Chapter 13: Statement of Cash Flows – Comprehensive Study Notes

Purpose of the Statement of Cash Flows

• Assesses a company’s ability to generate cash and what it did with the cash.

• Helps determine:

  • Ability to generate future cash flows

  • Investing and financing transactions and their effect on capital structure

  • Comparisons with other companies

Cash Classification of Cash Flows

Cash includes cash equivalents: short-term, highly liquid investments with insignificant risk, readily convertible to cash within three months.

• Operating activities

• Investing activities

• Financing activities

Operating Activities

These are cash effects of transactions that create revenues and expenses, entering into the determination of net income. They include relevant noncash current assets and current liabilities from the statement of financial position, where the related account is a statement of income account.

• Examples: cash received from customers, cash paid to suppliers and employees, interest paid, income taxes paid.

Investing Activities

These involve purchasing and disposing of long-term investments not held for trading, long-lived assets, and lending money and collecting loans. Generally, these are non-current asset items on the statement of financial position.

• Examples: purchase/sale of property, plant, and equipment; purchase/sale of investments; loans made to others and collections on those loans.

Financing Activities

These include obtaining cash from issuing debt and repaying borrowed amounts, as well as obtaining cash from selling shares and paying dividends. Generally, these are non-current liabilities and shareholders’ equity items.

• Examples: issuing shares, borrowing money, repaying loans, paying dividends, repurchasing shares.

• If a transaction does not affect cash, do not report it in the statement of cash flows.

• Report significant noncash activities in a separate note to the financial statements.

• Examples:

  • Issue of shares to purchase assets or reduce liabilities

  • Conversion of debt into equity

  • Exchange of property, plant, and equipment

Preparation of the Statement of Cash Flows

1. Prepare operating activities section

2. Prepare investing activities section

3. Prepare financing activities section

4. Complete the statement of cash flows

Step 1: Operating Activities

Determine net cash provided (used) by operating activities by converting net income from an accrual basis to a cash basis. This can be done using either the indirect method or the direct method. Most companies use the indirect method because it is easier to prepare and reveals less information to competitors.

Indirect vs. Direct Method

Indirect Method	Direct Method
Net income Adjustments to reconcile net income to net cash provided (used) by operating activities (e.g., add back noncash expenses, adjust for changes in current assets and liabilities) Net cash provided (used) by operating activities	Cash receipts from customers Cash payments to suppliers, for operating expenses, to employees, for interest, for income tax Net cash provided (used) by operating activities

Preparing the Operating Activities Section (Indirect Method)

• Start with Net Income

• Add back noncash expenses (e.g., depreciation, amortization)

• Deduct noncash gains

• Add decreases in current asset accounts and increases in current liability accounts

• Deduct increases in current asset accounts and decreases in current liability accounts

Key Adjustments to Operating Cash Flows

• Noncash Expenses: Add back (e.g., depreciation, amortization)

• Gains/Losses on Disposal of Long-Lived Assets: Deduct gains, add losses

• Changes in Current Assets: Decrease in current assets is added; increase is deducted

• Changes in Current Liabilities: Increase in current liabilities is added; decrease is deducted

Step 2: Investing Activities

Measure cash flows relating to non-current asset accounts, such as long-term investments, property, plant, and equipment, and intangible assets. Asset acquisitions are uses of cash; disposals are sources of cash. Depreciation expense is a noncash charge and does not appear in this section.

• Purchase of equipment: deduct cash outflow

• Sale of equipment: add cash inflow (proceeds)

• Losses on disposal: add back to operating activities

Step 3: Financing Activities

Determine net cash provided (used) by financing activities by analyzing changes in non-current liability and equity accounts. Increases in these accounts are added; decreases are deducted.

• Issuing shares: add cash inflow

• Repaying loans: deduct cash outflow

• Paying dividends: deduct cash outflow

Step 4: Complete the Statement of Cash Flows

• Calculate the net increase (decrease) in cash

• Ensure the ending cash balance matches the statement of financial position

• Identify and disclose any significant noncash activities

Using Cash Flows to Evaluate a Company

The statement of cash flows can be used to evaluate a company’s financial health and performance over its life cycle, which includes four phases: introductory, growth, maturity, and decline. Each phase has characteristic cash flow patterns from operating, investing, and financing activities.

Free Cash Flow

Free Cash Flow (FCF) measures the discretionary cash flow remaining from operating activities after accounting for capital expenditures and dividends paid. It is an important indicator of a company’s ability to expand operations, reduce debt, or pay additional dividends.

Formula:

$\text{Free Cash Flow} = \text{Net Cash Provided (Used) by Operating Activities} - \text{Net Capital Expenditures} - \text{Dividends Paid}$

Interpretation: Higher free cash flow is generally better, indicating more flexibility for growth and financial stability.