Analysis Using the Statement of Cash Flows

Learning objectives

After studying this chapter, you should be able to:

• Explain the purposes and uses of the statement of cash flows.
• Describe the content of the statement of cash flows and where certain items would appear on the statement.
• Describe how to calculate cash flows from operating activities under both the direct and indirect methods.
• Prepare a statement of cash flows, under both the direct and indirect methods, showing cash flows from operating activities, investing activities, and financing activities.
• Analyze a statement of cash flows of a real company.
• Analyze and use the financial results–cash flow per share of common stock, cash flow margin, and cash flow liquidity ratios.
• Use working paper to prepare a statement of cash flows (appendix).

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A career in external auditing

In 1929 the Dow Jones Industrial Average fell 40 percent over the period fromSeptember 3rd to October 29th. The Dow bottomed out in July 1932, after losing 89 percent of its value. Some blamed accounting for the run-up in prices and the subsequent crash. Stocks may have been overpriced because companies engaged in "window dressing" to enhance their reported income. At the time, accounting practices and reporting procedures were not well-established. As investors began to understand this, confidence fell. Investors panicked and sold stocks in a frenzy. This action contributed to the Great Depression of the 1930s. The Dow did not reach precrash levels again until 1954.

In response to the financial crisis, the Securities and Exchange Commission (SEC) was established in 1934 to regulate the filing requirements of firms listed on US stock exchanges. The SEC requires all listed firms in each year to prepare financial statements in accordance with generally accepted accounting principles (GAAP) and to have those financial statements audited by an independent party. This independent verification was meant to restore investor confidence and provide ongoing integrity in the capital market system. If a company fails to follow GAAP, it can be delisted from the stock exchange.

For many reasons, managers have incentives to manipulate income to enhance reported performance. It is the job of auditors to use their understanding of accounting principles and business practices to provide reasonable assurance that financial statements are free from such manipulation. One possible indication of income manipulation occurs when accrual earnings are high relative to cash flows from operating activities, sometimes referred to as "cash earnings". Accrual earnings are typically easier to manipulate because they employ estimates, whereas cash earnings are tied to actual cash receipts and payments from operations. Accrual earnings can be managed upward by recognizing earnings prematurely (or falsely) or by underestimating expenses such as depreciation expense or bad debts expense.

In addition to the challenges of verifying the accuracy of financial statements, a career in auditing provides a variety of options. Students can work for global auditing firms or small local firms, choose to travel frequently or on a limited basis, and decide to live in any geographic area around the world. A career in auditing also provides an excellent springboard for future opportunities. Companies realize that their auditors can be a valuable part of the management team. Auditors have expertise about the firm, its industry, and its accounting practices. Auditors commonly leave the auditing profession to work for one of their many clients.

The income statement, statement of stockholders' equity (or statement of retained earnings), and the balance sheet do not answer all the questions raised by users of financial statements. Such questions include: How much cash was generated by the company's operations? How can the Cash account be overdrawn when my accountant said the business was profitable? Why is such a profitable company able to pay only small dividends? How much was spent for new plant and equipment, and where did the company get the cash for the expenditures? How was the company able to pay a dividend when it incurred a net loss for the year?

In this chapter, you will learn about the statement of cash flows, which answers these questions. The statement of cash flows is another major required financial statement; it shows important information not shown directly in the other financial statements.

Purposes of the statement of cash flows

In November 1987, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 95, "Statement of Cash Flows". The Statement became effective for annual financial statements for fiscal years ending after 1988 July 15. Thus, the statement of cash flows is now one of the major financial statements issued by a company. The statement of cash flows replaced the statement of changes in financial position, on which funds were generally defined as working capital. Working capital is equal to current assets minus current liabilities.

The main purpose of the statement of cash flows is to report on the cash receipts and cash disbursements of an entity during an accounting period. Broadly defined, cash includes both cash and cash equivalents, such as short-term investments in Treasury bills, commercial paper, and money market funds. Another purpose of this statement is to report on the entity's investing and financing activities for the period. As shown in Exhibit 50, the statement of cash flows reports the effects on cash during a period of a company's operating, investing, and financing activities. Firms show the effects of significant investing and financing activities that do not affect cash in a schedule separate from the statement of cash flows.

Uses of the statement of cash flows

The statement of cash flows presents the effects on cash of all significant operating, investing, and financing activities. By reviewing the statement, management can see the effects of its past major policy decisions in quantitative form. The statement may show a flow of cash from operating activities large enough to finance all projected capital needs internally rather than having to incur long-term debt or issue additional stock. Alternatively, if the company has been experiencing cash shortages, management can use the statement to determine why such shortages are occurring. Using the statement of cash flows, management may also recommend to the board of directors a reduction in dividends to conserve cash.

