ACCT201

Accounting for Managers

Session 24
Statement of Cash Flows

Dr. Muhammed Suhail PS

Assistant Professor, Finance & Accounting
FLAME University, Pune
muhammed.ps@flame.edu.in
During the period 2012, Le-Nature’s delivered beverages to customers
who paid or promised to pay a total of $275.1 million. During the same
period, it collected $250.0 million in cash from customers. Which of the
two amounts will be shown on Le-Nature’s income statement for 2012?
Sales revenue in the amount of $275.1 million is recognized. Sales
revenue is normally reported on the income statement when goods or
services have been delivered to customers who have either paid or
promised to pay for them in the future.

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During the period 2012, Le-Nature’s produced beverages with a total cost
of production of $142.1 million. During the same period, it delivered to
customers beverages that cost a total of $140.8 million to produce.
Indicate which of the two numbers will be shown on Le-Nature’s income
statement as cost of goods sold expense for 2012. Why did you select
your answer?
Cost of goods sold expense is $140.8. Expenses are the dollar amount of
resources used up to earn revenues during the period. Only those
beverages that have been delivered to customers have been used up.

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Accrual Basis of accounting
• Revenues are recognized when goods or
services are transferred to customers,
and expenses are recognized when
incurred to generate that revenue.

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Revenue Recognition Principle
• Cash may be received before, after, or at the time of delivery

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Expense Recognition Principle (matching
principle)
• As with revenues and cash receipts, expenses are recorded as incurred, regardless
of when cash is paid.
• Cash may be paid (1) before, (2) during, or (3) after an expense

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Is profit the same as cash?

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Statement of Cash flows
• Reported revenues do not always equal cash collected from customers
because some sales may be on credit.
• Expenses reported may not be equal to the cash paid out during the period
because expenses may be incurred in one period and paid for in another.
• Income statement does not provide information concerning cash flows
• Accountants prepare the statement of cash flows to report inflows and outflows of
cash.

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Purpose of Cash Flow statement
• Cash Flow statement meticulously tracks the movement of cash (Deals with
inflow and outflow of cash and cash equivalents)
• Statement of cash flows explains how the amount of cash on the balance sheet at
the beginning of the period has become the amount of cash reported at the end of
the period.

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Cash flow is King
Positive cash flows permit a company to . . .

Pay
Pay
dividends
dividends to
to Expand
Expand its
its
owners.
owners. operations.
operations.

Take
Take
advantage
advantage of
of Replace
Replace
investment
investment worn
worn assets.
assets.
opportunities.
opportunities.

Both
Bothmanagers
managersand
andanalysts
analystsneed
needtotounderstand
understandthe thevarious
varioussources
sourcesand
anduses
uses
of
ofcash
cashthat
thatare
areassociated
associatedwith
withbusiness
businessactivity.
activity.
Some
SomeWall
WallStreet
Streetanalysts
analystsgo
gososofar
faras
astotosay
say“Cash
“Cashflow
flowisisking.”
king.”
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What is cash?
The definition of cash includes cash and cash equivalents.

Cash equivalents are short-term, highly liquid investments that are both
 Readily convertible into known amounts of cash and
 So near to maturity there is little risk that their value will change
if interest rates change.
Generally, only investments with original maturities of three months or
less qualify as cash equivalents
Example - Treasury bills (a form of short-term Indian government debt),
money market funds, and commercial paper (short-term notes payable
issued by large corporations).
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 Classifications of the Statement of Cash Flows

Together, these three Cash inflows and outflows directly related

Operating Activities
cash flow categories to earnings from normal operations.
explain the change in
cash from the
beginning balance to Cash inflows and outflows related to the
the ending balance on acquisition or sale of productive facilities
the balance sheet. Investing Activities
and investments in the securities of other
companies.

Cash inflows and outflows related to

Financing Activities external sources of financing (owners and
creditors) for the enterprise.

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 Cash Flows from Operating Activities
Inflows and outflows Inflows
that relate directly to Inflows
Cash
Cashreceived
receivedfrom:
from:
revenues and expenses 
 Customers
Customers
reported on the income
statement.
+ Inflows
Cash
CashFlows
Flows
from
from
Outflows
Outflows Operating
Operating
Cash
Cashpaid
paidfor:
for:

Activities
Activities
 Purchase
Purchaseof ofservices
services
(electricity,
(electricity, etc.)and
for resale
for resale
etc.) andgoods
goods _ Outflows

