Statement of Cash Flows

Learning Outcomes: At the end of this topic, students should be able to: Describe the Statement of Cash Flows in terms of its purpose and content Provide examples of transactions for each of the three classifications of activities: operating, investing and financing Evaluate a companys cash flow situation

Along with the Balance Sheet and Income Statement, the Statement of Cash Flows is one of the three principal financial statements that are required by both U.S. and International Accounting Standards, as well as those of many other countries. It shows the sources of cash received during a specified period (month, quarter, year), and how the cash was spent during that period. The statement organizes the sources and uses of cash into three categories: Cash inflows and outflows from operating activities (operation of the enterprise) Cash inflows and outflows from investing activities (mostly equipment) Cash inflows and outflows from financing activities (borrowing and stock issue) Examples of the types of cash transactions represented by each of the three categories are shown in the following illustration:

China Trade, Inc. Statement of Cash Flows (Direct Method) For the Month Ended August 31, 2001
Cash Flows from Operating Activities

Cash received from customers Cash paid to suppliers and employees Net cash flows from operating activities Cash Flows from Investing Activities Purchase of Equipment Proceeds from Sale of Equipment Net cash flows from investing activities Cash Flows from Financing Activities Cash received from issuing stock Cash received from borrowing Cash repayment of loans 34Dividends paid to shareholders Net cash flows from financing activities Net increase (decrease) in cash Cash and equivalents at beginning Cash and equivalents at end of period

7,000. (10,000) (3,000)

(4,000) (4,000)

10,000 (1,000) 9,000 ________ $ 2,000 0 $ 2,000

8/01/01 8/31/01

Self-test question:
Without referring to the illustration 1. Name the three categories of cash transactions shown on the Statement of Cash Flows. 2. For each of the three categories, give at least one example of a cash inflow transaction, and one example of a cash outflow transaction. Check your answer by looking back at the illustration

What is the purpose of the Statement of Cash Flows?

Lets answer that question with another question: Is it possible for a company to show increasing profits in recent years, but still be on the verge of bankruptcy -- unable to pay its bills or its employees? The answer is yes, and while that may be an extreme situation, it is not so unusual for companies to show increasing net income on the income statement, while at the same time suffering declining cash inflows from operating activities. This is a very unfavorable condition that is not readily apparent from reading the balance sheet or the income statement. Investors and creditors might very well be unaware of the condition, were it not for the Statement of Cash Flows. How is it possible for a company to show increasing profits on its income statements, yet declining net cash flows from operations? GAAP requires that financial statements be prepared under the accrual basis of accounting. That means that the companys revenue and correspondingly its profit -- is reflected on the income statement in the period in which sales are made to customers. But the cash may not be received from customers until the next period. And some of it may never be received. So in a period of growth, the revenue and net income that a company reports on its income statement is almost always ahead of the curve compared to cash inflows from customers. Such increases in receivables do not negatively impact net income, but they do negatively impact cash flows. Similarly, if a company expends increasing amounts of cash to build inventory in anticipation of increasing sales of its products, the cost of that inventory does not hit the income statement as a Cost of Goods Sold expense until the inventory is sold. Yet, cash paid out to buy the inventory definitely does hit the Statement of Cash Flows as cash outflow from operating activities.

So, while substantial increases in receivables and inventory have no negative impact on accrual basis net income (or the resulting earnings-per share), they definitely do have a negative impact on cash flows from operating activities. The difference between a companys Net Income and its Net Cash Flows from Operating Activities is analyzed in the alternative indirect method of presenting a Statement of Cash Flows (see illustration on the following page). GAAP allows both the direct method and the indirect method of presenting the Statement of Cash Flows. However, most companies choose the indirect method. (It is interesting to note that if a company chooses the direct method, GAAP requires that it add a supplemental exhibit that shows the operating activities section under the indirect method as well.)