The information in a statement of cash flows assists investors, creditors, and others in assessing the following:

• Enterprise's ability to generate positive future net cash flows.
• Enterprise's ability to meet its obligations.
• Enterprise's ability to pay dividends.
• Enterprise's need for external financing.
• Reasons for differences between net income and associated cash receipts and payments.
• Effects on an enterprise's financial position of both its cash and noncash investing and financing transactions during the period (disclosed in a separate schedule). 

Information in the statement of cash flows

Cash flows from operating activities

Cash flows from operating activities show the net amount of cash received or disbursed during a given period for items that normally appear on the income statement. You can calculate these cash flows using either the direct or indirect method. The direct method deducts from cash sales only those operating expenses that consumed cash. This method converts each item on the income statement directly to a cash basis. Alternatively, the indirect (addback) method starts with accrual basis net income and indirectly adjusts net income for items that affected reported net income but did not involve cash.

The Statement of Financial Accounting Standards No. 95 encourages use of the direct method but permits use of the indirect method. Whenever given a choice between the indirect and direct methods in similar situations, accountants choose the indirect method almost exclusively. The American Institute of Certified Public Accountants reports that approximately 98 percent of all companies choose the indirect method of cash flows.

The direct method converts each item on the income statement to a cash basis. For instance, assume that sales are stated at USD 100,000 on an accrual basis. If accounts receivable increased by USD 5,000, cash collections from customers would be USD 95,000, calculated as USD 100,000 - USD 5,000. The direct method also converts all remaining items on the income statement to a cash basis, as we will illustrate later.

The indirect method adjusts net income (rather than adjusting individual items in the income statement) for (1) changes in current assets (other than cash) and current liabilities, and (2) items that were included in net income but did not affect cash.

The most common example of an operating expense that does not affect cash is depreciation expense. The journal entry to record depreciation debits an expense account and credits an accumulated depreciation account. This transaction has no effect on cash and, therefore, should not be included when measuring cash from operations. Because accountants deduct depreciation in computing net income, net income understates cash from operations. Under the indirect method, since net income is a starting point in measuring cash flows from operating activities, depreciation expense must be added back to net income.

Consider the following example. Company A had net income for the year of USD 20,000 after deducting depreciation of USD 10,000, yielding USD 30,000 of positive cash flows. Thus, Company A had USD 30,000 of positive cash flows from operating activities. Company B had a net loss for the year of USD 4,000 after deducting USD 10,000 of depreciation. Although Company B experienced a loss, it had USD 6,000 of positive cash flows from operating activities, as shown here:

Company B's loss would have had to exceed USD 10,000 to generate negative cash flows from operating activities.

Companies add other expenses and losses back to net income because they do not actually use company cash; they call these addbacks noncash charges or expenses. Besides depreciation, the items added back include amounts of depletion that were expensed, amortization of intangible assets such as patents and goodwill, amortization of discount on bonds payable, and losses from disposals of noncurrent assets.

An accounting perspective:
Business insight

Certain revenues and gains included in arriving at net income do not provide cash; these items are noncash credits or revenues. Quick should deduct these revenues and gains from net income to compute cash flows from operating activities. Such items include gains from disposals of noncurrent assets, income from investments carried under the equity method, and amortization of premiums on bonds payable.

To illustrate why we deduct the gain on the disposal of a noncurrent asset from net income, assume that Quick sold the equipment just mentioned for USD 9,000. The journal entry to record the sale is:

Quick shows the USD 9,000 inflow from the sale of the equipment on its statement of cash flows as a cash inflow from investing activities. Thus, it has already recognized the total USD 9,000 effect on cash (including the USD 2,000 gain) as resulting from an investing activity. Since the USD 2,000 gain is also included in calculating net income, Quick must deduct the gain in converting net income to cash flows from operating activities to avoid double-counting the gain.

Steps in preparing statement of cash flows

Accountants follow specific procedures when preparing a statement of cash flows.

We show these procedures using the financial statements and additional data for Welby Company in Exhibit 52.

After determining the change in cash, the first step in preparing the statement of cash flows is to calculate the cash flows from operating activities, using either the direct or indirect method. The second step is to analyze all of the noncurrent accounts and additional data for changes resulting from investing and financing activities. The third step is to arrange the information gathered in steps 1 and 2 into the proper format for the statement of cash flows.

