3.5 Understanding Cash Flow Statement

Question 1

The cash flow statement

Answer 1

provides information about cash receipts and cash payments

It also provides information about cash transactions from investing and financing activities.

Question 2

Classification of Cash Flows and Non-Cash Activities

Answer 2

Operating Activities

Investing Activities

Financing Activities

Question 3

Operating Activities

Answer 3

are a company’s day-to-day operations, including sales, inventory purchases, and paying employees.

Cash flows from trading securities are also included in this category.

Question 4

Investing Activities

Answer 4

include purchasing and selling long-term assets, such as property, equipment, and intangible assets.

Purchases and sales of long-term and short-term investments (e.g., equities and bonds) are also included in this category, but cash equivalents and trading securities are excluded.

Question 5

Financing Activities

Answer 5

include cash flows between the company and its capital providers, such as inflows from new debt issues or outflows in the form of dividend payments.

Question 6

Summary of Differences between IFRS and US GAAP

Answer 6

Compared to US GAAP, IFRS allow more discretion with respect to classifying cash activities

Question 7

The main differences between the two sets of accounting standards (US GAAP and IFRS) on this issue are summarized below:

Interest received

Answer 7

IFRS: Operating or Investing

US GAAP: Operating

Question 8

The main differences between the two sets of accounting standards (US GAAP and IFRS) on this issue are summarized below:

Interest paid

Answer 8

IFRS: Operating or Financing

US GAAP: Operating

Question 9

The main differences between the two sets of accounting standards (US GAAP and IFRS) on this issue are summarized below:

Dividends received

Answer 9

IFRS: Operating or Investing

US GAAP: Operating

Question 10

The main differences between the two sets of accounting standards (US GAAP and IFRS) on this issue are summarized below:

Dividends paid

Answer 10

IFRS: Operating or Financing

US GAAP: Financing

Question 11

The main differences between the two sets of accounting standards (US GAAP and IFRS) on this issue are summarized below:

Bank overdrafts

Answer 11

IFRS: part of cash equivalents

US GAAP: Financing

Question 12

Cash flow from operating activities can be reported using either the direct method or the indirect method

The direct method

Answer 12

shows specific cash inflows and outflows.

It eliminates all accrual impacts and shows the sources of operating cash receipts and payments.

Question 13

Cash flow from operating activities can be reported using either the direct method or the indirect method

The indirect method

Answer 13

derives the cash flow from operations from the reported net income.

Adjustments are made to net income for non-cash items and non-operating items.

This approach highlights the differences between net income and operating cash flows.

It also mirrors common forecasting approaches. Depreciation is a big adjustment for mature companies.

Question 14

Under US GAAP, which of the following would an auto manufacturer most likely classify as a financing activity on its statement of cash flows?

A
The sale of a trading security

B
The repurchase of common stock

The payment of interest on a ten-year note

Answer 14

B
The repurchase of common stock

Financing activities include obtaining and repaying capital, like debt or equity. Thus, the repurchase of common stock (part of equity) would be considered a financing activity under US GAAP.

Selling a trading security would be considered an operating activity, whereas selling a non-trading security would be treated as an investing activity.

Under US GAAP, the cash paid for interest is included in operating cash flows. Note that interest payments may be classified as either operating or financing activities under IFRS.

Question 15

A stock buyback would most likely be considered what type of activity?

A
Operating

B
Investing

C
Financing

Answer 15

C
Financing

A stock buyback involves interactions with its providers of capital, so it would be a financing activity.

If the company bought a different company’s stock, that would be considered either an investing or operating activity

Question 16

Which of the following transactions will most likely have the smallest impact on the amounts reported in a company’s statement of cash flows?

A
Making €5 million in payments owed to holders of convertible debt

B
Issuing new convertible debt with a face value of ‎€100 million

C
Existing convertible debt with a face value of €50 million being exchanged for an equivalent value of common stock

Answer 16

C
Existing convertible debt with a face value of €50 million being exchanged for an equivalent value of common stock

Question 17

Dividends paid can be calculated using the following formula:

Answer 17

beginning retained earnings
+ Net Income
- Ending retained earnings

Question 18

The process of calculating operating cash flows using the indirect method is described below:

Answer 18

Start with net income

Add back depreciation and amortization expenses

Add back any amortization of discounts on long-term bonds

Subtract any amortization of bond premiums

Add back any losses (or subtract any gains) attributable to asset sales, write-downs, or debt retirement

Subtract any increases in current operating assets (e.g., accounts receivable, inventory, prepaid expenses,
but ignore changes in cash)

Add back any increases in current operating liabilities (e.g., accounts payable, accrued expenses)

Add back any increase in deferred tax liabilities

If the equity method is used to account for investments in other companies, add back any losses and subtract any income

Question 19

Conversion of Cash Flows from the Indirect to the Direct Method

Answer 19

Step 1: Aggregates all revenues and expenses.

Step 2: Determine the total value of expenses net of non-cash item

Step 3: Convert accrual amounts to cash flows by adjusting for working capital changes.

Question 20

Major sources and uses of cash between operating, investing, and financing activities

Answer 20

Mature companies will primarily get cash flows from operating activities.

These cash flows can be used for investing activities if there are good opportunities to grow the business.

If not, they should be returned to capital providers as a financing activity.

Operating cash flows are often negative for new companies.

