet, revenues not received yet.
Thats why adjust net income.

Depreciation

Although depreciation expense reduces net income, it does not reduce cash. So, add it
back.

Similarly, non-cash charges--- Amortization of intangible assets, depletion expense, bad

Loss on disposal (sale) of equipment

ELIMINATE from net income all gains and losses related to the disposal of plant assets, to
arrive at net cash provided by operating activities.
If GAIN, DEDUCT (-)

In the case of either a gain or a loss, companies report as a source of cash in the
INVESTING activities section of the statement of cash flows the actual amount of cash
received from the sale.

Non-cash Current asset & Current liabilities

(deduct from net income) -- increases in current asset

(add to the net income) -- decreases in current asset

Current Asset

• $10,000 Decrease in Accounts Receivable

This means cash receipts were $10k higher than sales revenue.

As A/R increases net income, so a decrease in A/R will result in ADD.

When the Accounts Receivable balance increases, cash receipts are lower than sales
revenue earned under the accrual basis. Therefore, the company deducts from net income
the amount of the increase in accounts receivable.

• $5000 increase in Inventory

The change is the difference between the amount of inventory purchased and the amount
sold (Cost of goods sold). In income statement, COGS doesnt reflect $5k cash payments.
So, DEDUCT $5000

If Inventory decreases, ADD.

• $4000 increase in Prepaid Expense

the company has made cash payments in the current period but will not charge expenses
to income until future periods. Reported expenses are lower than expenses paid.
Increase in Prepaid Expense, DEDUCT.

Decrease in P/E, ADD.

Current liabilities

• $16000 increase in Accounts Payable

company received $16,000 more in goods than it actually paid for. The company incurred
expenses but hasn't paid cash yet. Those expenses reduced net income (because of
accrual accounting). But since cash hasn’t gone out yet, it's not a cash outflow.

Increase--- ADD

Decrease--- DEDUCT

• Decrease in Income Taxes Payable

When a company incurs income tax expense but has not yet paid its taxes, it records
income taxes payable. Not paid yet recorded.

Decrease--- DEDUCT
Step-2: Investing and financing activities

Analyze changes in non-current asset and liability accounts and record as investing and
financing activities, or as non-cash investing and financing activities.

LAND, BUILDINGS, EQUIPMENT

• If the company purchase asset through issuing bonds (bonds payable)--- no effect
on cash. But separate schedule.
• If purchased with cash, deduct as Cash outflow. If an asset of $8000 cost, sold at
$4000, reports as a INFLOW of $4000 cash. The $3,000 loss (because the
equipment had a book value of $7,000 but sold for $4,000) is recorded separately in
the income statement, not the cash flow statement.
 • Increase in Bonds Payable

Reports as non-cash transaction which was for acquiring the land. At a separate schedule
at the bottom of the statement.

• Increase in Common Stock

By receiving cash provided by shareholders in return of stocks, it will be regarded as cash

• Increase in retained Earnings.

As net income increased and dividends decreased, the retained earnings subsequently
increased by $116,000. ($145,000-$29,000)

Payment of Dividends is a cash OUTFLOW reported as a financing activity.

Step-3: Net change in cash

Compare the net change in cash on the statement of cash flows with balance sheets of the
current and previous year.
FREE CASH FLOW

However, net cash provided by operating activities fails to take into account that a
company must invest in new fixed assets just to maintain its current level of operations.
Companies also must at least maintain dividends at current levels to satisfy investors.

Free cash flow describes the net cash provided by operating activities after adjustment for
capital expenditures and dividends.
Suppose that MPC produced and sold 10,000personal computers this year. It reported
$100,000 net cash provided by operating activities. In order to maintain production at
10,000 computers, MPC invested $15,000 in equipment. It chose to pay $5,000 in
dividends. Its free cash flow was $80,000 ($100,000 2 $15,000 2 $5,000). The company
could use this $80,000 either to purchase new assets to expand the business or to pay an
$80,000 dividend and continue to produce 10,000 computers.