The direct method converts the income statement from the accrual basis to the cash basis. Accountants must consider changes in balance sheet accounts that are related to items on the income statement. The accounts involved are all current assets or current liabilities. The following schedule shows which balance sheet accounts are related to the items on Welby's income statement:

For other income statement items, the relationship is often obvious. For instance, salaries payable relates to salaries expense, federal income tax payable relates to federal income tax expense, prepaid rent relates to rent expense, and so on.

The table below shows how income statement items are affected by balance sheet accounts:

Noncash operating expenses (such as depreciation expense and amortization expense), revenues, gains, and losses are reduced to zero in the cash basis income statement.

Exhibit 52: Financial statements and other data

Exhibit 53: Working paper to convert income statement from accrual basis to cash basis

As a general rule, an increase in a current asset (other than cash) decreases cash inflow or increases cash outflow. Thus, when accounts receivable increases, sales revenue on a cash basis decreases (some customers who bought merchandise have not yet paid for it). When inventory increases, cost of goods sold on a cash basis increases (increasing cash outflow). When a prepaid expense increases, the related operating expense on a cash basis increases. (For example, a company not only paid for insurance expense but also paid cash to increase prepaid insurance). The effect on cash flows is just the opposite for decreases in these other current assets.

An increase in a current liability increases cash inflow or decreases cash outflow.

Thus, when accounts payable increases, cost of goods sold on a cash basis decreases

(instead of paying cash, the purchase was made on credit). When an accrued liability (such as salaries payable) increases, the related operating expense (salaries expense) on a cash basis decreases. (For example, the company incurred more salaries than it paid). Decreases in current liabilities have just the opposite effect on cash flows.

Welby Company had no prepaid expenses. The current assets and current liabilities affecting the income statement items changed as follows:

Thus, Welby converted its income statement to a cash basis as shown in Exhibit 53.

The indirect method makes certain adjustments to convert net income to cash flows from operating activities. Welby must analyze the effects of changes in current accounts (other than cash) on cash. The firm should also take into account noncash items such as depreciation that affected net income but not cash. Welby had only one such item - depreciation expense of USD 5,000. Applying these adjustments to Welby's financial statements and other data in Exhibit 52 yields the following schedule:

Notice that both the direct and indirect methods result in USD 5,000 net cash provided by operating activities.

You can use the following table to make the adjustments to net income for the changes in current assets and current liabilities:

Note that you would handle all changes in current asset accounts in a similar manner. All changes in current liability accounts require the opposite treatment of the current asset changes. Use this table in making these adjustments:

In applying the rules in this table, add a decrease in a current asset to net income, and deduct an increase in a current asset from net income. For current liabilities, add increases to net income, and deduct decreases from net income.

Under the indirect method, the amount of cash flows from operating activities is calculated as follows:

Accrual basis net income

+ or - Changes in noncash current asset and current liability accounts

+ Expenses and losses not affecting cash

- Revenues and gains not affecting cash

= Cash flows from operating activities

After analyzing the changes in current accounts for their effect on cash, we examine the noncurrent accounts and additional data. Remember that a change in a noncurrent account usually comes about because cash is received or disbursed.

In the Welby example, we must analyze four noncurrent accounts: Retained Earnings, Equipment, Accumulated Depreciation - Equipment, and Common Stock.

• The analysis of the noncurrent accounts can begin with any of the noncurrent accounts; we begin by reviewing the Retained Earnings account. Retained Earnings is the account to which net income or loss for the period was closed. The USD 6,000 increase in this account consists of USD 10,000 of net income less USD 4,000 of dividends paid. 

The net income amount is in the income statement. We enter both net income and dividends on the statement of cash flows in Exhibit 54, Part B. The USD 10,000 net income is the starting figure in determining cash flows from operating activities.

Thus, we enter the net income of USD 10,000 on the statement in the cash flows from operating activities section. The dividends are shown as a deduction in the cash flow from financing activities section.

• The Equipment account increased by USD 20,000. The dividends are shown as a deduction in the cash flow from financing activities section. The additional data indicate that USD 20,000 of equipment was purchased during the period. A purchase of equipment is a deduction in the cash flows from investing activities section.
• The USD 5,000 increase in the Accumulated Depreciation - Equipment account equals the amount of depreciation expense in the income statement for the period. As shown earlier, because depreciation does not affect cash, under the indirect (addback) method we add it back to net income on the statement of cash flows to convert accrual net income to a cash basis.
• The USD 30,000 increase in common stock resulted from the issuance of stock at par value, as disclosed in the additional data (item 2) in Exhibit 52. An issuance of stock in the statement of cash flows is a positive amount in the cash flows from financing activities section.