Question 21

Primary determinants of operating cash flow

Answer 21

Companies get cash from customers and pay cash to employees and suppliers.

Operating cash flow should exceed net income for mature companies.

Question 22

Primary determinants of investing cash flow

Answer 22

Analyzing this section sheds light on a company’s investing activities.

Also, this analysis aids in understanding why assets are sold.

Question 23

Primary determinants of financing cash flow

Answer 23

Companies can either raise capital or repay the capital.

Question 24

Free cash flow

Answer 24

the excess of operating cash flow over capital expenditures.

Question 25

Free cash flow to the firm (FCFF)

Answer 25

is available to providers of both debt and equity capital.

It can be computed from net income or operating cash flow.

Question 26

Free cash flow to equity (FCFE)

Answer 26

available to common stockholders

Question 27

Which is an appropriate method of preparing a common-size cash flow statement?

A
Show each item of revenue and expense as a percentage of net revenue.

B
Show each line item on the cash flow statement as a percentage of net revenue.

C
Show each line item on the cash flow statement as a percentage of total cash outflows.

Answer 27

B
Show each line item on the cash flow statement as a percentage of net revenue.

Question 28

An analyst has calculated a ratio using as the numerator the sum of operating cash flow, interest, and taxes and as the denominator the amount of interest. What is this ratio, what does it measure, and what does it indicate?

A
This ratio is an interest coverage ratio, measuring a company’s ability to meet its interest obligations and indicating a company’s solvency.

B
This ratio is an effective tax ratio, measuring the amount of a company’s operating cash flow used for taxes and indicating a company’s efficiency in tax management.

C
This ratio is an operating profitability ratio, measuring the operating cash flow generated accounting for taxes and interest and indicating a company’s liquidity.

Answer 28

A
This ratio is an interest coverage ratio, measuring a company’s ability to meet its interest obligations and indicating a company’s solvency.

Question 29

A company recently engaged in a non-cash transaction that significantly affected its property, plant, and equipment. The transaction is:

A
reported under the investing section of the cash flow statement.

B
reported differently in cash flow from operations under the direct and indirect methods.

C
disclosed as a separate note or in a supplementary schedule to the cash flow statement.

Answer 29

C
disclosed as a separate note or in a supplementary schedule to the cash flow statement.

Question 30

When computing net cash flow from operating activities using the indirect method, an addition to net income is most likely to occur when there is a:

A
gain on the sale of an asset.

B
loss on the retirement of debt.

C
decrease in a deferred tax liability.

Answer 30

B
loss on the retirement of debt.

Question 31

Which of the following would most likely be considered a financing activity on a cash flow statement under US GAAP?

A
Receipt of dividends

B
Payment of interest on long-term debt

C
Principal repayments on long-term debt

Answer 31

C
Principal repayments on long-term debt

Question 32

Which of the following is an example of a financing activity on the cash flow statement under US GAAP?

A
Payment of interest.

B
Receipt of dividends.

C
Payment of dividends.

Answer 32

C
Payment of dividends.

Payment of dividends is a financing activity under US GAAP. Payment of interest and receipt of dividends are included in operating cash flows under US GAAP

Question 33

Under which section of a manufacturing company’s cash flow statement are the following activities reported?

Item 1: Purchases of securities held for trading

Item 2: Purchases of securities held for investment

A
Both items are investing activities.

B
Only Item 1 is an operating activity.

C
Only Item 2 is an operating activity.

Answer 33

B
Only Item 1 is an operating activity.

Question 34

Which of the following would most likely be considered a financing activity on a cash flow statement under US GAAP?

A
Receipt of dividends

B
Payment of interest on long-term debt

C
Principal repayments on long-term debt

Answer 34

C
Principal repayments on long-term debt

Question 35

A conversion of a face value $1 million convertible bond for $1 million of common stock would most likely be:

A
reported as a $1 million investing cash inflow and outflow.

B
reported as a $1 million financing cash outflow and inflow.

C
reported as supplementary information to the cash flow statement.

Answer 35

C
reported as supplementary information to the cash flow statement.

Question 36

Cash flows from taxes on income must be separately disclosed under:

A
IFRS only.

B
US GAAP only.

C
both IFRS and US GAAP.

Answer 36

C
both IFRS and US GAAP.

Question 37

Which of the following transactions will most likely have the smallest impact on the amounts reported in a company’s statement of cash flows?

A
Making €5 million in payments owed to holders of convertible debt

B
Issuing new convertible debt with a face value of ‎€100 million

C
Existing convertible debt with a face value of €50 million being exchanged for an equivalent value of common stock

Answer 37

C
Existing convertible debt with a face value of €50 million being exchanged for an equivalent value of common stock

Question 38

A stock buyback would most likely be considered what type of activity?

A
Operating

B
Investing

C
Financing

Answer 38

C
Financing

A stock buyback involves interactions with its providers of capital, so it would be a financing activity.

Question 39

Which of the following statements is most accurate? A company’s cash flow statement links to its balance sheet by showing the change in the value of:

A
equity.

B
an asset.

C
net income.

Answer 39

C
net income.

Question 40

When computing net cash flow from operating activities using the indirect method, an addition to net income is most likely to occur when there is a:

A
gain on the sale of an asset.

B
loss on the retirement of debt.

C
decrease in a deferred tax liability.

Answer 40

B
loss on the retirement of debt.