CASH FLOW STATEMENT

The third financial statement to compliment the balance sheet & Income statement by providing information on major sources of cash receipts & payments. Purpose of CFS is to identify cash flows associated with the periods operations and also about the investing & financing activities during the period.

Income Statement & Balance sheet are prepared on Accrual Basis

Income Statement Key concepts in measurement of periods income are Revenue Recognition & the Matching of Expenses.

Income Statement (Revenue Recognition).

i) Revenue is recognized in the period in which the entity performs revenuegenerating tasks (e.g.: delivering goods & rendering services); ii) irrespective of the fact that customer pays cash at that time or agrees to pay later.

Income Statement (Expense Measure).

Expenses measure the resources consumed in generating periods revenue and in administering the entity during the period irrespective of when cash was used to pay for these resources.

Income Statement .
Thus, periods income through I/S bears no direct relationship to the cash flows associated with periods operating, investing of financing activities of the organization.

Observations
Companies collapsed only months after their financial statements showed that they were managing good profits. (Nirlon & Machinery Manufacturer Corpn. In 1980s, W.T.Grant Company in 1970s). It is because there has always been a great difference between a companys earnings & cash generated from operations.

Cash Flow Statement

Requirement of Cash Flow Statement FASB, USA 1988 ASB, UK 1992 ASB, India 1997 (AS-3) International Accounting Standard - 1992

Sources & Uses of Cash

Activities that the CFS describes can be categorized to (1) activities that generate cash i.e. Sources; & (2) activities that spend cash i.e. Uses of cash. Sources: Operations, New borrowings, New issue of stocks, Sale of fixed assets i.e. property, plant & equipment etc. Uses: Cash dividends, Repayment of borrowings, Repurchase of stocks, Purchase of fixed assets etc.

Important Terms
CASH: refers to currency on hand, demand deposits with banks or F.I.s & other accounts that let the customers deposit & withdraw funds at any time. CASH EQUIVALENTS: Refers to shortterm, highly liquid investments when it has an original maturity of 3 months or less.

Cash Flow Statement

The connection between two successive balance sheets & the statement of cash flows can be shown as: Assets = Liabilities + Owners Equity Cash + Non-cash Assets = Liabilities + Owners Equity Cash = Liabilities Non-cash Assets+ Owners Equity Cash = Liabilities Non-cash Assets+ Owners Equity The change in a firms cash position between successive balance sheet dates will not equal the reported earnings for that period.

How Does the Statement of Cash Flows Look?

It is a separate financial statement. It has three sections divided by type of transaction (usually presented in this order):
Operating activities Investing activities Financing activities Each sections net cash flows are added together to get a total change in cash.

The total change in cash is added to the beginning cash balance to yield the ending cash balance, which should match cash on the current Balance Sheet.

OPERATING ACTIVITIES
Principal revenue generating activities of the firm. Operating cash inflows: Include receipts from customers for sale of goods or services (including collection of debtors). Operating cash Outflows: Include payments to suppliers for purchase of materials & services, payments to employees for services, & payments to government for taxes & duties.

Computation of Cash flow from Operating Activities

DIRECT METHOD Cash received from customers Less, Cash paid to suppliers & employees Cash generated from operations Less, Income Tax paid Cash flow before extra-ordinary item Less, Extra-ordinary item Net cash flow from Operating Activities

Notes to Computation (Direct Method)

1. Cash Received from Customers: Receipts from cash sales & receipts from debtors (earlier period sales may be collected at current period or current period sales may be collected in future period & some debtors may not be collected at all) (Sales + Decrease in Debtors (Gross) Bad Debts written off Increase in debtors)

Notes to Computation (Direct Method)

2. Cash Paid to Suppliers & Employees: Calculated by COGS & expenses on the I/S for in inventory, B/P, creditors,& pre-paid expenses, & for non-cash expenses. COGS be adjusted for in inventory to arrive at purchases If COGS in current period > Purchases indicates Inventory; & viceversa. If credit purchase > cash paid suppliers Creditors / Bills Payable & vice-versa.

If expenses on I/S > cash payments pre-paid expenses & viceversa.

Notes to Computation (Direct Method).

Depreciation/ Depletion/ Amortization & Provision for Doubtful Debts do not involve cash outflows but are allocations of past expenditures. So, to arrive at cash paid for expenses, depreciation, provisions, & other non-cash expenses must be deducted from expenses if such items have been included in operating expenses (viz. COGS; S&A Expenses).

If non-cash items are not included in COGS or other expenses but are shown separately in I?S then there is no need to deduct them.

