BUS105 Study Guide
Unit 10: Statement of Cash Flows
10a. Explain the purpose of the statement of cash flows
- Why is the purpose of the statement of cash flows?
- What is fundamentally different about the statement of cash flows, as compared to the other financial statements such as the balance sheet and income statement?
- Why is the statement of cash flows the last of the financial statements to be prepared?
Although Generally Accepted Accounting Principles (GAAP) require the use of accrual accounting, which recognizes revenues when earned and expenses when incurred, there is one statement dedicated to tracking the changes in cash. The statement of cash flows provides information on all inflows and outflows in cash for a company in a given time period. It also reconciles the change in cash balance from the beginning of the period to the end.
The statement of cash flows is used by managers, investors, creditors, and other stakeholders of a company to ensure that company always has sufficient cash flows for their needs. A company may show excellent performance on its income statement and balance sheet, but without adequate cash flows, it will be unable to survive.
10b. Explain what each of the three categories of cash flows (operating, investing, and financing) represents
- What are the three sections on the statement of cash flows?
- What do all the items in the operating section have in common?
- Why are dividends paid part of the financing section but dividends received part of the operating section?
The statement of cash flows breaks down all cash flows of a company into three categories: Operating activities, investing activities, and financing activities.
The first section of the statement of cash flows is always the section containing cash flows from operating activities. This includes any and all cash activities that factor into the determination of net income. For example, cash inflows from the sale of goods and cash outflows for raw materials or merchandise are operating activities. Interest revenue and expense as well as dividend revenue are also included in operating activities.
The second section of the statement of cash flows is the cash flows from investing activities. This includes all cash activities related to noncurrent assets such as the purchase and sales of property, plant, and equipment, or long-term investments as well as loans made to other entities.
The third and final section of the statement is the cash flows from financing activities. This includes all cash activities related to noncurrent liabilities such as the payment of long-term debt as well as any items related to owners' equity such as stock issuances and repurchases, and dividend payments.
10c. Prepare a statement of cash flows using the direct and indirect methods
- What is the main difference between the direct and indirect methods of preparing the statement of cash flows?
- Why do the majority of companies prefer to use the indirect method in preparing the statement of cash flows?
- In the preparation of the statement of cash flows, why are changes in certain balance sheet items such as accounts receivables and payables added or subtracted to net income?
There are two methods to prepare a statement of cash flows. The more popular method is known as the indirect method. This first step of this method begins with net income from the income statement as the starting point. From here, several adjustments related to changes in current assets, current liabilities, and other items are made in order to arrive at cash provided by operating activities. Essentially, it is converting net income as reported using the accrual method to what net income would be using the cash method. After this, steps two and three are preparing the investing and operating sections using any cash inflows or outflows that fall under those categories. The fourth step is reconciling the change in cash from the beginning to the ending balance.
The direct method differs from the indirect method only in the first step. Rather than starting with net income and backing into the cash basis net income, net income is directly determined using the cash method (Hence the name, "direct" method). The other three steps are the same under each method.
Review Four Key Steps to Preparing the Statement of Cash Flows, Using the Indirect Method to Prepare the Statement of Cash Flows, and Appendix: Using the Direct Method to Prepare the Statement of Cash Flows.
10d. Evaluate an organization's performance by analyzing its cash from operating activities
- What can be gained from knowing the cash from operating activities of a company?
- What are the three measures used to evaluate a company's cash flows?
- Why are capital expenditures subtracted from cash flows from operating activities to arrive at free cash flow?
There are three common cash flow measures that are used to evaluate companies. The first is the operating cash flow ratio:
Operating cash flow ratio = Cash provided by operating activities ÷ Current liabilities
This ratio measures a company's ability to generate enough cash to cover its current liabilities. In other words, for every dollar owed as a current liability, how many dollars in cash are generated by a company's operations.
The second measure is the capital expenditure ratio:
Capital expenditure ratio = Cash provided by operating activities ÷ Capital expenditures
This ratio measures a company's ability to generate enough cash to cover its capital expenditures. It tells us for every dollar spent on capital expenditures, how many dollars in cash are generated by a company's operations.
The third measure, free cash flow, is not a ratio, rather it is a dollar amount:
Free cash flow = Cash provided by operating activities − Capital expenditures
The idea behind this measure is that organizations need to be able to invest in fixed assets (capital expenditures) in order to continue to stay competitive. That being the case, this measures how much cash from operations is left over (is "free") after investing in capital assets.
Review Analyzing Cash Flow Information.
Unit 10 Vocabulary
This vocabulary list includes terms you will need to know to successfully complete the final exam.
- capital expenditure ratio
- direct method
- financing activities
- free cash flow
- indirect method
- investing activities
- operating activities
- operating cash flow ratio
- statement of cash flows