Chapter 11: Reporting and Interpreting Cash Flows Flashcards
Reporting and Interpreting Cash Flows
How is the statement of cash flows formatted?
Net cash from operating activities +
Net cash from investing activities
+
Net cash from financing activities =
Net change in cash balance
-Also non-cash transactions are reported at the end of the financial statement (e.g. issue stock for purchase of land)
What does the statement of cashflows do?
The statement of cashflows reports changes in cash for operating, investing, and financing activities for a period of time.
What are the two methods for preparing the cashflow from operating activities? What do they involve?
Direct method
-You count inflows which include: 1) cash received from customers and dividends and 2) interest on investments.
-You count cash outflows which includes: 1) cash paid for purchase of services and goods; 2) salaries and wages; 3) income tax; and 4) interest on borrowings.
Indirect method -Start with net earnings and then add or subtract adjustments for non-cash items. That gives you net cash provided by (used in) operating activities.
How do you prepare cashflow from investing activities?
-Record cash inflows as: 1) cash received from sale or disposal of property, plant, and equipment; 2) sale or maturity of investments in securities.
-Record cash outflows as: 1) purchase of property, plant, and equipment; and 2) purchase of investments and securities.
How do you prepare cashflow from financing activities?
-Record cash inflows as: 1) cash received from borrowing from creditors on notes, mortgages, bonds etc; and 2) issuing shares to shareholders.
-Record cash outflows as: 1) cash paid for repayment of principal to creditors; 2) interest on borrowings if it is classified as a financing act; 3) repurchasing shares from shareholders; 4) dividends to shareholders.
What does cashflows from operating activities report on?
Cashflows from operating activities reports on trasnactions related with providing goods and services to customers (revenue) and to paying expenses related to generating revenue (e.g. income statement activities)
What does cashflows from investing activities report on?
Cashflows from investing activities reports on cash inflows and outflows related to the purchase and sale of long-lived productive assets and investments in the securities of other companies.
What does cashflows from financing activities report on?
-Cashflows from financing activities reports on cash inflows and outflows related to external sources (owners and creditors) to finance the enterprise and its operations.
Cover the indirect method for the statement of cashflows in a lot of detail?
-Start with net earnings at at the top.
-Adjust for components of net earnings related with non-cash items or to investing activities.
-Add back expenses or subtract revenues that are non cash.
-Noncash items include depreciation and amortization.
-On statement of investing activities, add gain or losses on sale of PP&E or investments.
-Adjust for components of net earnings related to assets or liabilities create through operating activities (working capital).
-Change in cash=Change in liabilities+Change in Shareholder’s Equity-Change in non-cash assets
How do investors and creditors assess the cashflow from operating activities statement?
-Investors and creditors will avoid giving their money to firms with rising net earnings but falling cash flow from operations, because that means they are not collecting their income.
-Investors will not invest in a company if they do not believe that cash generated from operations will be available to pay them dividends or expand the company.
What is the quality of earnings ratio?
Quality of Earnings Ratio=Cash Flow from Operating Activities/Net Earnings
-This ratio measures how much of the net earnings were generated in cash.
When preparing the statement of cashflows, when is the direct approach used? When is the indirect approach used?
-The direct approach is theoretically informative, IASB (IAS 7) supports the use. It is rarely used.
-The indirect approach is normally used in published statements. It focuses on the diferences between net income and cash flow from operating activities.
-With both methods, the net cash flow will be the same. They only differ in format and content of the operating activities section.
-Investing and financing activities sections are the same in both approaches.
What are some examples of non-cash transactions?
1) Conversion of debt to equity securities
2) Conversion of preferred stock to common stock.
3) Leasing of an asset-capital lease.
4) Purchase of long term assets financed by a note
5) Exchange of non-cash asset for other non-cash assets - converting A/R to N/R
6) Purchase of non-cash assets in exchange for equity or debt securities.
What are the six disclosures that must be made on the statement of cashflows? What four areas are they bundled into?
1) Cash and Cash Equivalents: Requires disclosure if the amount differs from the balance sheet to explain discrepancies (e.g., timing differences or classification adjustments).
