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Statement of Cash Flows / Cash Flow Statement A statement of cash flows is a financial statement which summarizes cash transactions of a business during a given accounting period and classifies them under three heads, namely, cash flows from operating, investing and financing activities. It shows how cash moved during the period by indicating whether a particular line item is a cash in-flow or a cash out-flow. The term cash as used in the statement of cash flows refers to both cash and cash equivalents. Cash flow statement provides relevant information in assessing a company's liquidity, quality of earnings and solvency. Sections As stated above, a statement of cash flows comprises of three sections: 1. Cash Flows from Operating Activities This section includes cash flows from the principal revenue generation activities such as sale and purchase of goods and services. Cash flows from operating activities can be computed using two methods. One is the Direct Method and the other Indirect Method. 2. Cash Flows from Investing Activities Cash flows from investing activities are cash in-flows and out-flows related to activities that are intended to generate income and cash flows in future. This includes cash in-flows and out-flows from sale and purchase of long-term assets. 3. Cash Flows from Financing Activities Cash flows from financing activities are the cash flows related to transactions with stockholders and creditors such as issuance of share capital, purchase of treasury stock, dividend payments etc. Importance Of Cash Flow Statement The cash flow statement provides information regarding inflows and outflows of cash of a firm for a period of one year. Therefore cash flow statement is important on the following grounds. 1.Cash flow statement helps to identify the sources from where cash inflows have arisen within a particular period and also shows the various activities where in the cash was utilized. 2. Cash flow statement is significant to management for proper cash planning and maintaining a proper matching between cash inflows and outflows. 3. Cash flow statement shows efficiency of a firm in generating cash inflows from its regular operations. 4.Cash flow statement reports the amount of cash used during the period in various long-term investing activities, such as purchase of fixed assets. 5. Cash flow statement reports the amount of cash received during the period through various financing activities, such as issue of shares, debentures and raising long-term loan. 6. Cash flow statement helps for appraisal of various capital investment programmes to determine their profitability and viability. Cash Flow from Operating Activities Indirect Method The first section of a cash flow statement, known as cash flow from operating activities, can be prepared using two different methods known as the direct method and the indirect method. Here we will study the indirect method to calculate cash flows from operating activities. In indirect method, the net income figure from the income statement is used to calculate the amount of net cash flow from operating activities. Since the income statement is prepared on accrual basis in which revenue is recognized when earned and not when received therefore net income does not represent the net cash flow from operating activities and it is necessary to adjust earnings before interest and tax (EBIT) for those items which effect net income although no actual cash is paid or received against them. Formula The following is the indirect method formula to calculate net cash flow from operating activities: Cash Flows from Operating Activities: Net Income + Non-Cash Expenses: (Depreciation, Depletion & Amortization Expense) + Non-Operating Losses: (Loss on Sale of Non-Current Assets) − Non-Operating Gains: (Gain on Sale of Non-Current Assets) + Decrease in Current Assets: (Accounts Receivable, Prepaid Expenses, Inventory etc.) − Increase in Current Assets + Increase in Current Liabilities: (Accounts Payable, Accrued Liabilities, Income Tax Payable etc.) − Decrease in Current Liabilities Net Cash Flow from Operating Activities Cash Flow from Operating Activities: Direct Method The direct method to calculate cash flow from operating activities involves determination of various types of cash receipts and payments such as cash receipts from customers, cash paid to suppliers, cash paid for salaries, etc. and then putting them together under the cash flow from operating section of cash flow statement. These figures are calculated using the beginning and ending balances of various accounts of the business and the net increase or decrease in the account. The exact formulas to calculate various cash inflows and outflows vary. The most importan ones are given below: Formulas Cash Receipts from Customers = + Net Sales + Beginning Accounts Receivable = − Ending Accounts Receivable Cash Payments to Suppliers = + Purchases + Ending Inventory − Beginning Inventory + Beginning Accounts Payable − Ending Accounts Payable Cash Payments to Employees = + Beginning Salaries Payable − Ending Salaries Payable + Salaries Expense Cash Payments for Purchase of Prepaid Assets = + Ending Prepaid Rent, Prepaid Insurance etc. + Expired Rent, Expired Insurance etc. − Beginning Prepaid Rent, Prepaid Insurance etc. Interest Payments = + Beginning Interest Payable − Ending Interest Payable + Interest Expense Income Tax Payments = + Beginning Income Tax Payable − Ending Income Tax Payable + Income Tax Expense In the formulas given above it is assumed that accounts receivable are only used for credit sales. It is also assumed that all sales are on credit. If there are cash sales as well, then receipts from cash sales must be included in the cash receipts from customers to obtain a correct figure of cash flow from operating activities. Similarly, it is assumed that accounts payable are used merely for purchases on account and that all purchases are on credit. If there are cash purchases as well, then cash payments for them must be included in the cash paid to suppliers. It is important to note that here may be receipts & payments other than those discussed above. Once the all the cash inflows and outflows from operating activities are calculated, they are added in the operating section of cashflows to obtain the net cashflow from operating activities. The following example shows the format and calculation of cash flows from operating activities using direct method. Example Prepare the cash flows from operating activities section of cash flow statement by direct method using the following information: December 31 Accounts Receivable Prepaid Rent Prepaid Insurance Inventory Accounts Payable 2011 2010 $34,130 $28,410 20,000 25,000 6,800 6,000 23,030 15,450 14,590 31,300 Salaries Payable Interest Payable Income Tax Payable 8,310 700 2,340 5,120 360 0 Year Ended December 31 2011 Net Sales 64,970 Salaries Expense 8,610 Rent Expense 5,000 Insurance Expense 3,200 Interest Expense 1,650 Solution: Cash Flow from Operating Activities: Cash Receipts From Customers (1) $59,250 Cash Payments To Suppliers (2) −24,290 To Employees (3) −5,420 For Purchase of Prepaid Assets (4) −4,000 Interest (5) −1,310 Income Tax (6) −0 Net Cash Flow from Operating Activities 24,230 Working Notes 1) 64,970 + 28,410 - 34,130 2) 23,030 - 15,450 + 31,300 - 14,590 3) 5,120 - 8,310 + 8,610 4) 20,000 + 6,800 + 5,000 + 3,200 - 25,000 - 6,000 5) 360 - 700 + 1,650 6) 0 - 2,340 + 2,340 Cash Flows From Investing Activities Cash flows from investing activities is the second section of a statement of cash flows which details cash flows related to acquisition and disposal of a company's long-term investments such as property, plant and equipment, investment in subsidiaries and associates, etc. Cash flows from investing activities is separately reported because it tells the users of the financial statements whether the company is investing in resources that are expected to result in increased profits in future periods or whether it is disposing out resources already owned. Following are cash flows that are typically reported as cash flows from investing activities: 1. Cash payments to acquire or construct long-term fixed assets such as plant and machinery, vehicles, equipment, etc. 2. Cash receipts from sale of PPE and intangible assets such as buildings, copyrights, etc. 3. Cash payments to purchase bonds or shares of other companies (subsidiaries, associates and joint ventures). 4. Cash receipts from sale of bonds and shares of other companies. 5. Cash payments in the form of loans and advances and receipt related to payback of such loans and receivables, etc. In general, US GAAP and IFRS converge on classification of cash flows from investing activities. However, there are some exceptions: IFRS allows dividend income earned on investment in shares and interest earned on loans and advances to other parties to be classified as either an inflow from operating activities or an inflow from investing activities while US GAAP requires it to be reported under the cash flows from operating activities only. Cash Flows From Financing Activities Cash flows from financing activities is the last of the three sections of a statement of cash flows. It shows the cash inflows and outflows related to transactions with the providers of finance i.e. the owners and the creditors of the company. Thus, cash flows from financing activities include the following basic components: Proceeds from borrowings (both shot-term and long-term) Cash received from owners usually on issuance of stock Repayments of borrowings Repayments to owners However certain items are classified differently by different accounting standards. For example, under IFRS, interest payments and dividend payments are classified either as cash flows from operating activities or cash flows from financing activities. Under US GAAP interest payments can only be classified as cash flows from operating activities and