China Trade, Inc. Statement of Cash Flows (Indirect Method) For the Month Ended August 31, 2001
Cash Flows from Operating Activities: Net Income, per Income Statement Adjustments to reconcile Net Income to Net Cash Flows from Operating Activities : Add back: depreciation expense Accounts receivable, inventory and asset adjustments: Decrease (increase) in accounts receivable Decrease (increase) in inventory Decrease (increase) in prepaid expenses Accounts payable and other liability adjustments: Increase (decrease) in accounts payable Increase (decrease) in wages payable Increase (decrease) in income tax payable Net cash flows from operating activities $ 6,600 200 100 (3,000) (5,650) (4,500) (300) 250 $ 300

Operating Activities: Indirect Method

Cash Flows from Investing Activities Purchase of Equipment Proceeds on Sale of Equipment Net cash flows from investing activities Cash Flows from Financing Activities Cash from issuing stock Cash from borrowing Payments on loans 34Dividends paid to shareholders Net cash flows from financing activities Net increase (decrease) in cash Cash and equivalents at beginning of period Cash and equivalents at end of period

(4,000) (4,000)

10,000 (1,000) 9,000 __________ 2,000 8/1/01 8/31/01 0 $ 2,000

Investing and Financing Activities same

under both direct and indirect methods

Analysis Question No. 1

In this example of the Indirect Method, the Operating Activities section of the Statement of Cash Flows shows the individual adjustments that caused an accrual basis profit of $300 to become a $3,000 loss (negative cash flow) from operations. Re-examine the sample statement, and then indicate the principal causes for this substantial difference between Net Income and Cash Flows from Operating Activities. See answers at the end of this topic

Evaluating a Companys Cash Flow Situation

Question: If a companys Statement of Cash Flows shows a steady decline in its balance sheet cash during the past several years, is that an indicator that the company is heading toward insolvency? The answer is, not necessarily. It could be such an indicator, but it is also possible that the company is using a cash surplus to reduce its debt and actually be strengthening its financial position, while at the same time reducing interest charges and increasing profits. Or, the company may be investing heavily in its future by acquiring new plant facilities, or acquiring other companies to enhance earnings potential. (If a company is in a growth mode, you would expect its cash flows from investing activities to be negative, perhaps only partially offset by positive cash flows from financing activities.) Or, perhaps the company has been purchasing a substantial amount of treasury stock, thereby increasing earnings per share for its remaining shareholders. So the answer is, not necessarily. Whether or not a decline in cash balances is an indicator of failing financial health can best be determined from an analysis of the three categories of cash inflows and outflows as shown on the companys statement of cash flows. Another question: If a companys Statement of Cash Flows shows a steady increase in cash balances during the past three years, is that an indicator that the company is in sound financial health? The answer is again, not necessarily. If the increase in cash is due to increased borrowing, or additional capital paid in by investors, rather than from operations, the company may eventually find itself unable to attract any new investors or borrow any more cash, and thereby face insolvency. Still another question:

So, if an upward trend in cash is not the best indicator of a sound cash flow situation, what is an appropriate indicator? What criteria should be used to evaluate a companys cash flow situation? Answer: Focus on Cash flows from operating activities! Not on changes in total cash. Two criteria with which to assess a companys cash flow health: 1. Are cash flows from operating activities increasing from year to year? 2. Are cash flows from operating activities sufficient to cover negative cash flows from investing activities?

Analysis Question No. 2

In June 2002, WorldCom, the 2nd largest long distance telephone company after AT&T, disclosed that more than $3 billion of operating expenses in 2001 and $797 million in the first three months of 2002 were recorded as capital expenditures instead of operating expenses. As a result, earnings (net income) on WorldComs Income Statements for that 5-quarter period were overstated by almost $4 billion. Explain the effect of this misstatement on WorldComs Statement of Cash Flows with regard to: (a) Net Increase (Decrease) of cash, (b) Cash Flows from Operating Activities? (c) Cash Flows from Investing Activities? See WorldCom Income Statements on the next page

WorldCom statements of cash flows as of June 26, 2002 before restatement: ANNUAL CASH FLOW STATEMENT (Indirect Method)
In Millions of U.S. Dollars (except for per share items) 12 Months Ending 12/31/01 12 Months Ending 12/31/00 12 Months Ending 12/31/99 12 Months Ending 12/31/98

Net Income Depreciation/Depletion Deferred Taxes Non-Cash Items Changes in Working Capital Net Cash Flows from Operating Activities Capital Expenditures Other Investing Cash Flow Items, Total Net Cash Flows from Investing Activities Financing Cash Flow Items Dividends Paid Issuance (Retirement) of Stock, Net Issuance (Retirement) of Debt, Net Net Cash Flows from Financing Activities Foreign Exchange Effects Net Increase (Decrease) in Cash Cash Interest Paid (Indirect Format) Cash Taxes Paid (Indirect Format)

