Statement of Cash Flows: Concepts, Preparation, and Analysis

Statement of Cash Flows

Introduction and Purpose

The Statement of Cash Flows is a fundamental financial statement that provides information about a company's cash inflows and outflows during an accounting period. It is essential for understanding how a business generates and uses cash, and is a critical analytical tool for investors, creditors, and management.

• Purpose: To explain the sources and uses of cash over a period.

• Relevance: Helps assess liquidity, solvency, and financial flexibility.

• Segregation: Cash flows are classified into operating, investing, and financing activities.

Learning Objectives

• Explain the purpose and relevance of the statement of cash flows.

• Define and identify operating, investing, and financing activities.

• Understand the difference between net income and cash from operations.

• Prepare a statement of cash flows.

• Prepare a summary analysis of the statement of cash flows.

• Analyze a statement of cash flows.

Why Cash Flow is Important

Case Example: Lehman Brothers Holding, Inc.

The Lehman Brothers case illustrates the importance of cash flow analysis. Despite reporting rising net income, the company failed to generate cash from operations, relying on borrowings to offset deficits. Ultimately, this led to bankruptcy in 2008.

Year	Net Income	Cash from Operations	Cash from Investing	Cash from Financing	Total Debt
2007	4,192	(45,595)	(1,698)	48,592	89,683
2006	4,007	(36,376)	(792)	38,255	52,934
2005	3,260	(12,205)	(447)	12,112	23,785

• Key Point: Positive net income does not guarantee sufficient cash to meet obligations.

• Application: Cash flow analysis is crucial for evaluating a company's ability to pay employees, suppliers, and creditors.

Components of the Statement of Cash Flows

Operating Activities

Operating activities include the primary revenue-generating activities of the business. They reflect cash flows from transactions that affect net income.

• Inflows: Cash receipts from sales of goods and services, returns on equity (dividends), returns on interest-earning assets (interest).

• Outflows: Payments for inventory, operating expenses, interest to lenders, and taxes.

• Example: Cash received from customers, cash paid to suppliers.

Investing Activities

Investing activities involve the acquisition and disposal of long-term assets and investments.

• Inflows: Cash from sales of property, plant, and equipment (PPE), collections from loans, sales of debt or equity securities, sale of a business segment.

• Outflows: Purchases of PPE, loans made to others, purchases of debt or equity securities.

• Example: Buying new machinery, selling a subsidiary.

Financing Activities

Financing activities result in changes in the size and composition of the equity and borrowings of the entity.

• Inflows: Proceeds from borrowing, issuing equity securities.

• Outflows: Repayment of debt principal, repurchase of shares, payment of dividends.

• Example: Issuing new shares, paying off a bank loan.

Statement of Cash Flows: Basic Principle

Relationship to the Balance Sheet

The statement of cash flows is based on changes in balance sheet accounts between periods. It explains the change in cash by analyzing all other balance sheet accounts.

• Balance Sheet: Shows amounts at the end of the accounting period.

• Statement of Cash Flows: Shows changes in balance sheet accounts between periods.

• Each account is related to operating, investing, or financing activities.

Formula for Change in Cash

The change in cash during an accounting period is calculated as:

• $ext{Total Inflows} - ext{Total Outflows} = ext{Change in Cash}$

Preparing a Statement of Cash Flows

Steps in Preparation

1. Calculate the changes in all balance sheet accounts, including cash.

2. List the changes in all accounts except cash as inflows or outflows.

3. Categorize the flows by operating, investing, or financing activities.

4. Calculate the total inflows less total outflows to identify the change in cash for the period.

Cash Flow Classification Rules

• Asset account increase: Outflow

• Asset account decrease: Inflow

• Liability account increase: Inflow

• Liability account decrease: Outflow

• Equity account increase: Inflow

• Equity account decrease: Outflow

Summary Table: Cash Flow Activities

Activity Type	Examples of Inflows	Examples of Outflows
Operating	Cash from sales, interest, dividends	Payments for inventory, expenses, interest, taxes
Investing	Sale of PPE, sale of investments	Purchase of PPE, loans to others, purchase of investments
Financing	Issuing shares, borrowing	Repaying debt, repurchasing shares, paying dividends

Analysis and Interpretation

Importance of Cash Flow Analysis

• Helps assess a company's ability to generate cash from operations.

• Identifies reliance on external financing.

• Highlights potential liquidity issues not evident from net income alone.

• Supports decision-making for investors and creditors.

Example: Lehman Brothers

• Despite positive net income, negative cash flow from operations indicated underlying financial distress.

• Heavy reliance on financing activities (borrowing) masked operational cash deficits.

Key Terms

• Operating Activities: Transactions affecting net income and cash from day-to-day business operations.

• Investing Activities: Transactions involving acquisition or disposal of long-term assets and investments.

• Financing Activities: Transactions that alter the equity and borrowings of the company.

• Net Income: The profit or loss after all revenues and expenses have been accounted for.

• Cash Equivalents: Short-term, highly liquid investments readily convertible to cash.

Practice Questions

• Why is the statement of cash flows a useful document?

• Define operating activities, investing activities, and financing activities as they relate to the statement of cash flows.

• Classify the following as financing activities (F) or investing activities (I).

• Classify the following as cash (C), operating activities (O), investing activities (I), or financing activities (F).

Additional info: Some worksheet and example tables were incomplete or unclear; main principles and classification rules have been inferred and expanded for academic completeness.