Financial Accounting: The Statement of Cash Flows (5)

Operating Section: Direct Method

All of the cash collections from operating activities and subtract all of the cash dispersements from operating activities

Summary of Accrual Rules under the Indirect Method

- An increase in operating current assets is subtracted from net income. - A decrease in operating current assets is added to net income. - An increase in operating current liabilities is added to net income. - A decrease in operating current liabilities is subtracted from net income.

Financing Activity Examples

- If a business takes out a new loan or pays off an existing one, it would be reflected in this section - If a business receives contributions from owners it is shown in this section - Dividends Paid are included in this section under US GAAP, but under IFRS they can be include in financing or operating - Interest paid under IFRS can be included here or in the operating section

Asset Accrual Rules under the Indirect Method

- If an asset account increases, it must be that the company acquired an additional asset. Acquisitions of assets generally require a cash payment, so the general inference is that if an asset account increased (for example, inventory was purchased, or more sales were on account), then the cash account decreased. - On the other hand, if an asset account decreases, it must be that the company sold or disposed of an asset. The sale of assets is generally accompanied by a receipt of cash. So the general inference is that if an asset account decreased (for example, inventory was sold, or accounts receivable was collected), then the cash account increased.

How to set up the investing activities section

- List the cash that was paid out to purchase long- lived assets - List any cash that was received through selling or disposing of long-lived assets

Liability Accrual Rules under the Indirect Method

- When looking at adjustments for operating current liability accounts, the calculation is just the opposite of what we did for assets. - If an account such as accounts payable increases during the period, it indicates that a benefit was received, such as receiving inventory, before the actual cash was paid out. To adjust for this we add that increase to net income. Consider this to be similar to spending less cash than we incurred for the related expenses, hence we have saved cash. If the same account decreases, it means we paid cash to reduce the liability previously created, so we expensed less than we paid and we subtract the difference from net income. Consider this to be similar to spending more cash than we incurred for the related expenses. The same rule applies to all operating liability accounts.

Investing Activities

2nd section on the statement of cash flows that contains cash flows relating to long-lived assets, such as property, plan, and equipment, intangible assets, and financial investments

Financing Activities

3rd and last section that contains cash flows associated with raising and paying back money to investors and creditors

Interpretation: Profitable/Growing Stage

Operating: Cash flow from operating activities will usually be positive. These businesses are generating cash receipts large enough to cover regular operating cash outflows and are growing at a slow enough rate that internally generated cash can cover the growth. Investing: Continued growth means that machinery and equipment will need to be purchased. So, investing cash flows will usually be negative for growing companies because more is spent to purchase new equipment than is received from disposing of old equipment. Financing: Financing cash flows could easily be positive or negative depending on how fast the business is growing and how much cash flow from operations it generates. If cash flow from operations is sufficient to cover purchases of new equipment and other investing activities, then financing cash flows could be negative as the business uses excess cash flow to pay down loans. If a business is growing faster than its cash flow from operations can finance, then it will have positive cash flow from financing activities as it receives more money from investors and creditors. Cash flows from financing could also be neutral or close to zero as the company is generating enough cash from operations to cover investments, but is not generating enough to begin to pay dividends.

Interpreation: In Decline Stage

Operating: Operating cash flows will generally be negative as business conditions have deteriorated and the business hasn't adapted to a changing environment. Investing: Cash flow from investing activities for a business in decline is likely to be positive. Fewer customers and less revenue means less work to be done, which means lower investments in new equipment. The business could also sell off existing assets that aren't being used, creating positive cash from investing activities. Financing: Financing cash flow could be positive or negative. These businesses could find it difficult to obtain new loans due to their deteriorating circumstances. On the other hand, they likely won't be generating excess cash flow to be able to pay down their loans.

Interpretation: Mature/Steady Stage

Operating: Operating cash flows will generally be positive for these businesses. They will have a consistent and steady stream of cash from revenue and will generally be one of the major players in their market. Investing: Because they aren't looking to grow or expand rapidly, cash flow from investing activities will generally be slightly negative as the new equipment being purchased replaces the equipment that has worn out. Financing: Although it can fluctuate, cash flow from financing activities will generally be negative for mature companies. This is because they are generating cash through operations that is sufficient to cover their investment needs. Because any excess cash generated isn't needed to fund growth, the money can be used to pay down loans or give money back to shareholders through dividends.

Interpretation: Startup/Fast Growing Stage

Operating: This often leads to negative or very low cash flows from operations. This is especially true if it takes a business longer to collect cash from sales than it has to pay its suppliers. In this situation, even if the business has a positive gross profit and net income, it could still have negative cash flows from operations. Some businesses spend years in this phase before achieving positive cash flows from operations. Investing: The investing section is also likely to be negative for a startup. These businesses will be purchasing equipment and buildings, and since they are just getting started, they won't often have equipment to dispose of to provide cash inflow. Financing: The financing section can have large fluctuations for a startup. When a business has negative cash flow from operations and investments, it needs a source of cash to fund both of these activities as it grows and becomes more profitable. This money comes from the financing section. However, a company in the startup phase will often have difficulty raising funds from a bank because there is so much risk involved in a startup. Much of the financing will likely come from equity investments, either by the founders or outside equity investors. In some cases, a business may not need to raise money every year; it could raise a lot of money one year and then use it to purchase equipment and assets over multiple periods.

The Statement of Cash Flows

Provides a more detailed summary of what happened to a company's cash through the accounting period - it is mainly looking to see if a company is generating cash

Gains

Sold above the net book value (to adjust for gains we remove it from the net income)

Loss

Sold below the net book value (to adjust for loss we add it back to net income)

Operating Activities

The 1st section of the Statement of Cash Flows that shows cash used or received in preparing good and services for customers

What section do gains and losses belong in?

The investing section

What Information do you need to prepare a statement of cash flows?

Two balance sheets and and the income statement when using the indirect method

Depreciation and Amortization under the Indirect Method

We add them back to the net income - If you recognize 10k of depreciation expense you have to add it back since it was a non cash transaction

Operating Section: Indirect Method

We start with net income from the income statement and make adjustments to undue the impact of the accruals we made during the accounting period (We are converting net income to actual cash flow by deaccruing it_

Typical cash flows from operating activities

o Cash received from customers: - cash received from current period sales - cash collections from previous period credit sales - cash received in advance for future period sales o Cash paid to suppliers: - cash paid for current period operating activity purchases - cash paid for previous period credit purchases - cash paid in advance for future period purchases