 Salaries
Salariesand
andwages
wages

 Income
Incometaxes
taxes

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Two alternative approaches for Operating
section
Direct Method
• Reports the components of cash flows from operating activities as receipts and
payments
• The difference between the inflows and outflows is called net cash provided by
(used by) operating activities
• It is rarely used in practice
• Many financial executives have reported that they do not use it because it is more
expensive to implement than the indirect method

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Need for Indirect Method ?
• Manually tracking every cash transaction and compiling it quarterly or yearly is a
difficult task
• Volume of transactions, time, and effort required for this process can be
overwhelming
• Alternative – Indirect Method
• Instead of directly tracking cash transactions, this method involves deriving cash
flow information from the P&L and balance sheet data over two years
(Indirectly)
• Starts with net income from the income statement and then eliminates noncash
items to arrive at net cash inflow (outflow) from operating activities.

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Indirect Method
• Ninety-nine percent of large U.S. companies use the indirect method.
Why would income and cash flows from operating activities differ?
• Remember that on the income statement, revenues are recorded when they are
earned, without regard to when the related cash inflows occur.
• Similarly, expenses are matched with revenues and recorded without regard to
when the related cash outflows occur.
• Most important thing to remember about the two methods is that they are simply
alternative ways to arrive at the same number
• The total amount of cash flows from operating activities is always the same
regardless of whether it is computed using the direct or indirect method

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Direct Method vs. Indirect Method
Two Formats for Reporting Cash Flow from Operating Activities

99
%
com of l
Indirect Method pan arge
Direct Method use ie
ind the s
me irect
tho
d
Reports the cash effects of Starts with accrual net
each operating activity income and converts to
cash flow from
operating activities

The cash flows from operating activities are always the same,
regardless of whether the direct or indirect method is used.

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Cash Flows from Investing Activities
• Cash inflows and outflows related to the
purchase and disposal of long-lived productive
assets and investments in the securities of other
Inflows
Inflows companies and the return from those investments
Cash received from:
Cash received from: • The difference between these cash inflows and

 Sale
Saleorordisposal
disposalofofproperty,
property,plant,
plant,and
and outflows is called net cash provided by (used by)
equipment
equipment investing activities.

+ Inflows

 Sale
Saleorormaturity
maturityofofinvestments
investmentsinin
securities
securities

 Dividends
Dividendsandandinterest
intereston
oninvestments
investments
Cash
CashFlows
Flowsfrom
from
Investing
Investing
Outflows Activities
Activities
Outflows
Cash
Cashpaid
paidfor:
 Purchase
for:
Purchaseofofproperty,
equipment
property,plant,
plant,and
and _ Outflows
equipment
 Purchase
Purchaseofofinvestments
investmentsinin
securities
securities
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Cash Flows from Financing Activities
• Exchanges of cash with
debtholders and owners
Inflows
Inflows (stockholders)
Cash
Cashreceived
receivedfrom:
from:
• The difference between these cash

 Borrowings
Borrowingson onnotes,
notes,Debentures,
Debentures, inflows and outflows is called net
bonds,
bonds,etc.,
etc.,from
fromcreditors
creditors cash provided by (used by)
 Issuing

Issuingstock
stocktotoowners
owners + Inflowsfinancing activities.

Cash
CashFlows
Flowsfrom
from
Financing
Financing
Activities
Activities
Outflows
Outflows
Cash
Cashpaid
paidfor:
_ Outflows
for:
 Repayment
Repaymentofofprincipal
principalto
tocreditors
creditors
 Dividends
Dividendspaid
paidto
toowners
owners
 Interest
Interestpaid
paidononborrowings
borrowings

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Net Increase (Decrease) in Cash
• The combination of the net cash flows from operating, investing, and financing
activities must equal the net increase or decrease in cash.

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Reporting And Interpreting Cash Flows From
Operating Activities
• The operating section can be prepared in two formats: Direct and Indirect Method
Please note:
• Cash flow from operating activities is always the same regardless of whether it is
computed using the direct or indirect method.
• The investing and financing sections are always presented in the same manner
regardless of the format of the operating section.

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Reporting Cash Flows from Operating
Activities—Indirect Method
• The indirect method starts with
net income and converts it to cash
flows from operating activities
• This involves adjusting net
income for the differences in the
timing of accrual basis net income
and cash flows
• The general structure of the
operating activities section is

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Interpreting Cash Flows from Operating
Activities
• A common rule of thumb followed by financial and credit analysts is to avoid
firms with rising net income but falling cash flow from operations.
• In the long run, operations are the only source of cash!
• Investors will not invest in a company if they do not believe that cash generated
from operations will be available to pay them dividends or expand the
company.
• Creditors will not lend money if they do not believe that cash generated from
operations will be available to pay back the loan.

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