Cash Flows I

Go to Financial Statement Analysis

Topics

• Introduction
• Linkages between the Financial Statements
  • Primary Financial Statements
  • Relationship between Financial Statements
  • Linkages Between Current Assets and Current Liabilities
• The Direct Method for Cash Flows from Operating Activities
  • Operating Activities: Direct Method
• The Indirect Method for Cash Flows from Operating Activities
  • Operating Activities: Indirect Method
• Conversion from the Indirect to Direct Method
  • Method to Convert Cash Flow from Indirect to Direct
• Cash Flows from Investing Activities
  • Cash Flows from Investing Activities
• Cash Flows from Financing Activities
  • Cash Flow from Financing activities: Long-Term Debt and Common Stock
  • Computing Dividends Paid
• Differences in Cash Flow Statements Prepared under US GAAP versus IFRS

Table of Contents

Introduction

The cash flow statement provides important information about a company’s cash receipts and payments during an accounting period. It is a vital information source that assists users to evaluate a company’s liquidity, solvency, and financial flexibility.

Under both IFRS and US GAAP, cash flows are categorized as operating, investing, or financing activities on the cash flow statement.

• Operating activities: These are activities related to the normal operations of a company.
  • Cash inflows such as cash collected from sales, commissions, royalties, etc.
  • Cash outflows such as cash payments for inventory, salaries, and operating expenses.
  • Cash payments and receipts related to trading securities (securities that are not bought as investments).
• Investing activities: These are activities associated with acquisition and disposal of long-term assets.
  • Cash from sale of property, plant, and equipment.
  • Cash spent to purchase property, plant, and equipment.
  • Cash payments and receipts related to investment securities (not trading securities).
• Financing activities: These are activities related to obtaining or repaying capital.
  • Issuance or repurchase of a company’s own preferred or common stock.
  • Issuance or repayment of debt.
  • Dividend payments to shareholders.

Linkages Between the Financial Statements

With Balance Sheet

Cash is an asset and is reported on the balance sheet. The cash flow statement explains the change in cash during an accounting period.

• Plus for Cash Receipts
• Less for Cash Payments

With Balance Sheet and Income Statement

(B) Beginning Acc Receivable = 200 → Ending Acc Receivable = 400
(I) Plus: Revenue = 5000
(C) Less: Cash Collected from Customers = 4800

Here, Ending receivables = Beginning receivables + Revenue – Cash collected from customers

The Direct Method for Cash Flows From Operating Activities

Under IFRS and US GAAP, there are two acceptable formats for reporting cash flow from operating activities: indirect and direct.

• The indirect method shows how cash flow from operations can be obtained from reported net income through a series of adjustments.
• The direct method shows the specific cash inflows and outflows that result in reported cash flow from operating activities.

Indirect Method

With the indirect method, we start with net income and make several adjustments for non-cash, non-operating items to arrive at the cash flow from operations.

Direct Method

In the direct format, we look at the specific cash inflows and outflows that resulted in cash flow from operating activities. This method is encouraged by both IFRS and US GAAP.

Operating Activities: Direct Method

Only cash flow from operating activities is presented differently under the two methods.

In the direct method, we take each item from the income statement and convert it to its cash equivalent by removing the impact of accrual accounting.

The rules to adjust are:

• Increase in assets is use of cash (-ve adjustment)

• Decrease in assets is source of cash (+ve adjustment)

• Increase in liability is source of cash (+ve adjustment)

• Decrease in liability is use of cash (-ve adjustment)

• Cash collected from customers: Adjust sales for changes in accounts receivable (A) and unearned revenue (L).

• Cash for inputs: Adjust COGS for changes in inventory (A) and accounts payable (L).

• Cash operating expenses: Adjust SG&A for changes in related accrued liabilities or prepaid expenses (L).

• Cash interest paid: Adjust interest expense for changes in interest payable (L).

• Cash taxes paid: Adjust tax expense for changes in tax payable (L) and changes in deferred tax assets and liabilities (>0 → A and <0 → L)

The Indirect Method for Cash Flows from Operating Activities

Indirect method shows how cash flow from operations can be obtained from reported net income as a result of a series of adjustments.

The steps are:

• Begin with net income.
• Add back all non-cash charges to income and subtract all non-cash components of revenue
  • For example, add depreciation and amortization.
• Subtract any gains that resulted from financing or investing cash flows
  • For example, gain on the sale of an equipment.
• Add or subtract changes to related balance sheet operating accounts.
• Decrease in operating assets (source of cash) should be added and increase in operating assets (use of cash) should be subtracted.
• Increase in current liabilities (source of cash) should be added and decrease in current liabilities (use of cash) should be subtracted.

Conversion from the Indirect to Direct Method

The operating cash flow from indirect method can be converted to direct by using the three-step process:

1. Aggregate all the revenues and expenses.
2. Remove all non-cash items from aggregated revenues and expenses and break up remaining items into relevant cash flow items.
3. Convert accrual amounts to cash flow amounts by adjusting for changes in corresponding working accounts.

Cash Flows from Investing Activities

CFI is calculated by examining the change in the gross asset account that results from investing activities. Typically, this change results from purchases or sale of equipment (long term assets). To determine the cash inflow from the sale of equipment, we need to use the expression shown below.

Sale of Equipment

where

• Net Cash Flow from Creditors = New Borrowings} - Principal Repaid
• Net Cash Flow from Shareholders = New Equity Issued - Shares Repurchased - Cash Dividends

Differences in Cash Flow Statements Prepared Under US GAAP Versus IFRS

The reporting of interest paid/received and dividends paid/received is different between IFRS and US GAAP. The differences between the two standards are summarized in the table below.