Chapter 12

indirect and direct methods (three major steps)

1) determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis 2) analyze changes in non-current asset and liability accounts and record as investing and financing activities or as significant non-cash transactions 3) compare the net change in cash on the statement of cash flows with the change in the cash account reported on the balance sheet to make sure the amounts agree

as a general rule ....

1)operating activities involve income statement items 2)investing activities involve cash flows resulting from changes in investments and long-term asset items 3)financing activities involve cash flows resulting from changes in long-term liability and stockholders' equity items

the info in a statement of cash flows helps investors, creditors and others assess:

The company's ability to pay dividends and meet obligations. employees, creditors, stockholders, should be particularly interested in this statement because it alone shows the flows of cash in a business

investing activities include

a) acquiring and disposing of investments and property, plant & equipment b) lending money and collecting loans

some cash flows relating to investing or financing activities are not reported in the income statement

because these items are reported in the income statement

indirect vs. direct methods

both methods arrive at the same total amount for net cash provided by operating activities. these two diff. methods only effect the operating activities

financing activities

category includes a)obtaining cash from issuing debt and repaying the amounts borrowed b)obtaining cash from stockholders, repurchasing shares and paying dividends

indirect

companies favor the indirect method: 1)because it is easier and less costly to prepare 2) it focuses on the differences between net income and net cash flow from operating activities

the information to prepare the statement of cash flows comes from three sources:

comparative balance sheets (amount of change in assets, liabilities and stockholders' equities from beginning to the end of the period), current income statement (helps determine the amount of cash provided or used by operations during the period) and additional information (includes transaction data that are needed to determine how cash was provided or used during the period)

current ratio is a measure of liquidity

current assets / current liabilities (uses year end assets) - disadvantage is that it may not represent these numbers from the whole year (higher ratio is good liquidity)

free cash flow

describes the cash remaining from operations after adjustment for capital expenditures and dividends

many analysts are critical of accrual based numbers because they feel that the adjustment process allows too much management discretion

in relation to cash flows vs. accrual

operating activities cash flow sheet

include the cash effects of transactions that create revenues and expenses and enter into the determination of net income

cash provided by operations

is considered to be the best measure of whether a company can generate sufficient cash to continue as a going concern

operating activities

is the most important category because it shows the cash provided by company operations

operating cash activities

is the most important category because it shows the cash provided by company operations

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 it must at least maintain dividends at current levels to satisfy investors

direct method

more consistent w/ the objective of the statement of cash flows because it shows operating cash receipts and payments

Statement of Cashflows Usefulness & Format:

reports the cash reciepts and cash payments from the operating, investing and financing activities during a period, in a format that reconciles the beginning and ending cash balances

maturity phase

sales and production level off. cash from operations and net income are about the same. cash from operations exceeds investing needs. the company can start to pay dividends and retire debt or buy back stock

classification of cash flows

the statement of cash flows classifies cash receipts and cash payments as operating, investing and financing activities.

financing activities cash outflows:

to stockholders as dividends , to redeem long-term debt or reacquire capital stock (treasury stock)

solvency

the ability of a firm to survive over the long term

liquidity

the ability to pay obligations expected to become due within the next year

format of the statement of cash flows

operating, investing & financing and the signigicant noncash investing and financing make up the general format of the statement of cash flows

the info in a statement of cash flows helps investors, creditors and others assess:

-the company's ability to generate future cash flows (by examining the relationships between items in the statement of cash flows, investors make predictions of the amounts, timing & uncertainty of future cash flows)

indirect method

1) determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis companies must adjust net income to convert certain items to the cash basis. the indirect method starts with net income and converts it to net cash provided by operating activities by applying three types of adjustments (b/c revenue, credit sales, etc. ) -1) add back noncash expenses (depreciation expense, amortization, or depletion) (they dont reduce cash, they are non cash charges so they have to be added back!!!!) -2) deduct gains and losses that resulted from investing and financing activities: cash from sale of fixed assets, gain/loss. gain is subtracted, loss is added -3) analyze changes to noncash current asset and current liability accounts (not cash) subtract increases in current asset accounts, and add decreases in current asset accounts. -add net income increases in current liability and deduct for decreases in current liability