dividends can only be classified as cash flows from financing activities. Example Cash Flows from Financing Activities Loan Obtained Issuance of Common Stock Treasury Stock Purchased Dividends Paid $20,000 125,000 − 32,000 − 10,000 Net Cash Flow from Financing Activities $103,000 Cash Flow Statement Indirect Method The statement of cash flows is one of the components of a company's set of financial statements, and is used to reveal the sources and uses of cash by a business. Under the indirect method of presenting the statement of cash flows, the presentation begins with net income or loss, with subsequent additions to or deductions from that amount for non-cash revenue and expense items, resulting in net income provided by operating activities. The format of the indirect method appears in the following example. In the presentation format, cash flows are divided into the following general classifications: Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities The indirect method of presentation is very popular, because the information required for it is relatively easily assembled from the accounts that a business normally maintains in its chart of accounts. The indirect method is less favored by the standard-setting bodies, since it does not give a clear view of how cash flows through a business (as is shown under the direct method of presentation). Statement of Cash Flows Indirect Method Example For example, Lowry Locomotion constructs the following statement of cash flows using the indirect method: Lowry Locomotion Statement of Cash Flows for the year ended 12/31x1 Cash flows from operating activities Net income $3,000,000 Adjustments for: Depreciation and amortization Provision for losses on accounts receivable Gain on sale of facility $125,000 20,000 (65,000) 80,000 Increase in trade receivables (250,000) Decrease in inventories 325,000 Decrease in trade payables (50,000) 25,000 Cash generated from operations 3,105,000 Cash flows from investing activities Purchase of property, plant, and equipment Proceeds from sale of equipment (500,000) 35,000 Net cash used in investing activities (465,000) Cash flows from financing activities Proceeds from issue of common stock 150,000 Proceeds from issuance of long-term debt 175,000 Dividends paid (45,000) Net cash used in financing activities 280,000 Net increase in cash and cash equivalents 2,920,000 Cash and cash equivalents at beginning of period 2,080,000 Cash and cash equivalents at end of period $5,000,000 Cash Flow Statement Direct Method The direct method of presenting the statement of cash flows presents the specific cash flows associated with items that affect cash flow. Items that typically do so include: Cash collected from customers Interest and dividends received Cash paid to employees Cash paid to suppliers Interest paid Income taxes paid The advantage of the direct method over the indirect method is that it reveals operating cash receipts and payments. The standard-setting bodies encourage the use of the direct method, but it is rarely used, for the excellent reason that the information in it is difficult to assemble; companies simply do not collect and store information in the manner required for this format. Using the direct method may require that the chart of accounts be restructured in order to collect different types of information. Instead, they use the indirect method, which can be more easily derived from existing accounting reports. Statement of Cash Flows Direct Method Example Lowry Locomotion constructs the following statement of cash flows using the direct method: Lowry Locomotion Statement of Cash Flows for the year ended 12/31/x1 Cash flows from operating activities Cash receipts from customers $45,800,000 Cash paid to suppliers (29,800,000) Cash paid to employees (11,200,000) Cash generated from operations 4,800,000 Interest paid (310,000) Income taxes paid (1,700,000) Net cash from operating activities $2,790,000 Cash flows from investing activities Purchase of property, plant, and equipment Proceeds from sale of equipment Net cash used in investing activities (580,000) 110,000 (470,000) Cash flows from financing activities Proceeds from issuance of common stock 1,000,000 Proceeds from issuance of long-term debt 500,000 Principal payments under capital lease obligation (10,000) Dividends paid (450,000) Net cash used in financing activities 1,040,000 Net increase in cash and cash equivalents 3,360,000 Cash and cash equivalents at beginning of period 1,640,000 Cash and cash equivalents at end of period $5,000,000 Reconciliation of net income to net cash provided by operating activities: Net income $2,665,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Provision for losses on accounts receivable $125,000 15,000 Gain on sale of equipment (155,000) Increase in interest and income taxes payable 32,000 Increase in deferred taxes 90,000 Increase in other liabilities 18,000 Total adjustments Net cash provided by operating activities 125,000 $2,790,000