Basic Elements of The Statement of Cash Flows - Financial Reporting and Analysis

The statement of cash flows provides an explanation of the changes that occurred in the firm’s cash balances for a specific period. Cash is considered to be the life blood of the firm. Understanding the flow of cash is critical to having a handle on the pulse of the firm.

The statement of cash flows is prepared using a concept of cash that includes not only cash itself but also short-term, highly liquid investments. This is referred to as the “cash and cash equivalent” focus. The category cash and cash equivalents includes cash on hand, cash on deposit, and investments in short-term, highly liquid investments. The cash flow statement analysis explains the change in these focus accounts by examining all the accounts on the balance sheet other than the focus accounts.

Management may use the statement of cash flows to determine dividend policy, cash generated by operations, and investing and financing policy. Outsiders, such as creditors or investors, may use it to determine such things as the firm’s ability to increase dividends, its ability to pay debt with cash from operations, and the percentage of cash from operations inrelation to the cash from financing.

The statement of cash flows must report all transactions affecting cash flow. A company will occasionally have investing and / or financing activities that have no direct effect on cash flow. For example, a company may acquire land in exchange for common stock. This is an investing transaction (acquiring the land) and a financing transaction (issuing the common stock). The conversion of long-term bonds into common stock involves two financing activities with no effect on cash flow. Since transactions such as these will have future effects on cash flows, these transactions are to be disclosed in a separate schedule presented with the statement of cash flows.

The statement of cash flows classifies cash receipts and cash payments into operating, investing, and financing activities. 1 In brief, operating activities involve income statement items. Investing activities generally result from changes in long-term asset items. Financing activities generally relate to long-term liability and stockholders’ equity items. A description of these activities and typical cash flows are as follows:

  1. Operating activities. Operating activities include all transactions and other events that are not investing or financing activities. Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income.
    • Typical cash inflows:
      1. From sale of goods or services
      2. From return on loans (interest)
      3. From return on equity securities (dividends)
    • Typical cash outflows:
      1. Payments for acquisitions of inventory
      2. Payments to employees
      3. Payments to governments (taxes)
      4. Payments of interest expense
      5. Payments to suppliers for other expenses
  2. Investing activities. Investing activities include lending money and collecting on those loans and acquiring and selling investments and productive long-term assets.
    • Typical cash inflows:
      1. From receipts from loans collected
      2. From sales of debt or equity securities of other corporations
      3. From sale of property, plant, and equipment
    • Typical cash outflows:
      1. Loans to other entities
      2. Purchase of debt or equity securities of other entities
      3. Purchase of property, plant, and equipment
  3. Financing activities. Financing activities include cash flows relating to liability and owners’ equity.
    • Typical cash inflows:
      1. From sale of equity securities
      2. From sale of bonds, mortgages, notes, and other short - or long-term borrowings
    • Typical cash outflows:
      1. Payment of dividends
      2. Reacquisition of the firm’s capital stock
      3. Payment of amounts borrowed

The statement of cash flows presents cash flows from operating activities first, followed by investing activities and then financing activities. The individual inflows and outflows from investing and financing activities are presented separately. The operating activities section can be presented using the direct method or the indirect method. (The indirect method is sometimes referred to as the reconciliation method.) The direct method essentially presents the income statement on a cash basis, instead of an accrual basis. The indirect method adjusts net income for items that affected net income but did not affect cash.

SFAS No. 95 encouraged enterprises to use the direct method to present cash flows from operating activities. However, if a company uses the direct method, the standard requires a reconciliation of net income to net cash provided by operating activities in a separate schedule. If a firm uses the indirect method, it must make a separate disclosure of interest paid and income taxes paid during the period. Figure presents skeleton formats of a statement of cash flows using the direct method and the indirect method.

Jones Company Example

Jones Company Example

The 1986 SFAS Exposure Draft, “Statement of Cash Flows,” indicates that:

The principal advantage of the direct method is that it shows the operating cash receipts and payments. Knowledge of where operating cash flows came from and how cash was used in past periods may be useful in estimating future cash flows. The indirect method of reporting has the advantage of focusing on the differences between income and cash flow from operating activities.2

Figure presents the 1999 Nike Statement of Cash Flows. This statement presents cash from operations, using the indirect method. The statement closely follows the standard format. In addition to reviewing the flow of funds on a yearly basis, reviewing a flow of funds for a three-year period may be helpful. This can be accomplished by adding a total column to the statement that represents the total of each item for the three-year period. This has been done for Nike in Figure.

Some observations on the 1999 Nike Statement of Cash Flows, considering the three year period ended May 31, 1999, follow:

  1. Net cash provided by operating activities was the major source of cash.
  2. Net cash used in investing activities, specifically additions to property, plant, and equipment, was the major use of cash.
  3. Repurchase of stock was the major financing use of cash.
  4. Cash dividends were approximately 20.23% of net cash provided by operating activities.

Nike, Inc

Statement of cash flows with three years total for years

Figure presents the 1998 cash flow statement of Rowe Furniture, with a total column for the three-year period. This firm presented the cash flows from operating activities using the direct method. Note the following with regard to Figure:

  1. Net cash provided by operations represented the major source of cash.
  2. Capital expenditures represented the major outflow of cash under investing activities.
  3. Cash proceeds from issuance of long-term debt was more than the cash provided by operations.

Figure on page 365 restates the 1998 cash flows for Rowe Furniture, viewingi nflows and outflows separately. Some observations regarding Figure follow:

  1. Approximately 88% of the total cash inflows came from operations.
  2. Approximately 87% of the total cash outflows related to operations.
  3. Approximately 5% of the total cash outflows related to payments to acquire businesses.
  4. Approximately 12% of the inflows came from proceeds from issuance of long-term debt.

Rowe Furniture Corporation

Rowe Furniture Corporation

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