1,524.0 4,121.0 1,131.0 (251.0) (136.0) 6,389.0 (7,986.0) (832.0) (8,818.0) (246.0) (200.0) 3,526.0 3,080.0 38.0 689.0 886.0 148.0

2,598.0 3,280.0 1,410.0 1,471.0 (3,429.0) 5,330.0 (11,755.0) (1,857.0) (13,612.0) 2,029.0 (1.0) (190.0) 6,377.0 8,215.0 (19.0) (86.0) 488.0 28.0

2,366.0 3,013.0 2,510.0 508.0 (1,045.0) 7,352.0 (8,318.0) 273.0 (8,045.0) 2,920.0 (9.0) 0.0 (2,894.0) 17.0 (221.0) (897.0) 816.0 35.0

(2,189.0) 1,744.0 626.0 2,933.0 (580.0) 2,534.0 (5,192.0) (2,114.0) (7,306.0) (49.0) (24.0) 0.0 6,390.0 6,317.0 0.0 1,545.0 37.0

WorldCom Comparative Income Statements as of June 26, 2002, before restatement: ANNUAL INCOME STATEMENT
In Millions of U.S. Dollars (except for per share items) 12 Months Ending 12/31/01 12 Months Ending 12/31/00 12 Months Ending 12/31/99 12 Months Ending 12/31/98

Revenue Other Revenue, Total Total Revenue Cost of Revenue Gross Profit Selling/General/Admin. Expenses, Total Research & Development Depreciation/Amortization Unusual Income/Expense Total Operating Expense Operating Income (EBIT) Interest Income (Expense), Non-Operating Gain (Loss) on Sale of Assets Other non-operating Income (Expense) Income Before Tax Income Tax - Total Income After Tax Minority Interest Equity In Affiliates Net Income

21,348.0 21,348.0 8,120.0 13,228.0 6,058.0 4,121.0 18,299.0 3,049.0 (1,029.0) 412.0 2,432.0 943.0 1,489.0 35.0 1,524.0

22,755.0 22,755.0 8,745.0 14,010.0 5,689.0 3,280.0 17,714.0 5,041.0 (458.0) 385.0 4,968.0 1,990.0 2,978.0 (305.0) 2,598.0

19,736.0 19,736.0 7,905.0 11,831.0 4,195.0 3,013.0 (8.0) 15,105.0 4,631.0 (460.0) 237.0 4,408.0 1,856.0 2,552.0 (186.0) 2,366.0

9,809.0 9,809.0 4,801.0 5,008.0 2,212.0 1,744.0 2,474.0 11,231.0 (1,422.0) (180.0) 44.0 (1,558.0) 409.0 (1,967.0) (93.0) (2,189.0)

ANSWERS Analysis Question No. 1

In this example of the Indirect Method, the Operating Activities section of the Statement of Cash Flows shows the individual adjustments that caused an accrual basis profit of $300 to become a $3,000 loss (negative cash flow) from operations. Re-examine the sample statement, and then indicate the principal causes for this substantial difference between Net Income and Cash Flows from Operating Activities. Answer The principal causes for the difference between the $300 Net Income and the negative $3,000 cash flow from operations are the substantial increase in both Accounts Receivable and Inventory, over $10,000 in total. This was partially offset by the $6,900 increase in payables, plus a small $250 add-back for Depreciation Expense (which is an expense that does not require the outlay of cash.) The net result is a negative adjustment in the amount of $3,300 -- from a positive Net Income of $300, to a negative Net cash outflow from operating activities of $3,000.

Analysis Question No. 2

In June 2002, WorldCom, the 2nd largest long distance telephone company after AT&T, disclosed that more than $3 billion of operating expenses in 2001 and $797 million in the first three months of 2002 were recorded as capital expenditures instead of operating expenses. As a result, earnings (net income) on WorldComs Income Statements for that 5-quarter period were overstated by almost $4 billion. Explain the effect of this misstatement on WorldComs Statement of Cash Flows with regard to: (a) Net Increase (Decrease) of cash, (b) Cash Flows from Operating Activities? (c) Cash Flows from Investing Activities? Answer: WorldComs misstatement of operating expenses as capital expenditures would result in: (a) No difference in the overall net increase or decrease in cash (b) Net cash flows from Operating Activities would be overstated because of the omission of cash outflows from payment of the operating expenses Net cash flows from Investing Activities would be understated as a result of overstating the outflows from the acquisition of capital assets