Chapter 5

The Statement of Cash Flows

 Learning Objectives
– Understand and explain why the statement of
cash flows is of significance to users
– Explain how the statement of cash flows and the
statement of income differ
– Identify the three major types of activities that
are presented in the statement of cash
flows and describe some of the typical
transactions included in each category of
activity

2
 Learning Objectives

– Prepare a statement of cash flows using the

indirect method for operating activities
– Prepare a statement of cash flows using the
direct method for operating activities

3
 Learning Objectives

– Interpret the statement of cash flows and

develop potential solutions to any cash flow
challenges identified
– Calculate and interpret a company’s cash flows
to total liabilities ratio and determine the
amount of net free cash flow being
generated

4
 Definition of “Cash”
• Includes both cash and cash equivalents
• Cash includes cash on hand together with
demand deposits
• Cash Equivalents include short term, highly
liquid investments, for example:
• Money market funds, short term deposits,
treasury bills
• Cash equivalents must be convertible into
known amounts of cash and be maturing within
next three months
5
 Significance of the Statement of Cash Flows
• Information in the statements enable the user to
retrospectively:
• Assess company’s ability to generate cash flows
from operations
• Evaluate where cash has come from – debt or
equity
• Assess level and type of capital assets investments
• Determine how much cash was used for debt
repayment
• Evaluate the distribution of cash dividends
6
Significance of the Statement of Cash Flows
• Information in the statements enable the user
to prospectively:
• Estimate the value of the company based on
cash flows
• Assess the company’s ability to repay debt in
the future
• Evaluate the potential for dividend payments in
the future
• Estimate the company’s future cash
requirements and capital structure
7
 Cash Flow versus Income
• The statement of cash flows differs from the
statement of income because is:
• Reflects the cash basis rather than the accrual
basis of accounting
• Focuses on more than just operating activities –
it includes investing and financing activities as
well

8
 The Statement of Cash Flows

• Measures the cash flow the company in three

categories:
• Operating Activities
• Investing Activities
• Financing Activities

9
 Operating Activities

• Operating activities
• Sale of goods and services to customers
• Changes to current assets and current liabilities
• All other transactions not covered by financing
or investing activities

10
 Operating Activities

• Cash flows from operating activities are key

because:
• They are result of day to day business
operations
• They are the source for future debt repayments
• They are the source for future dividend
payments

11
 Investing and Financing Activities

• Investing activities
• Investment, sale, or disposal of long-term assets
• Examples: property, plant, equipment, long-
term marketable securities
• Financing activities
• Obtaining and repaying resources from
shareholders and lenders
• Examples: shares, bonds, mortgages, notes,
dividends
12
Cash Flow Transactions by Category

Typical Transactions for Each Category of Cash Flows 13

Direct vs Indirect Methods of Preparing Cash Flows

• Companies may choose between the direct

method and the indirect method
• The only difference is in how the cash flows
from operating activities are determined – total
operating cash flows are the same under both
methods
• The choice of method has NO effect on cash
flows from investing or financing activities

14
 Direct vs Indirect Method

• Most companies prefer the indirect method for

the following reasons:
• Simpler to prepare
• Uses information available in most accounting
systems
• Provides a linkage between net income and
cash flows from operating activities

15
 Direct vs Indirect Method
• The indirect method is also known as the
reconciliation method
• Standards setters prefer the direct method;
however, most public companies still use the
indirect method

16
 Options for Classifying Cash Flows related to
Interest and Dividends Paid and Received
• Under IFRS, options enable companies to present
information in a way that is most informative to
users:
• Interest paid can be classified as an operating or
financing activity
• Interest and dividends received can be classified as
operating or investing activities
• Dividends paid can be classified as a financing activity
• Classifications chosen must be applied consistently
from period to period
17
 Investing / Financing Activities
• It is possible to have activities that do NOT appear
on the cash flow statement. For example:
• Company purchased assets by assuming debt or
issuing shares
• Company acquired the shares of another company
by assuming debt or issuing shares rather than
paying cash
• Company repaid debt by issuing shares rather than
paying debt
• Since there is no cash inflow or outflow needs only
to be disclosed in the notes to the financial
statements
18
 Preparing the Statement of Cash Flows

• In order to prepare the statement of cash flows,

a company requires the following information:
• Comparative Statement of Financial Position,
for the current and previous period
• Statement of Income for the current period
• Any additional relevant information

19
20
 Cash Flow Statement Preparation Example 1
Consider the following information to be used to prepare a Cash Flow Statement:
22
23
Cash Flow Statement Preparation Example 2
Comparative Statement of Financial Position

Matchett Manufacturing Ltd. Statement of Financial Position

 Statement of Income

Matchett Manufacturing Ltd. Statement of Income

 Matchett Manufacturing Ltd:
Additional Information

The following additional information was gathered

in relation to the company’s investing and
financing activities:
a) Equipment that had originally cost $25,000 and
had a net carrying amount of $5,000 was sold
for $8,900 during the year.
b) No principal repayments were made on the
loan during the year.