After we have analyzed the noncurrent accounts, we can prepare the statement of cash flows from the information generated. Part A of Exhibit 54 presents the statement of cash flows for Welby using the direct method. Part B shows the statement of cash flows for Welby using the indirect method. The appendix to this chapter shows how a working paper can be used to assist in preparing a statement of cash flows for the Welby Company under the indirect method. However, we believe you will gain a greater conceptual understanding by not using a working paper.

The statement of cash flows has three major sections: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. The format in the operating activities section differs for the direct and indirect methods. The direct method adjusts each item in the income statement to a cash basis. The indirect method makes these same adjustments but to net income rather than to each item in the income statement. Both methods eliminate not only the effects of noncash items, such as depreciation, but also gains and losses on sales of plant assets.

The only item in the cash flows from investing activities section is the cash outflow of USD 20,000 for the purchase of equipment. In a more complex situation, other items could be included in this category.

Two items are under the cash flows from financing activities section: The issuance of common stock resulted in a cash inflow of USD 30,000 and the payment of dividends resulted in a cash outflow of USD 4,000.

The last line of the statement is the USD 11,000 increase in cash for the year. Other examples could result in a decrease in cash for the year.

If the direct method is used, the reconciliation of net income to net cash flows from operating activities (the indirect method) must be shown in a separate schedule. However, if the indirect method is used and the reconciliation is shown in the statement of cash flows, no such separate schedule is required. Possibly this is one of the reasons why so many companies use the indirect method.

However, if the indirect method is used, the amount of interest and income taxes paid must be provided in related disclosures, usually immediately below the statement of cash flows. For instance, if Welby Company had paid interest of USD 200 and income taxes of USD 8,000, these facts would be reported as follows:

A. Direct Method

B. Direct Method

Exhibit 54: Statement of cash flows-Welby company

Analysis of the statement of cash flows

Business students will benefit throughout their careers from knowing how to analyze a statement of cash flows. We will use the consolidated statement of cash flows from Synotech, Inc. to illustrate the analysis. This company will be used in the next chapter to illustrate the complete analysis and interpretation of all the financial statements. The example is adapted from a real USA company's recent annual report.

Exhibit 55 shows the consolidated statements of cash flows for the years 2010, 2009, and 2008 for Synotech, Inc. We also include portions of Management's Discussion and Analysis of the 2010 statement of cash flows. We will then discuss the statement further, explaining various items and illustrating how the information might be used for decision making.

Liquidity and capital resources

Net cash provided by operations increased 13 percent to USD 1,101.0 in 2010 compared with USD 972.3 in 2009 and USD 995.3 in 2008. The increase in cash generated by operating activities in 2010 reflects the Company's improved profitability and working capital management. Cash generated from operations was used to fund capital spending, reduce debt levels and increase dividends.

During 2010, long-term debt decreased from USD 3,634.8 to USD 3,476.6. The Company continued to focus on enhancing its debt portfolio, resulting in the refinancing of a substantial portion of commercial paper and other short-term borrowings to longer term instruments. In 2010, the Company entered into a USD 595.6 loan agreement and obtained a USD 487.2 term loan with foreign commercial banks.

As of 2010 December 31, USD 410.3 of domestic and foreign commercial paper was outstanding. These borrowings carry a Standard & Poor's rating of A1. The commercial paper as well as other short-term borrowings are classified as long-term debt at 2010 December 31, as it is the Company's intent and ability to refinance such obligations on a long-term basis. The Company has additional sources of liquidity available in the form of lines of credit maintained with various banks. At 2010 December 31, such unused lines of credit amounted to USD 2,142.8.

The ratio of net debt to total capitalization (defined as the ratio of the book values of debt less cash and marketable securities ["net debt"] to net debt plus equity) decreased to 58 percent during 2010 from 64 percent in 2009. The decrease is primarily the result of higher Company earnings in 2010 as well as effective working capital management and lower acquisitions than in prior years. The ratio of market debt to market capitalization (defined as above using fair market values) decreased to 17 percent during 2010 from 23 percent in 2009. The Company primarily uses market value analyses to evaluate its optimal capitalization.

Capital expenditures were 5.2 percent of net sales in both 2010 and 2009 and were 5.3 percent of net sales in 2008. Capital spending continues to be focused primarily on projects that yield high aftertax returns, thereby reducing the Company's cost structure. Capital expenditures for 2008 are expected to continue at the current rate of approximately 5 percent of net sales.

Other investing activities in 2010, 2009, and 2008 included strategic acquisitions and equity investments worldwide. The aggregate purchase price of all 2010, 2009, and 2008 acquisitions was USD 46.2, USD 1,586.3, and USD 179.8, respectively.

