16.1 Explain the Purpose of the Statement of Cash Flows

The statement of cash flows presents the sources and uses of cash.
The statement of cash flows is used to predict future cash flows and to assess the quality of an entity’s earnings.
There are two approaches utilized to prepare the statement of cash flow: the indirect method and the direct method.

16.2 Differentiate between Operating, Investing, and Financing Activities

Transactions must be segregated into the three types of activities presented on the statement of cash flows: operating, investing, and financing.
Operating cash flows arise from the normal operations of producing income, such as cash receipts from revenue and cash disbursements to pay for expenses.
Investing cash flows arise from a company investing in or disposing of long-term assets.
Financing cash flows arise from a company raising funds through debt or equity and repaying debt.

Preparing the operating section of statement of cash flows by the indirect method starts with net income from the income statement and adjusts for items that affect cash flows differently than they affect net income.
Multiple levels of adjustments are required to reconcile accrual-based net income to cash flows from operating activities.
The investing section of statement of cash flows relates to changes in long-term assets.
The financing section of statement of cash flows relates to changes in long-term liabilities and changes in equity.
Company activities that reflect changes in long-term assets, long-term liabilities, or equity, but have no cash impact, require special reporting treatment, as noncash investing and financing transactions.

Preparing the operating section of statement of cash flows by the indirect method starts with net income from the income statement and adjusts for items that affect cash flows differently than they affect net income.
Multiple levels of adjustments are required to reconcile accrual-based net income to cash flows from operating activities.
The investing section of the statement of cash flows relates to changes in long-term assets.
The financing section of statement of cash flows relates to changes in long-term liabilities and changes in equity.
Company activities that reflect changes in long-term assets, long-term liabilities, or equity, but have no cash impact, require special reporting treatment, as noncash investing and financing transactions.

Free cash flow relates to the amount of expected cash from operations which is left over after planned capital expenditures and dividends are paid.
The cash flow to assets ratio correlates the company’s free cash flow to its total asset value.
The cash flow to sales ratio considers free cash flow in relation to the company’s sales revenue.

This section included an example of a statement of cash flows, prepared under the direct method, using the continuing example for Propensity Company.
The direct method of preparing the statement of cash flows is identical to the indirect method except for the cash flows from the operating section.
To complete the cash flows from operating activities, the direct method directly shows the cash collected from customers from revenue activities and the cash spent on operations, rather than reconciling net income to cash flows from operating activities as done using the indirect method. Calculating the amounts directly collected from revenues and spent on expenditures involves calculating the cash effect of the accrual amounts reported on the income statement.