financing activities

a) obtaining cash from issuing debt and repaying the amounts borrowed b) obtaining cash from stockholders, repurchasing shares, and paying dividends

investing activities

a)acquiring and disposing of investments and property, plant and equipment and b)lending money and collecting the loans

corporate life cycle

all products go through a series of phases called the product life cycle

operating activities cash flow

always appears first, followed by investing and then financing activities

step 2: investing and financing

analyze changes in non-current asset and liability accounts and record as investing and financing activities or disclose as noncash transactions

receipts of investment revenue (interest and dividends) & payments of interest to lenders are classified as operating activities

because these items are reported in the income statement

introductory phase

beginning of a company's life when it is purchasing fixed assets and beginning to produce and sell products, likely not generating positive cash from operations because it is spending a lot of money to purchase assets and issuing stock or debt

current cash debt coverage ratio is a measure of liquidity

cash from operating activities / average current liabilities (uses entire year ) (higher number is good)

investing activities- changes in investments and long-term assets

cash inflows: from sale of property, plant and equipment, from sale of investments in debt or equity securities of other entities, from collection of principal on loans to other entities

investing activities cash outflows: changes in investments and long-term assets

cash outflows: to purchase property, plant and equipment. to purchase investments in debt or equity securities of other entities. to make loans to other entities

step 3: net change in cash:

compare the net cash in cash on the statement of cash flows with the change in the cash account reported on the balance sheet to make sure the amounts agree

operating activities - income statement items. cash inflows:

from sale of goods or services, from interest and dividends received

the reporting of significant activities not affecting cash in a separate schedule satisfies the

full disclosure

significant noncash activities - not all of a company's significant activities involve cash.

direct issuance of common stock to purchase assets, conversion of bonds into common stock, direct issuance of debt to purchase assets, exchanges of plant assets

Using cash flows to evaluate a company

free cash flow - cash from operations shows the cash-generating capability of the company

financing activities - changes in long-term liabilities and stockholders' equity cash inflows:

from sale of common stock, from issuance of debt (bonds and notes)

product life cycle

introductory phase, growth phase, maturity phase and decline phase

statement of cash flows is

not prepared from an adjusted trial balance. it deals with cash receipts and payments, so adjustments must be made to accrual accounting to determine cash flows.

decline phase

sales of the product fall due to a weakening in consumer demand. during this, cash from operations decreases. cash from investing might actually become positive as the firm sells off excess assets, and cash from financing may be negative as the company buys back stock and retires debt

growth phase

striving to expand its production and sales. the company will start to generate small amounts of cash from operations. cash from operations on the statement will be less than net income on the income statement. sales are projected to be increasing -- so size of inventory purchases will increase. less inventory will be expensed on an accrual basis than purchased on a cash basis in the growth phase. collections on accounts receivable will be behind sales and accrual sales during a period will exceed cash collections during that period. the company continues to show negative cash from investing and positive cash from financing

the info in a statement of cash flows helps investors, creditors and others assess:

the cash investing and financing transactions during the period. by examining a company's investing & financing transactions, a financial statement reader can better understand why assets and liabilities changed during the period

the sum of the operating, investing and financing sections equals

the net increase or decrease in cash for the period

the info in a statement of cash flows helps investors, creditors and others assess:

the reasons for the difference between net income and net cash provided (used) by operating activities. People want to know the reasons for the difference between net income & net cash provided by operating activities. they can assess for themselves the reliability of the income numbers

significant financing and investing activities that do not affect cash are not reported in the body of the statement of cash flows.

they are reported in a separate schedule at the bottom of the statement of cash flows, or in a separate note or supplementary schedule to the financial statements.

the net increase or decrease in cash for the period is added to the beginning cash balance to arrive at the ending cash balance

this is the same amount reported on the balance sheet

cash debt coverage ratio = cash provided by operations / average total liabilities

this ratio measures a company's ability to repay its liabilities from cash generated from operations without having to liquidate property plant and equipment (total not current)

operating activities- income statement items. cash outflows:

to suppliers for inventory, to employees for services, to government for taxes, to lenders for interest, to others for expenses

debt to assets ratio as a measure of solvency

total liabilities / total assets (lower value is good solvency)