Notes to Computation (Direct Method)

Cash Paid to Suppliers & Employees: COGS + Selling & Admn. Exp Depreciation Exp (if included in COGS) Bad Debts Exp (if included in S&A Exp) + Increase in Inventory / Prepaid exp Decrease in Inventory / Prepaid exp Increase in B.P/ Creditors + Decrease in B.P/ Creditors

Notes to Computation (Direct Method)

3. Income Tax Paid: Amount of tax paid usually differs from estimation as appeared in I/S also a part of income tax expense for one year is paid in the following year. If amount of Income Tax expense on I/S > Cash payment for tax; in Income Tax Payable in current year & vice versa. Income tax expenses + Decrease in Income Tax Payable Increase in Income Tax Payable.

4. Extra ordinary item should be shown separately, from operating cash inflows and outflows.

Computation of Cash flow from Operating Activities INDIRECT METHOD

It starts with net profit & adjusts it for revenue & expense items that did not involve operating cash receipts or payments in the current period to arrive at Net Cash flows from Operating Activities.

INDIRECT METHOD
To use Indirect Method, start with net income and adjust it for non-cash items like gains, losses & depreciation expenses. Then, make adjustments for all of the changes in CAs & CLs that occurred during the year (except Dividends Payable, which will be related to Financing Cash flows). Increase in CA Decrease in CA Increase in CL Decrease in CL (-) from Net Income (+) to Net Income (+) to Net Income (-) from Net Income

How the Indirect Method Works (Income from Operations Section)

Start with Net Income Add back non-cash expenses (e.g. depreciation, amortization) Add back losses and subtract gains the cash account has already been adjusted for the cash payment in these transactions. Subtract increases in current assetsbecause they tie up cash Add back decreases in current assetsthey represent increases in cash (e.g. receiving the accounts receivable) Add back increases in current liabilitiesbecause cash has not been spent, but the expense has been recorded Subtract decreases in current liabilitiesbecause you use cash to pay them off

INDIRECT METHOD
Net Profit ADD: Depreciation/Amortization, Bad Debts; Loss on Sale of Fixed assets/ Investments; Decrease in (Inv/A.R/Pre-paid Expenses); Increase in (Creditors/ Payables*) DEDUCT: Excess provision for Depreciation written back; Gain on Sale of Fixed assets/ Investments; Increase in (Inv/A.R/Pre-paid Expenses); Decrease in (Creditors/ Payables*) Net Cash flows from operating Activities * Includes Accounts, Wages, Interest and Taxes payables but does not include Notes Payable or Current portion of long-term debt.

Example of Two Methods for computing Cash from Operations

Assets Cash Marketable securities net Accounts receivable Other current assets Investments net Equipment Total assets Liabilities and Equity Accounts Payable Other Current liabilities Long term liabilities Stock Retained earnings Total liabilities and equity 2003 $100 11,000 40,000 43,000 800 70,000 $164,900 2002 $2,400 12,000 22,000 33,000 600 80,000 $150,000 change ($2,300) ($1,000) $18,000 $10,000 $200 ($10,000)

1,000 $11,000 38,000 100,000 14,900 $164,900

2,000 $9,000 28,000 100,000 11,000 $150,000

($1,000) $2,000 $10,000 $0 $3,900

Sales (net) Cost of goods sold Gross margin Operating expenses Salaries and wages Depreciation Other Income from operations Interest expense Income before tax Tax expense Net income

$200,000 140,000 $60,000 $30,000 10,000 13,000

RE, beginning $11,000 Add: NI 4,830 Less:Dividends (930) RE, end $14,900

53,000 $7,000 100 $6,900 2070 $4,830

These three financial statements have all the info you need for a simple Stmt of Cash Flows

Example of Direct MethodCash flows from Operations

Cash flows from Operating Activities (Direct Method) Cash Receipts: Collection from Customers $1,82,000 Cash Payments: To Suppliers $1,50,000 To Employees 28,000 Other Payments 13,000 Interest 100 Taxes 2,070 (1,93,170) Cash outflows from Operating Activities (11,170)

Example of Indirect MethodCash flows from Operations

Statement of Cash Flows, Indirect Method Cash from Operating Activities Net income $4,830 Add: Depreciation 10,000 Decrease in Mktable securities 1,000 Increase in other current liabilities 2,000 Less: Increase in Accts Receivable (18,000) Increase in other current assets (10,000) Decrease in Accts Payable (1,000) Net cash outflows from operations ($11,170)

DIRECT vs. INDIRECT Method

ASB recommends Direct method as: It is easier to understand, & Provides information useful in estimating future cash flows. On the contrary, Indirect method is followed by a majority of firm as it is easier to prepare.

INVESTING ACTIVITIES
Involve purchase & sale of fixed assets & investments. Cash receipts & payments are calculated by analyzing changes in the two Balance sheet amounts for F.As & Investments & the cash effect of transactions took place during the year. Interest & dividends received are also cash inflows from investing activities.

