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Principles of Finance

5.5 The Statement of Cash Flows

Principles of Finance5.5 The Statement of Cash Flows

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Outline the purpose and importance of the statement of cash flows.
  • Identify the structure and key elements of the statement of cash flows.

The final financial statement is the statement of cash flows. It is a crucial statement, as it shows the sources of and uses of cash for the firm during the accounting period. Remember, under accrual accounting, transactions are recorded when they occur, not necessarily when cash moves. Thus, the income statement does not provide all the insights necessary to understand a firm’s cash flows. To fully understand the firm’s flow of cash, the statement of cash flows is needed.

Importance of the Statement of Cash Flows

Remember, most firms use accrual accounting. Revenues and expenses are recorded when they occur, not necessarily when cash moves. This can create timing differences between profits and cash flows. A firm can be profitable and still not have an adequate flow of cash. The opposite is also true: it can experience a net loss and still have cash on hand. Earning a profit is wonderful, but it is not the only goal an organization has. It must also have adequate cash flow to support daily operations. To support cash planning and to provide external financial statement users such as lenders and investors information about the firm’s cash flow, the statement of cash flows is prepared. Cash flow is also a crucial metric for determining the value of a company.

External financial statement users also rely on the statement of cash flows to help them evaluate the quality of the firm’s earnings. Users compare earnings to cash flow to assess the validity of the earnings data. For example, a firm reporting a strong profit but very little cash flow might raise some questions as to what was recorded to drive profits that isn’t also driving cash flows.

The statement of cash flows also helps external users determine the driving forces behind the firm’s cash flows. They can see if cash is generated primarily by daily operations or if cash is being generated or consumed by events outside the firm’s normal course of business.

There are two key methods of preparing the statement: direct and indirect. FASB (Financial Accounting Standards Board) favors the direct method. Despite that, the most common method used by far in general practice is the indirect method. The direct method lists cash flows directly from revenues and expenses, whereas the indirect method reconciles income to cash flows. The indirect method begins with net income and reconciles each account in order to arrive at net cash flow. It essentially reconciles accrual basis accounting to cash basis, or cash flow.

Operating Activities

To provide clear information about what areas of the business generated and used cash, the statement of cash flows is broken down into three key categories: operating, financing, and investing. The operating section reflects cash flows generated by and used by the day-to-day operations of the business. Investing activities include investments in other firms as well as investments in the firm itself (items like machinery, land, or other fixed assets). Finally, financing activities are those used to provide funds to run the business (loans, interest).

As mentioned, operating activities are those that are used or generated by the day-to-day operations of the firm. The operating activities section of the statement of cash flows begins with net income. All lines thereafter, in that section, are then adjustments to reconcile net income to actual cash flows by adding back noncash expenses like depreciation and adjusting for changes in asset and liability accounts. For example, depreciation is a noncash expense. Thus, depreciation is added back to net income.

To prepare the statement of cash flows for Clear Lake Sporting Goods, we need the beginning cash balance from the balance sheet, net income and depreciation expense from the income statement, and a set of comparative balance sheets to see the change in asset and liability accounts (see Figure 5.15).

Comparative Income Statements and Balance Sheets for Clear Lake Sporting Goods. On Clear Lake Sporting Good's Comparative Year-End Income Statement, the current year depreciation expense and net income figures are highlighted. On the company's comparative year-end balance sheet, the following figures are highlighted for both the prior and current year: Current assets (which in this example includes cash, accounts receivable, inventory, & short-term investments); Noncurrent assets (which includes equipment); current liabilities (in this case, accounts payable and unearned revenue), noncurrent liabilities (which only includes notes payable), and common stock under total and stock holder's equity.
Figure 5.15 Comparative Income Statements and Balance Sheets

Clear Lake’s statement of cash flows begins with the current year net income of $35,000 from the income statement. Next, noncash expenses are deducted. Clear Lake’s only noncash expense on their current year income statement is depreciation of $3,600. Since deprecation is an expense that reduces income but is not actually paid out in cash in the current period, it must be added back to net income to reconcile net income to cash flow.

