Analysis Using the Statement of Cash Flows

Read this chapter, which shows how to record cash flow from operating activities on the statement of cash flows. The chapter also provides an overview of cash flows from operating activities and steps in preparing a statement of cash flows, which will be covered in more detail in the resources that follow.

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.