Reporting and Analyzing Cash Flows Basics of Cash Flow Reporting

Chapter 17

Reporting and Analyzing Cash Flows

Basics of Cash Flow Reporting 

Purpose of a Statement of Cash Flows:

To report all major cash receipts (inflows) and cash payments (outflows) during a period.

1. Operating activities
2. Financing activities
3. Investing activities

Importance of Cash Flows: Information about cash flows, and its sources and uses, can influence decision makers in important ways.

Measuring Cash Flows - The statement of cash flows details the difference between the beginning and ending balances of cash and cash equivalents. A cash equivalent must satisfy two criteria:

1. Be readily convertible to a known amount of cash.
2. Have a maturity of three months or less from its date of acquisition.

Classifying Cash Flows: Cash receipts and payments are classified and reported in one of three categories: 

1. Operating activities examples:

1. Cash inflows from cash sales, collections on credit sales (accounts receivables), receipts of cash dividends, interest, suppliers for refunds, and settlements of lawsuits.
2. Cash outflows for payments to suppliers for goods and services, to employees for salaries and wages, to lenders for interest, to government for taxes and fines, to charities, and to customers for refunds.

2. Investing activities examples:

1. Cash inflows from selling long-term productive assets, selling equity (shares) investments or debt investment, selling (discounting) of loans, and collecting principal on loans to others.
2. Cash outflows for purchasing long-term productive assets, purchasing equity and debt investments, and making loans to others.

3. Financing activities examples:

1. Cash inflows from issuing company's own stock, from issuing bonds and notes and from issuing short and long-term liabilities.
2. Cash outflows from repaying cash loans, pay withdrawals by owner, paying shareholder's cash dividend and repurchasing shares.

Non-cash Investing and Financing Activities: Activities that do not affect cash receipts or payments but because of their importance and the full disclosure principle they are disclosed at the bottom of the statement of cash flows or in a note to the statement.

Format of the Statement of Cash Flows

1. Lists cash flows by categories (operating, financing and investing) and identifies the net cash inflow or outflow in each category.
2. Combines the net cash flow in each of the three categories and identifies the net change in cash for the period.
3. Combines the net change in cash with the prior period ending cash to prove the current period ending cash.
4. Contains a separate schedule or note disclosure of any non-cash financing and investing activities.

Preparing the Statement of Cash Flows

Five steps:

1. Compute the net increase or decrease in cash and cash equivalents (bottom line or target number).
2. Compute and report net cash inflows (outflows) from operating activities using either the
1. Direct method  (cash basis) or
2. Indirect method (accrual convert to cash)
3. Compute net cash inflows (outflows) from investing activities.
4. Compute net cash inflows (outflows) from financing activities.
5. Compute net cash flow by combining by operating, investing, and financing activities and then prove it by adding it to the beginning cash balance to show that it equals the ending cash balance.

Note: Non-cash investing and financing activities are disclosed in either a note.

Preparing the statement of cash flows

1. Comparative balance sheets.
2. The current income statement.
3. Other information: generally derived from analyzing non-cash balance sheet accounts.

Indirect and Direct Methods of Reporting:

Two ways of reporting that apply only to the operating activities section.

1. Direct Method: separately lists each major item of operating cash receipts and each major item of operating cash payments. Cash payments are subtracted from cash receipts to determine the net cash provided (used) by operating activities.
2. Indirect Method: reports net income and then adjusts it for items necessary to obtain net cash provided (used) by operating activities.
3. Net cash provided (used) by operating activities is the same under both the direct and indirect method. The direct method is encouraged, most companies prefer the indirect format because it reconciles profit or loss to cash flows and clearly presents non-cash operating items, such as depreciation and gains/losses.

Indirect Method for Operating Cash Flows

Indirect Method of Reporting

1. Net income and then adjustments.
2. Adjustments are:
1. Non-cash current assets and current liabilities relating to operating activities.
2. Items that do not affect cash inflows or outflows during the period.
3. Eliminate gains and losses from investing and financing activities
3. Adjustments for changes in current assets and current liabilities are made as follows:

1. Decreases in non-cash current assets are added.
2. Increases in non-cash current assets are subtracted.
3. Increases in current liabilities are added.
4. Decreases in current liabilities are subtracted.
3. Adjustments for operating items not providing or using cash are made as follows:
1. Expenses with no cash outflows are added back.

1. Revenues with no cash inflows are subtracted.
4. Adjustments for non-operating items are made as follows:

1. Non-operating losses are added back.
2. Non-operating gains are subtracted.

Cash Flows from Investing Activities: identical under direct and indirect methods. 

Three-stage process of analysis to determine cash provided (used) by investing activities:

1. Identify changes in investing-related accounts
1. all non-current assets, and
2. the current accounts for both notes receivable and
3. investments in securities: excluding trading securities.
2. Explain these changes to identify their cash flows effects using reconstruction analysis (reconstructed entries: not the actual entries by the preparer).
3. Report their cash flow effects.

Cash Flows from Financing: identical under direct and indirect methods. 

Three-stage process of analysis to determine cash provided (used) by financing activities:

1. Identify changes in financing-related accounts
1. all non-current liabilities: including
2. current portion of any notes and bonds, and
3. the equity accounts.
2. Explain these changes to identify their cash flows effects using reconstruction analysis (reconstructed entries: not the actual entries by the preparer).
3. Report their cash flow effects.

Cash Flows from Operating Activities: Direct Method

We calculate cash flows from operating activities under the direct method by adjusting accrual based income statement items to a cash basis. The usual approach is to adjust income statement accounts related to operating activities for changes in their related balance sheet accounts.

Separately list each major item or class of operating cash receipts and cash payments.

cash received from customers, renters, interest, and dividends.

cash payments to suppliers, to employees and other operating expenses, interest, and income taxes.

Subtract the cash payments from cash receipts to determine the net cash provided (used) by operating activities.

The accrual basis income statement items to cash basis items.