Exhibit 55: Consolidated statements of cash flows for Synotech, Inc. - Indirect method

Dividend payments were USD 355.5 in 2010, up from USD 331.8 in 2009 and USD 296.3 in 2008.

Internally generated cash flows appear to be adequate to support currently planned business operations, acquisitions, and capital expenditures. Significant acquisitions would require external financing.

The Company is a party to various superfund and other environmental matters and is contingently liable with respect to lawsuits, taxes, and other matters arising out of the normal course of business. Management proactively reviews and manages its exposure to, and the impact of, environmental matters. While it is possible that the Company's cash flows and results of operations in particular quarterly or annual periods could be affected by the one-time impacts of the resolution of such contingencies, it is the opinion of management that the ultimate disposition of these matters, to the extent not previously provided for, will not have a material impact on the Company's financial condition or ongoing cash flows and results of operations.

Refer to Exhibit 55. First we will discuss the items in the operating activities section of the statement of cash flows, then we will discuss investing activities and financing activities.

Operating activities The company used the indirect method of calculating net cash provided by operations. Various adjustments were made to convert accrual based net income to cash basis net income.

The "restructured operations, net" item resulted from the fact that many companies restructured their operations by closing plants and significantly reducing their work forces. Some companies recognized a net loss from restructuring and others recognized a net gain. Apparently, the company recognized a net gain in 2010 because it deducted the item from net income on the statement of cash flows. The actual cash flows from restructuring will occur in a later period.

"Depreciation and amortization" includes depreciation on plant assets and amortization of intangible assets. Depreciation and amortization are noncash charges against revenues and must be added back to net income.

The "deferred income taxes and other, net" item deduction from net income results primarily from the fact that income tax expense on the income statement was lower than the actual income taxes paid in 2010. This phenomenon occurs because of using a different method for tax and accounting purposes for such items as depreciation.

Receivables and inventories increased (causing cash to decrease), while other current assets remained about the same. Payables and accruals increased (causing cash to increase). These changes are net of any amounts related to acquisitions, dispositions, or amounts that are included elsewhere, such as in "restructured operations, net". The changes described may differ from the amounts derived from only analyzing the balance sheets for the last two years because of certain technical "adjustments" that are beyond the scope of this text.

Investing activities "Capital expenditures" include the purchase of plant assets, such as new machinery and equipment, to modernize production facilities. Companies normally select those capital expenditures with the highest rate of return. For instance, if funds are limited (and they normally are) and two capital investments (a machine and a mainframe computer) are being considered, one yielding a 20 percent return and the other yielding a 25 percent return, the company will normally select the one with the 25 percent return.

"Payment for acquisitions, net of cash acquired" shows the amount spent in acquiring other companies and segments of other companies, net of the amount of cash held by those companies and obtained as a part of the acquisition.

The company sold "marketable securities and other investments". These securities normally consist of stocks, bonds, and other instruments of other companies. For fiscal years beginning after 1993 December 15, marketable securities must be identified as trading securities, available-for-sale securities, or held-to-maturity securities. Trading securities and available-for-sale securities were discussed in some detail in Chapter 14. Held-to-maturity securities were mentioned briefly in Chapter 15. These held-to-maturity securities are debt securities (such as bonds of other companies) that the company has purchased and has both the intent and ability to hold to maturity. As mentioned earlier, the proceeds from sales and purchases of trading securities must be shown as cash flows from operating activities, and the proceeds from sales and purchases of available-for-sale and held-to-maturity securities must be shown as cash flows from investing activities.

Financing activities The company paid off some old debt (USD 1,397.5 million) and incurred new debt (USD 1,292.9 million). Recently many companies are substituting new debt with a low interest rate for old debt with a high interest rate, just as homeowners refinance their homes to lower their interest rate.

The "proceeds from outside investors" resulted from the other participants in the formation of certain businesses in which the company holds more than a 50 percent share.

"Dividends paid" is an item that should be familiar to you. Dividends paid increased each year for the period 2008 through 2010.

The company bought back some of its own stock (treasury stock). Companies often buy back their own shares because they (1) need the shares to issue to employees or officers under stock option plans, (2) want to bolster the market price of the stock, or (3) hope to later sell the stock at a substantially higher price.