26
Steps for Preparing the Statement of Cash Flows
– Indirect Method
• Step 1 – Determine the net change in cash
during the period
• Subtract the balance of cash and cash
equivalents at the beginning of the period from
the balance at the end of the period
• Step 2 – Read any additional information
provided and cross-reference it the to the
related statement of financial position accounts

27
Steps for Preparing the Statement of Cash Flows
– Indirect Method
• Step 3 – Using the statement of income:
• record net income and adjust it for
• non cash items included in the statement, such
as depreciation/amortization expense
• any items that do not involve operating
activities, such as gains/losses from sale of
capital assets and investments

28
Steps for Preparing the Statement of Cash Flows
– Indirect Method
Step 4 – Determine the net change in cash in each
current asset and currently liability account
(except for the Cash and Dividends Payable
accounts) and record the impact of these change
on cash

Cash Flow Impact of Changes in Current Assets and Current Liabilities

29
 Steps for Preparing the Statement of Cash Flows
• Step 5 – Determine and record the cash proceeds
received from selling and cost of capital assets
purchased with cash during the period. In our
example:
• Equipment that originally cost $25,000 and had a
net book value of $5,000 was sold for $8,900
during the year
Dr. Cash(+A) 8,900
Dr. Accum. Depreciation(-xA, +A)20,000
Cr. Equipment(-A) 25,000
Cr. Gain on disposal(+R, +SE) 3,900
• A T account may be helpful in your analysis
30
Steps for Preparing the Statement of Cash Flows

Account Equipment Purchased by MML

31
Steps for Preparing the Statement of Cash Flows

• Step 6 – Determine and record the cash

proceeds from the sale of shares of other
companies (investments) and the cost of any
investments in other companies purchased
with cash during the period
• Step 7 – Determine the amount of cash
dividends paid during the period
• A T account can help organize the data

32
Steps for Preparing the Statement of Cash Flows

33
T Account to Determine Dividends Declared and Paid by MML
Steps for Preparing the Statement of Cash Flows

• Step 8 – Determine and record the cash

received from borrowings (new loans or
increases to existing loans) made during the
period and the amount of cash principal repaid
on loans during the period

• A T account can help organize the data

34
Steps for Preparing the Statement of Cash Flows

Loans Payable T Account for MML 35

Steps for Preparing the Statement of Cash Flows

• Step 9 – Determine the cash received from

shares issued during the period

36
Steps for Preparing the Statement of Cash Flows

• Step 10 –Calculate the sum of the cash flows

from operating, investing and financing
activities and agree it to the net change in cash
for the period
• Companies are also required to disclose:
• Interest paid and received during the period
• Dividends paid and received during the period
• Income taxes paid during the period

37
Classification of Components of the Statement
of Financial Position

The Statement of Cash Flow Classification of Components of the Statement of

Financial Position
38
 Statement of Cash Flows

39
5.6 Matchett Manufacturing Ltd. Statement of Cash Flows
 Statement of Cash Flows

Matchett Manufacturing Ltd. Statement of Cash Flows Continued 40

 Preparing the Statement of Cash Flows - Direct
Method
• The direct method differs only in the way the
operating activities section of the cash flow statement
is prepared. The direct method categorizes cash flows
by cash receipts and cash payments.
• These categories are as follows:
• Receipts from customers
• Payments to suppliers
• Payments to employees
• Payment of interest
• Payment of income taxes

41
 Using the Direct Method

Direct Method: Determining Cash Receipts/Payments from Common Categories

42
 Using the Direct Method

Cash Flow From Operating Activities: Direct Method 43

 Interpreting Cash Flow Information
• The longer a company’s cash-to-cash cycle the
more pressure is placed on cash flow

The Cash-to-Cash Cycle 44

 Mitigating Cash Flow Challenges

• Companies can resolve common cash flow

challenges by taking the following measures:
• Reduce the rate of growth
• Shorten the cash-to-cash cycle
• Increase company’s capitalization

45
Cash Flow Patterns

46
 Financial Statement Analysis

Cash flows to total liabilities =

This ratio measures the percentage of a

company’s total liabilities that could be met
with one year’s operating cash flows

47
 Financial Statement Analysis

• Free Cash Flow is a non-IFRS financial measure

• Net Free Cash Flow
• Is a standardized measure introduced by
Canadian accounting standard setters.
• Considered to be the cash flow generated from
the company’s operating activities that would
be available to common shareholders.

48
Financial Statement Analysis

49