Example of Investing Activities:

Suppose you sell a $500 long term bond and buy a $700 plot of land as an investment
Cash from Investing Activities Sale of investment in bond Purchase of land investment Net cash outflow from investing $500 (700) (200)

FINANCING ACTIVITIES
Involve raising of capital & repayment of loan. Cash inflows & outflows are computed by analyzing the changes in the B/S items for shareholders equity & loan funds; & considering cash effect of transactions took place during the year. Interest & dividends paid are a part of Financing activities of a firm.

Example of Cash Flows from Financing Activities

Cash from Financing Activities Cash inflow from borrowing Payment of dividends Net cash inflow from financing

$10,000 (930) $9,070

PREPARATION OF CASH FLOW STATEMENT

CFS is prepared by putting together the cash flows from Operating, Investing & Financing activities. The CFS does not include certain financing and investing activities that do not cause a change in cash, viz. purchase of fixed assets with a longterm mortgage note or the conversion of debenture into common stock. However, these non-cash transactions are supplementally disclosed so as to give a full picture to investing and financing activities.

And here is what the entire statement looks like, in the Indirect Method
Statement of Cash Flows, Indirect Method Cash from Operating Activities Net income $4,830 Add: Depreciation 10,000 Decrease in Mktable securities 1,000 Increase in other current liabilities 2,000 Less: Increase in Accts Receivable (18,000) Increase in other current assets Decrease in Accts Payable Net cash outflows from operations Cash from Investing Activities Sale of investment in bond Purchase of land investment Net cash outflow from investing Cash from Financing Activities Cash inflow from borrowing Payment of dividends Net cash inflow from financing Net Change in Cash Cash, beginning balance Cash, ending balance (10,000) (1,000) ($11,170)

$500 (700) (200)

$10,000 (930) $9,070 ($2,300) 2,400 $100

And here is what the entire statement looks like, in the Direct Method
Statement of Cash Flows, Indirect Method Direct Cash from Operating Activities Cash receipts Collections from customers $182,000 Cash payments To suppliers To employees Other payments Interest Taxes Cash from Investing Activities Sale of investment in bond Purchase of land investment Net cash outflow from investing Cash from Financing Activities Cash inflow from borrowing Payment of dividends Net cash inflow from financing Net Change in Cash Cash, beginning balance Cash, ending balance

150,000 28,000 13,000 100 2,070

193,170 ($11,170) $500 (700) (200)

$10,000 (930) $9,070 ($2,300) 2,400 $100

Summary of Preparation Procedures - Steps

1. 2. From the companys balance sheet, enter the beginning and ending balance of each account & the change in each accounts balance on a worksheet. For each account (other than Cash), analyze the nature of the transactions causing the amount of net change, & Classify the change from each such transaction as either Cash from Operations, Cash from Investment, or Cash from financing activities. This analysis will require reference to the Income Statement (e.g., to explain the change in Retained Earnings), and, in some cases, to other financial records of the company. Put them in appropriate format.

3.
4.

5.

Using Cash flows to Evaluate Performance

1. Free Cash Flow: Provides a measure of firms ability to engage in long-term investment opportunities & a firms financial flexibility. Net Cash flow from Operating Activities - Cash Dividends - Capital Expenditure = Free Cash flow. 2. Cash Flow Adequacy Ratio: defined as cash from operating activities divided by net cash required for investing activities measures firms ability to generate the cash it needs for investing activities from operations.

Using Cash flows to Evaluate Performance

3. Current Cash Debt Coverage Ratio: measures firms ability to generate the cash it needs in the short-run; calculated as net cash provided by operations divided by average current liabilities.

CASE FOR DISCUSSION

Greg Rhoda and Debra are examining the following statement of cash flows for K.K. Bean Trading Company for the year ended January 31, 2009. K.K. BEAN TRADING COMPANY Statement of Cash Flows For the Year Ended January 31, 2009 Sources of cash From sales of merchandise $390,000 From sale of capital stock 420,000 From sale of investment (purchased below) 80,000 From depreciation 55,000 From issuance of note for truck 20,000 From interest on investments 6,000 Total sources of cash 971,000 Uses of cash For purchase of fixtures and equipment 340,000 For merchandise purchased for resale (all sold) 258,000 For operating expenses (including depreciation) 160,000 For purchase of investment 75,000 For purchase of truck by issuance of note 20,000 For purchase of treasury stock 10,000 For interest on note payable 3,000 Total uses of cash 866,000 Net increase in cash $105,000 Greg claims that K.K. Beans statement of cash flows is an excellent example of a superb first year, with cash increasing $105,000. Debra replies that it was not a superb first year but rather, that the year was an operating failure. She says that the statement was incorrectly presented and that $105,000 is not the actual increase in cash. The cash balance at the beginning of the year was $140,000.

Instructions
With whom do you agree, Greg or Debra? Explain your position. Using the data provided, prepare a statement of cash flows in proper form using the indirect method. The only noncash items in the income statement are depreciation and the gain from the sale of the investment.