Chapter 10: The Statement of Cash Flows

Use of Cash Flow Statement; Operating, Investing & Financing Activities; Indirect Method

Uses of the Statement of Cash Flows

What Does the Statement of Cash Flows Include?

This statement includes details about a company’s cash receipts & cash disbursements from operating, investing & financing activities. It permits a user to determine exactly what caused the company’s cash balance to increase or decrease during the period.

What Does the Statement of Cash Flow help Users Do?

  • Predict Future Cash Flows: Past cash receipts/payments are reasonably good predictors of future cash flows.
  • Evaluate Management Decisions: Reports how managers got cash & how they used it to run the business.
  • Determine Ability to Pay Dividends/Interest: Reports on the ability to make these payments.
  • Assess the Relationship of Net Income to Cash Flows: Usually, cash & net income move together. High income tends to lead to increases in cash, and low levels tend to lead to decreases in cash. A company’s cash flow can, however, suffer even when net income is high, or improve when it suffers a net loss. Thus, a company needs both net income & strong cash flow to succeed.
  • Compare Performance of Different Companies: Because it eliminates the effects of using different accounting methods for the same types of transactions & events, it’s easily comparable to other companies.

What are Cash Equivalents?

On the Statement of Cash flows, cash means cash & cash equivalents. These are short-term investments that are readily convertible to known amounts of cash, that are unlikely to change in value.

Generally, only investments with maturities of 3 months or less meet this criterion (such as money-market investment accounts or 3-month Treasury bills).

What Does ‘Bank Overdraft’ Mean?

An overdraft usually refers to a checking account where the amount of checks presented to the bank for payment exceeds the amount on deposit. When this occurs, we say that the checking account customer has overdrawn its account. The overdraft means that the bank's records indicate a negative checking account balance.

Bank overdraft balances should also be netted against cash in the statement.

Operating, Investing & Financing Activities

What are Operating Activities?

Operating activities comprise the main revenue-producing activities of a company & generally result from the transactions and events that determine net income. Other activities that are not investing or financing activities are also classified as operating activities.

Common activities include cash receipts from sales of its primary products and cash payments to suppliers/employees for the products they sold.

What are Investing Activities?

Investing activities include the purchase & sale of long-term assets and other investments that don’t qualify as cash equivalents. Generally, consist of transactions related to resourced used for generating future income & cash flows. IFRS & ASPE state that only expenditures related to assets that are recognized on the balance sheet qualify as investing activities.

Common activities include cash payments to acquire tangible/intangible long-lived assets, and the cash received on the sale of these assets. Also includes purchase & sale of equity and debt instruments of other companies, and those related to both short-term & long-term advances & loans made to other entities. Any short-term investments that qualify as cash equivalents are excluded.

What are Financing Activities?

Financing activities result in changes in the size & composition of a company’s contributed equity and borrowings.

Common activities include issuance & acquisition of shares; cash dividend payments; cash proceeds from loans, bonds & notes; and repayment of amounts borrowed. With the exception of bank overdrafts, both short-term & long-term borrowings are included in financing activities.

Classifying Interest & Dividends

Under IFRS

Interest paid and interest and dividends received may be classified as operating cash flows because they enter into the determination of net income. Alternatively, interest paid may be classified as a financing cash flow because it is a cost of obtaining financial resources, while interest and dividends received may be classified as investing cash flows because they represent returns on investments. Under IFRS, a company is free to choose either classification scheme but must use it consistently from then onward.

IFRS also offer a choice when classifying dividends paid: they may either be classified as a financing cash flow because they are a cost of obtaining financial resources, or they may be classified as cash flows from operating activities so that users may determine the company’s ability to pay dividends out of operating cash flows.

Under ASPE

ASPE require that all interest paid and all interest and dividends received and included in the determination of net income be classified as operating activities.

ASPE require that any dividends paid & charged against retained earnings be classified as a financing activity.

Under Textbook Convention (for MGT120)

This course classifies all interest paid and interest and dividends received as operating activities, while classifying dividends paid as a financing activity.

2 Methods of Determining Cash Flows from Operating Activities

  • Indirect Method: Where net income is adjusted for non-cash transactions, for any deferrals or accruals of past or future operating cash receipts or payments, and for items of income or expense associated with investing or financing cash flows.
  • Direct Method: Which reports all cash receipts and cash payments from operating activities.

Both will give the same figure, but most of the accounting world uses the indirect method due to historical popularity. In MGT120, we’re only responsible for the indirect method.