2) Interest Paid and Income Taxes Paid: These are critical for the operating activities section of the cash flow statement. They reflect actual cash outflows, which may differ from accrual-based expenses on the income statement.
3) Non-Cash Transactions: Must be disclosed even though they don’t involve cash.
4) Reconciliation of Profit to Cash Flow from Operations:
Explains how net profit (from the income statement) is adjusted for non-cash items (e.g., depreciation) and changes in working capital to derive cash from operations.
What are some examples of non-cash transactions?
Examples include: debt/equity conversions, asset exchanges, capital leases, or asset purchases financed by notes/securities. These transactions impact the company’s financial position but bypass the cash flow statement.
Explain the difference between the income statement and the cash flow statement?
-The income statement measures performance at a point in the cycle, and it ignores timing differences between revenues and expenses and the related cash flows. It’s not useful in tracking cash flows.
-The cash flow statement summarizes what happened to cash.
-The statement of cash flows shows how
management has elected to fund its growth. This
information is used by analysts who wish to
evaluate the capital structure and growth
potential of a business.
What cashflows are included in cash flows from investing activities?
-Cash flows from investing activities includes cash inflows from the proceeds from sale or disposal of property, plant, and equipment.
-It also includes outflows to purchase property, plant, and equipment, purchase investments in securities, and outflows to invest in other companies or make loans to other companies.
What are the three things that change net PPE?
1) Purchase of new asset
2) Disposal of old asset
3) Periodic depreciation of these assets
What is the formula for free cash flow?
Free Cash Flow=Cash Flow from Operating Activities-Dividends Paid-Capital Expenditures
Which cashflows are included in cashflows from financing activities?
-Cashflows from financing activities includes inflows from borrowing on notes, mortgages, and bonds issued from creditors.
-It also reports inflows from issuing equity securities to shareholders.
-Cashflows from financing activities includes outflows to repay principal to creditors (excluding interest), repurchase equity securities from owners, and pay dividends to shareholders.
-Cashflows from financing activities relates to the cash inflows and outflows that relate to the sources of financing the company has.
What three sources is the long-term growth of a company financed from?
1) Internally generated funds
2) The issuance of shares
3) Money borrowed on a long-term basis
What is the formula for capital expenditures ratio? What does the capital expenditures ratio show?
-The formula is is Capital Expenditures Ratio=Cash Flow from Operating Activities/Cash Paid for Capital Expenditures
-This ratio reflects the company’s ability to finance their purchases of PPE from their operating cashflows. The higher the ratio the better. It indicates less of a need to take outside financing.
How does change in accounts receivable affect cashflow from operations?
-If accounts receivable increases, cashflow decreases
-If accounts receivable decreases, cashflow increases.
How does change in inventory affect cashflow from operations?
-If inventory increases, cashflow decreases.
-If inventory decreases, cashflow increases.
How does change in accounts payable affect cashflow from operations?
-If accounts payable decreases, cashflow decreases.
-If accounts payable increases, cashflow increases.
How does cashflows from operating activities work with the indirect method?
-Start with net earnings at the top.
-Add back depreciation and amortization.
-Adjust for changes in working capital.
-Reductions in working capital increase cashflows from operations, while increases in working capital decrease cashflows from operations.
How does cashflows from operating activities work with the direct method?
-At the top you add collections from customers, where there is sales revenue from the current years income statement, and you also factor in changes in accounts receivable between the prior year and the current year in the balance sheet.
-Beneath that you subtract payments to suppliers, which includes cost of sales from the income statement, and you also factor in changes in inventory as well as changes in accounts payable between the past two years from the balance sheet.
-You subtract salaries and wage expense from the income statement, and factor in changes in accrued wages payable on the balance sheet.
-From statement of earnings, you straight up subtract rent expense, interest expense, and income tax expense.
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How are gains and losses recorded on the statement of cashflows?
-Gain on sale is subtracted from cashflow from operating activities.
-Loss on sale is added to cashflow from operating activities.
-Gain on sale is added to cashflow from financing activities.
-Loss on sale is subtracted from cashflow from financing activities.
-Overall, the gain or loss on sale will not affect the net cash balance