"Proceeds from exercise of stock options and other, net" represents the proceeds received from employees and officers who exercised their stock options. Stock options are usually granted to employees to encourage them to work efficiently to increase profitability, which should increase the market price of the stock. Stock options made available to officers are for the same purpose or to attract or retain a talented executive. Normally, an option gives the recipient the right to buy a certain number of shares at a stated price within a given time frame. For instance, the president of a company may be granted an option to buy 10,000 shares at USD 40 per share any time after two years from that date and before six years from that date. Assume that the current market price is USD 38. If the market price of the stock rises to USD 80 at some time during the option period, the president could buy the shares at USD 40 and then hold them or sell them at the higher market price. Executives of companies have become multimillionaires by exercising their stock options. The employees and executives of Synotech, Inc., paid the company between USD 22.2 million and USD 36.8 million per year to exercise their stock options during the three-year period. The company re-issued some of its treasury stock as a result of the exercise of the stock options.

We will discuss some examples of the ways that the information in the statement of cash flows can be used by management, stockholders, and creditors to make decisions. Each of these parties would use more than the statement of cash flows to perform an analysis of the company's performance, but we will restrict ourselves to the statement of cash flows. The next chapter shows a more complete analysis of the company's performance.

Management Management is the first to see the information contained in the statement of cash flows. You have already read portions of "Management's Discussion and Analysis" concerning the information contained in that statement. Management concluded that the amount of internally generated cash flows (net cash provided by operations) appears adequate to support currently planned business operations, acquisitions, and capital expenditures. Thus, unless the company engages in a significant acquisition it will not have to sell more stock or borrow more funds in the foreseeable future. Also, the company apparently replaced some of its high interest rate debt (USD 1,397.5 million) with lower interest rate debt (USD 1,292.9 million). Many companies are doing this same thing recently to take advantage of the low interest rates available.

Stockholders Stockholders can see that dividend payments (USD 355.5 million) are comfortably covered by net cash provided by operations (USD 1,101.0 million). Stockholders are undoubtedly pleased that the per share dividend rate has increased each year during 2008 through 2010. The company continues to invest in its future by making capital expenditures (USD 550.8 million) to modernize its productive facilities. The repurchase of its own stock (USD 32.9 million) decreases the number of shares outstanding, although some of the stock will undoubtedly be reissued in the future as employees and executives exercise their stock options. Any net reduction in the number of shares outstanding will tend to increase earnings per share and help to increase the market price per share in the future. Also, the company may decide to increase dividends per share in the future. These favorable factors might induce present stockholders to retain their stock or even increase their holdings. Potential stockholders might also be attracted to the stock.

A broader perspective:

Johnson & Johnson

Creditors An encouraging factor is the increasing amount of net cash provided by operations in 2010. Also comforting to creditors is the information in Management's Discussion and Analysis that the company has access to USD 2,142.8 million in lines of credit.

The preceding discussions are merely examples of how the information contained in the statement of cash flows might be analyzed to make decisions. The next section describes three ratios that can provide further analyses of cash flows.

Analyzing and using the financial results-Cash flow per share of common stock, cash flow margin, and cash flow liquidity ratios

The information in the statement of cash flows provides a basis for analyzing financial results. However, further analysis is possible through the use of three ratios relating to cash flow: the cash flow per share of common stock, cash flow margin, and cash flow liquidity ratios. The ratios shown below are results for Synotech, Inc. and recent results for other companies. All dollar amounts are rounded to the nearest million.

The cash flow per share of common stock ratio is equal to the net cash provided by operations divided by the average number of shares of common stock outstanding. This ratio indicates the company's ability to pay dividends and liabilities. The higher the ratio, the greater the ability to pay. The cash flow per share of common stock ratios for the companies were:

*To determine the average number of shares, add the beginning and ending numbers outstanding and divide by two.

The cash flow margin ratio is equal to net cash provided by operating activities divided by net sales. This ratio is a measure of a company's ability to turn sales revenue into cash. The higher the ratio, the better. The cash flow margin ratios for the companies were:

The cash flow liquidity ratio is equal to the total of cash, marketable securities, and net cash provided by operating activities divided by current liabilities. This ratio is a test of a company’s short-term, debt-paying ability. The higher the ratio, the better. The cash flow liquidity ratios for the companies were:

On the first of these measures, Synotech, Inc., seems to be in the strongest position, although all of the companies are financially sound. On the second measure, Walt Disney and General Electric have the highest cash flow margin ratios. On the third measure, Walt Disney seems to be in the strongest position. However, a more valid comparison on each of these measures would be made if each of these companies was compared with other companies in its industry. Dun & Bradstreet's Industry Norms and key business ratios can be used for this purpose. (This source could also be used for comparisons of ratios in the next chapter). A complete analysis using the techniques described in the next chapter would provide additional information about the strengths and weaknesses of each of these companies.