Indirect Method for Operating Activities

Step 1: Use this Template

Step 2: Determine Increases or Decreases in Cash

This is done by comparing 2 balance sheets, one from the beginning of the period & one from the end.

Step 3: Income Statement Information

From the income statement, take net income, depreciation & amortization expense, and any gains or losses on the sale of long-term assets. Print these items on the statement of cash flows.

Step 4: Prepare Statement of Cash Flows

Use the income statement & balance sheet data to prepare the statement of cash flows. The statement is complete only after you’ve shown the year-to-year changes in all the balance sheet accounts.

Adjustments to Cash Flows from Operating Activities

Depreciation/Amortization Expense

We debit depreciation expense & credit accumulated depreciation. Net income decreases, but there’d no outflow of cash. Thus, we add depreciation/amortization expense back to net income.

Gains & Losses on the Sale of Investing Assets

Sales of tangible & intangible assets and investments other than cash equivalents are investing activities, and there is often a gain or loss on these sales. On the statement of cash flows, a gain or loss on the sale is an adjustment to net income.

The entire sale price is included under investing activities, while gains & losses are adjusted under operating activities. Subtract gains & add losses.

Changes in Non-Cash Operating Working Capital Accounts

A company’s operating activities affect many of its non-cash current asset & liability accounts.

What does Non-Cash Operating Working Capital Accounts mean?

  • Non-Cash means that it’s not included in the cash & cash equivalents balance on the statement of cash flows.
  • Operating because they derive from operating activities.
  • Working Capital: Current Assets minus Current Liabilities

These accounts include:

  • Accounts Receivable: When a company sells on credit, net income increases but cash doesn’t. Thus, we must deduct any increase in the accounts receivable and add any decreases to net income. Changes in other types of non-investing receivables (e.g. tax receivables) are treated the same way.
  • Inventory: When a company buys inventory, cash decreases but there’s no impact on net income. Thus, we must deduct an increase in inventory and add any decrease to net income. THIS IS ONLY IF PAID WITH CASH!
  • Prepaid Expense: If a company prepays an expense, there’s a cash outflow with no consequent decrease in net income. Thus, we must deduct an increase in prepaid expense and add a decrease to net income.
  • Accounts Payable & Accrued Liabilities: When a company incurs an expense, but pays for it later, net income decreases via an increase in the affected expense account but cash doesn’t decrease. Thus, we must deduct any decreases in accounts payable and add any increases to net income. Changes in similar types of non-financing liabilities (e.g. provisions) are treated the same way.
  • Unearned Revenue: If a customer pays before receiving a good or service, cash increases but net income doesn’t. Thus, we must deduct any decrease in unearned revenue and add any increase to net income.

As a rule, increases (decreases) in non-cash operating current asset accounts result in decreases (increases) to net income when determining CFO—the account impact is the opposite of the CFO impact. In contrast, increases (decreases) in non-cash operating current liability accounts result in increases (decreases) to net income when reconciling to CFO—the account impact is consistent with the CFO impact.

Cash Flows from Investing Activities

Acquisitions & Sales of Tangible and Intangible Assets

Acquisitions & Sales of Investments Other Than Cash Equivalents

Same as above except there’s no Depreciation.

Making & Collecting Loans and Advances to Others

Cash Flows from Financing Activities

Borrowing Money & Repaying Debts

Issuing & Reacquiring Shares

Payment of Dividends

Non-Cash Financing Working Capital

Any increase or decrease in a Dividend Payable account is treated the same way as a change in a non-cash operating current liability account, except that the adjustment to cash flows is included in the Financing Activities section. If, for example, Bradshaw had a Dividends Payable account that had increased by $5,000 during 2017, then we would add this increase as a Change in non-cash financing working capital to the Financing Activities section of its statement of cash flows.

Non-Cash Investing & Financing Activities

Companies sometimes engage in financing & investing activities that don’t involve cash flows. For example: the acquisition of a subsidiary company in exchange for shares of the acquiring company. In this transaction, the acquiring company has invested in a new asset, the subsidiary company, and financed it with its own shares, but because the transaction does not involve cash, these activities are not included in the statement of cash flows. IFRS and ASPE do, however, require note disclosure of non-cash investing & financing activities.

What is ‘Free Cash Flow’?

Some users want to know how much cash a company can “free up” for new opportunities. Free cash flow is the amount of cash available from operations after paying for property, plant & equipment.

It is important to note, however, that a negative free cash flow is not necessarily a bad sign.

Decision Guidelines: Investors’ & Creditors’ Use of Cash Flow Info

Summary of IFRS-ASPE Differences

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