Chapter 19th Edition Statement of Cash Flows and Articulation Intermediate Accounting James D Stice Earl K Stice PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University © 2014 Cengage Learning 5-1 What Good is a Cash Flow Statement? We need the cash flow statement because: • • • Sometimes earnings fail Everything is on one page It is used as a forecasting tool 5-2 The Big Loss Scenario When a company reports large noncash expenses such as: - write-offs - depreciation - provisions for future obligations … earnings may give a gloomier picture of current operations than warranted (continued) 5-3 The Rapid Growth Scenario • Rapidly growing firms use large amounts of cash to expand inventory • Cash collections on the growing accounts receivable often lag behind the need to pay creditors • Reported earnings may be positive, but operations are actually consuming rather than generating cash 5-4 The Reality Check Scenario √ Companies entering phases in which it is critical that reported earnings look good, accounting assumptions can be stretched • Just before making a large loan application • Just before the initial public offering of stock • Just before being bought out by another company (continued) 5-5 The Reality Check Scenario • Cash flow from operations, which is not impacted by accrual assumptions, provides an excellent reality check for earnings (continued) 5-6 Everything is on One Page • The cash flow statement includes information on operating, investing, and financing activities • Everything you ever wanted to know about a company’s performance for the year is summarized in this one statement (continued) 5-7 It is Used as a Forecasting Tool A pro forma cash flow statement is a prediction of what the actual cash flow statement will look like in future years if the operating, investing, and financing plans are implemented 5-8 Statement of Cash Flows A statement of cash flows explains the change during the period in cash and cash equivalents What is this? (continued) 5-9 Cash Equivalent • A cash equivalent is a short-term, highly liquid investment that can be converted easily into cash • To qualify as a cash equivalent, an item must be: Readily convertible into cash So near to its maturity that there is insignificant risk of changes in value due to changes in interest rates 5-10 Preparing a Complete Statement of Cash Flows Step Step 2: 2: Continued Continued (b) Eliminate gains and losses associated with investing or financing activities to avoid counting these items twice 5-33 Preparing a Complete Statement of Cash Flows Step Step 2: 2: Continued Continued (c) Adjust for changes in the balances of current operating assets and operating liabilities 5-34 Preparing a Complete Statement of Cash Flows Step Step 3: 3: Analyze Analyze the the Long-Term Long-Term Assets Assets to to Identify Identify the the Cash Cash Flow Flow Effects Effects of of Investing Investing Activities Activities • Orchard Blossom reports two long-term asset accounts: Land and Buildings 5-35 Investing Activities • • • Cash Inflow Sale of plant assets Sale of securities, other than trading securities Collection of principal on loans • • • Cash Outflow Purchase of plant assets Purchase of securities, other than trading securities Making of loans with other entities 5-36 Preparing a Complete Statement of Cash Flows Step Step 4: 4: Analyze Analyze the the Long-Term Long-Term Debt Debt and and Stockholders’ Stockholders’ Equity Equity Accounts Accounts to to Determine Determine the the Cash Cash Flow Flow Effects Effects of of Any Any Financing Financing Transactions Transactions 5-37 Financing Activities Cash Inflow • Issuance of own stock • Borrowings Cash Outflow • Dividend payments • Repaying principal on borrowing • Treasury stock purchase 5-38 Preparing a Complete Statement of Cash Flows Step Step 5: 5: Prepare Prepare aa Formal Formal Statement Statement of of Cash Cash Flows Flows Based on our analyses of the income statement and balance sheet accounts, we have identified all inflows and outflow of cash for Orchard Blossom for the year, and we have categorized those cash flows based on the type of activity (continued) 5-39 Preparing a Complete Statement of Cash Flows Step Step 6: 6: Prepare Prepare Supplemental Supplemental Disclosure Disclosure • • Cash paid for interest and income taxes Noncash investing and financing activities 5-40 Cash Flow Ratios Cash Cash Flow Flow to to Net Net Income Income Ratio Ratio Cash from operations Cash-flow-to-net= Net income income ratio • • • Measure of earnings quality Tends to be greater than Should remain fairly stable for the years for a specific company (continued) 5-41 Cash Flow Ratios Cash Cash Flow Flow Adequacy Adequacy Ratio Ratio Cash flow = adequacy ratio • • Cash from operations Capital expenditures and acquisitions A cash cow is a business that is generating enough cash from operations to completely pay for all new plant and equipment purchases with cash left over to repay loans or distribute to owners This ratio indicates whether a business is a cash cow (continued) 5-42 Cash Flow Ratios Cash Cash Times Times Interest Interest Earned Earned Cash times interest earned ratio • • = Cash from operations + Interest paid + Taxes paid Interest expense Measures interest-paying ability Generally, a higher ratio indicates more solvency 5-43 Articulation: How the Financial Statements Tie Together In an accounting context, articulation means that the three primary financial statements are not isolated lists of numbers but are an integrated set of reports on a company’s financial health 5-44 Forecasted Statement of Cash Flows Compute the change in cash Convert the income statement from an accrual basis to a cash basis Analyze the long-term asset accounts Analyze the long-term debt and stockholders’ equity accounts Prepare the statement of cash flows Disclose any significant noncash activities 5-45 Chapter ₵ The The End End $ 5-46 5-47 ... look good, accounting assumptions can be stretched • Just before making a large loan application • Just before the initial public offering of stock • Just before being bought out by another company... company (continued) 5-5 The Reality Check Scenario • Cash flow from operations, which is not impacted by accrual assumptions, provides an excellent reality check for earnings (continued) 5-6 Everything... Three Categories of Cash Flows Financing activities include those transactions and events whereby resources are obtained from, or repaid to, owners (equity financing) and creditors (debt financing):