Understanding the learning objectives

• The statement of cash flows summarizes the effects on cash of the operating, financing, and investing activities of a company during an accounting period.
• Management can see the effects of its past major policy decisions in quantitative form.
• Investors and creditors can assess the entity's ability to generate positive future net cash flows, to meet its obligations, and to pay dividends, and can assess the need for external financing.
• Operating activities generally include the cash effects (inflows and outflows) of transactions and other events that enter into the determination of net income. The cash flows from operating activities can be measured in two ways. The direct method deducts from cash sales only those operating expenses that consumed cash. The indirect method starts with net income and adjusts net income for items that affected reported net income but did not involve cash.
• Investing activities generally include transactions involving the acquisition or disposal of noncurrent assets.
• Financing activities generally include the cash effects (inflows and outflows) of transactions and other events involving creditors and owners.
• The direct method deducts from cash sales only those operating expenses that consumed cash. The FASB recommends use of the direct method. The indirect method starts with accrual basis net income and indirectly adjusts net income for items that affected reported net income but did not involve cash. A large majority of companies use the indirect method.
• The first step is to determine the cash flows from operating activities. Either the direct or indirect method may be used.
• The second step is to analyze all the noncurrent accounts for changes in cash resulting from investing and financing activities.
• The third step is to arrange the information gathered in steps 1 and 2 into the format required for the statement of cash flows.
• Business students will benefit throughout their careers from knowing how to analyze a statement of cash flows.
• "Management's Discussion and Analysis" in the annual report provides part of the analysis.
• Inspection of the statement of cash flows together with "Management's Discussion and Analysis" will provide the most insight as to the cash flow situation.
• The cash flow per share of common stock ratio tests a company's ability to pay dividends and liabilities and is equal to net cash provided by operating activities divided by the average number of shares of common stock outstanding.
• The cash flow margin ratio measures a company's ability to turn sales revenue into cash and is equal to net cash provided by operating activities divided by net sales.
• The cash flow liquidity ratio tests a company's short-term, debt-paying ability and is equal to the total of cash, marketable securities, and net cash provided by operating activities divided by current liabilities.
• A work sheet can be used to assist in preparing a statement of cash flows.
• A company's comparative balance sheets, income statement, and additional data are used to prepare the work sheet.
• The work sheet technique makes the recording of the effects of transactions on cash flows almost a mechanical process.

Appendix: Use of a working paper to prepare a statement of cash flows

This appendix shows how a work sheet could be used to assist in preparing a statement of cash flows. We use the comparative balance sheets, income statement, and additional data for the Welby Company, shown on Exhibit 53, as the basis for this example.

Look at the working paper in Exhibit 56 for Welby Company, which we use to analyze the transactions and prepare the statement of cash flows. While discussing the steps in preparing the working paper, we describe the items and trace their effects in the entries.

• Enter the beginning account balances of all balance sheet accounts in the first column and the ending account balances in the fourth column. Notice that the debit items precede the credit items.
• Total the debits and credits in the first and fourth columns to make sure that debits equal credits in each column.
• Write "Cash Flows from Operating Activities" immediately below the total of the credit items. Skip sufficient lines for recording adjustments to convert accrual net income to cash flows from operating activities. Then write "Cash Flows from Investing Activities" and allow enough space for those items. Finally, write "Cash Flows from Financing Activities" and allow enough space for those items.
• Enter entries for analyzing transactions in the second and third columns. The entries serve two functions: (a) they explain the change in each account; and (b) they classify the changes into operating, investing, and financing activities. We discuss these entries individually in the next section.
• Total the debits and credits in the second and third columns; they should be equal. You will have one pair of totals for the balance sheet items and another pair for the bottom portion of the working paper. We use the bottom portion of the working paper to prepare the statement of cash flows.

To complete the working paper in Exhibit 56, we must analyze the change in each noncash balance sheet account. The focus of this working paper is on cash, and every change in cash means a change in a noncash balance sheet account. After we have made the proper entries to analyze all changes in noncash balance sheet accounts, the working paper shows all activities affecting cash flows. The following explanations are keyed to the entry numbers on the working paper:

Entry 0 In comparing the beginning and ending cash balances, we determine the change in the Cash account during the year is an USD 11,000 increase. An entry on the working paper debits Cash for USD 11,000 and credits Increase in Cash for Year near the bottom of the schedule. This 0 entry does not explain the change in cash but is the "target" of the analysis. The entry sets out the change in cash that the statement seeks to explain. No further attention need be paid to cash in completing the working paper.

We now direct our attention toward changes in other balance sheet accounts. These accounts can be dealt with in any order; first, we record the net income for the period and analyze the current assets (other than cash) and the current liabilities. Second, we analyze the changes in the noncurrent accounts.