Next, changes in operational assets and liabilities are used to continue reconciling net income to actual cash flow. For example, Clear Lake’s accounts receivable increased from the prior period to the current period. This means that there were more sales recorded but not yet received in cash in this period than there were in the prior period, making an increase in accounts receivable a reduction on the statement. Inventory increased, which means additional cash was spent to acquire it, making it a use of cash or reduction to net income to move closer to cash. Accounts payable and unearned revenue, both liability accounts, increased. Since these are liabilities, an increase would indicate that the liability was incurred but not as quickly paid out; thus it is an increase to the statement.

Tallying all these adjustments to net income shows Clear Lake’s net cash flows provided by operating activities of $53,600 (see Figure 5.16).

Operating Activities Section of the Statement of Cash Flows for Clear Lake Sporting Goods. The net cash flow from operating activities is $53,600.
Figure 5.16 Operating Activities Section of the Statement of Cash Flows

Investing Activities

As mentioned, investing activities include investments in other firms as well as investments in the firm itself (items like machinery, land, or other fixed assets). These are items that are capitalized (placed on the balance sheet and depreciated over time) and thus did not reduce net income. They did, however, cause an impact to cash flow (see Figure 5.17).

During the current year, Clear Lake purchased an additional $5,000 in short-term investments (see the comparative balances sheets; the balance in that account increased by $5,000 since the prior year). They also purchased additional plant assets in the amount of $13,600. This amount can be figured by comparing the difference in the current and prior plant assets accounts and including the impact of current year depreciation ($50,000 current year balance less $40,000 prior year balance and $3,600 of depreciation = $13,600 of new assets purchased).

Investing Activities Section of the Statement of Cash Flows for Clear Lake Sporting Goods. Because of the purchase of short-term investments and the cost of new plant assets, the net cash flow from investing activities is negative $18,600.
Figure 5.17 Investing Activities Section of the Statement of Cash Flows

Financing Activities

Recall that financing activities are those used to provide funds to run the business. Common items in this section of the statement include the payment of dividends, issuance of common or preferred stock, and issuance or payment of notes payable (see Figure 5.18).

In the current year, Clear Lake took out additional notes payable (a cash inflow). We can see this by the increase in their notes payable account from the prior year to current year ($40,000 to $50,000). This is an inflow of cash and thus an increase on the statement. Dividends of $30,000 were paid to shareholders (found on the statement of retained earnings and the statement of owner’s equity). Finally, we see that Clear Lake must have issued additional common stock, as their common stock balance increased from $75,000 to $80,000.

Financing Activities Section of the Statement of Cash Flows for Clear Lake Sporting Goods. The net cash flow from financing activities is negative $15,000.
Figure 5.18 Financing Activities Section of the Statement of Cash Flows

The final task to wrap up the statement of cash flows is to tally net cash generated or used by summing all three sections. This amount is then used to adjust the beginning cash balance from the balance sheet. Assuming the statement was prepared correctly, the sum should equal the ending cash balance on the balance sheet.

In the full statement, we can see that Clear Lake has net cash flow of $20,000. The beginning cash balance was $90,000, making the ending cash balance $110,000 (see Figure 5.19).

Full Statement of Cash Flows for Clear Lake Sporting Goods. Clear Lake has net cash flow of $20,000. The beginning cash balance was $90,000, making the ending cash balance $110,000.The net cash flow figure was found by calculating the Net Cash Flow from Operating Activities ($53,600) and subtracting the cost of investing activities ($18,600) and the cost of financing activities ($15,000).
Figure 5.19 Full Statement of Cash Flows

Analyzing Performance

The statement of cash flows can be used in a number of ways to assess firm performance by both internal and external financial statement users. Internal users can assess sources of and uses of cash in order to aid in adapting, as necessary, to ensure adequate future cash flows. External users also use the statement. Recall that comparing net income to operational cash flows can help assess the quality of earnings. In the next section you’ll explore operating cash flow and free cash flow to the firm, two key points of analysis in assessing cash flows.

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