Entry 1 The income statement shows a net income for 2010 of USD 10,000. Entry 1 records the USD 10,000 as the starting point in measuring cash flows from operating activities and credits Retained Earnings as a partial explanation of the change in that account.

The next task is to analyze changes in current accounts other than Cash. The current accounts of Welby Company are closely related to operations, and their changes are included in converting net income to cash flows from operating activities.

Entry 2 We deduct the USD 10,000 increase in accounts receivable from net income when converting it to cash flows from operating activities. If accounts receivable increased, sales to customers exceeded cash received from customers. To convert net income to a cash basis, we must deduct the USD 10,000.

The working paper technique makes the recording of these effects almost mechanical. By debiting Accounts Receivable for USD 10,000, we increase it from USD 20,000 to USD 30,000. If Accounts Receivable is debited, we must credit an item that can be entitled "Increase in Accounts Receivable". We deduct the increase from net income in converting it to cash flows from operating activities.

Entry 3 is virtually a duplicate of entry 2, except it involves merchandise inventory rather than receivables and is a decrease rather than an increase.

Entry 4 records the effect of a decrease in accounts payable on net income in converting it to cash flows from operating activities.

Entry 5 records the effect of an increase in accrued liabilities payable in converting net income to cash flows from operating activities.

Next, we analyze the changes in the noncurrent balance sheet accounts.

Entry 6 We add the USD 5,000 depreciation back to net income and credit the respective accumulated depreciation account. You can find the depreciation expense (1) on the income statement, or (2) by solving for the credit needed to balance the accumulated depreciation account on the balance sheet.

 
Exhibit 56: Working paper for statement of cash flows

Entry 7 We debit the Equipment account and credit "Purchase of Equipment" in the investing activities section for the USD 20,000 cash spent to acquire new plant assets (equipment).

Entry 8 We show the USD 30,000 cash received from sale of common stock as a financing activity. The entry also explains the change in the Common Stock account. If stock had been sold for more than its stated value of USD 50 per share, we would record the excess in a separate Paid-In Capital in Excess of Stated Value account. However, we would report the total amount of cash received from the issuance of common stock as a single figure on the statement of cash flows. Only this total amount received is significant to creditors and other users of the financial statements trying to judge the solvency of the company.

Entry 9 We debit Retained Earnings and credit Payment of Cash Dividends for the USD 4,000 dividends declared and paid. The entry also completes the following explanation of the change in Retained Earnings. Notice that on the statement of cash flows, the dividends must be paid to be included as a cash outflow from financing activities.

Using the data in the lower section of the working paper, we would prepare the statement of cash flows under the indirect method shown in Exhibit 54 (Part B).

Key terms

Cash flow liquidity ratio Cash and marketable securities plus net cash provided by operating activities divided by current liabilities.

Cash flow margin ratio Net cash provided by operating activities divided by net sales.

Cash flow per share of common stock ratio Net cash provided by operating activities divided by the average number of shares of common stock outstanding.

Cash flows from operating activities The net amount of cash received or disbursed during a given period on items that normally appear on the income statement.

Direct method Deducts from cash sales only those operating expenses that consumed cash.

Financing activities Generally include the cash effects of transactions and other events involving creditors and owners. Cash payments made to settle current liabilities such as accounts payable, wages payable, and income taxes payable are not financing activities. These payments are operating activities.

Indirect method A method of determining cash flows from operating activities that starts with net income and indirectly adjusts net income for items that do not involve cash. Also called the addback method.

Investing activities Generally include transactions involving the acquisition or disposal of noncurrent assets. Examples include cash received or paid from the sale or purchase of property, plant, and equipment; available-for-sale and held-to-maturity securities; and loans made to others.

Noncash charges or expenses Expenses and losses that are added back to net income because they do not actually use cash of the company. The items added back include amounts of depreciation on plant assets, depletion that was expensed, amortization of intangible assets such as patents and goodwill, amortization of discount on bonds payable, and losses from disposals of noncurrent assets.

Noncash credits or revenues Revenues and gains included in arriving at net income that do not provide cash; examples include gains from disposals of noncurrent assets, income from investments carried under the equity method, and amortization of premium on bonds payable.

Operating activities Generally include the cash effects of transactions and other events that enter into the determination of net income.

Statement of cash flows A statement that summarizes the effects on cash of the operating, investing, and financing activities of a company during an accounting period. Both inflows and outflows are included in each category. The statement of cash flows must be prepared each time an income statement is prepared.

Working capital Equal to current assets minus current liabilities.