Chapter 5 Statement of Cash Flows and Articulation 1. Important companion of the income statement 2. Three main categories of the cash flow statement: operating, investing, and financing 3. Cash flows from operations using either the direct or the indirect method 4. Prepare a complete statement of cash flows 5. Analysis of a firm’s financial strength from perspective of cash flows 6. Articulation of the three primary financial statements 7. Forecasted statement of cash flows 5-1 1. Describe the circumstances in which the cash flow statement is a particularly important companion of the income statement. What Good is a Cash Flow Statement? We need the cash flow statement because: • Sometimes earnings fail. • Everything is on one page. • It is used as a forecasting tool. 5-2 Sometimes Earnings Fail The Big Loss Scenario When a company reports large noncash expenses such as: - write-offs - depreciation - provisions for future obligations … earnings may give a gloomier picture of current operations than warranted. (continued) 5-3 The Rapid Growth Scenario • Rapidly growing firms use large amounts of cash to expand inventory. • Cash collections on the growing accounts receivable often lag behind the need to pay creditors. • Reported earnings may be positive, but operations are actually consuming rather than generating cash. 5-4 The Reality Check Scenario Companies entering phases in which it is critical that reported earnings look good, accounting assumptions can be stretched • Just before making a large loan application • Just before the initial public offering of stock • Just before being bought out by another company • Cash flow from operations, which is not impacted by accrual assumptions, provides an excellent reality check for earnings. 5-5 Everything is on One Page • The cash flow statement includes information on operating, investing, and financing activities. • Everything you ever wanted to know about a company’s performance for the year is summarized in this one statement. (continued) 5-6 It is Used as a Forecasting Tool A pro forma cash flow statement is a prediction of what the actual cash flow statement will look like in future years if the operating, investing, and financing plans are implemented. 5-7 2. Outline the structure of and information reported in the three main categories of the cash flow statement: operating, investing, and financing Statement of Cash Flows A statement of cash flows explains the change during the period in cash and cash equivalents. What is this? 5-8 Cash Equivalent • A cash equivalent is a short-term, highly liquid investment that can be converted easily into cash. • To qualify as a cash equivalent, an item must be: 1. Readily convertible into cash 2. So near to its maturity that there is insignificant risk of changes in value due to changes in interest rates 5-9 Three Categories of Cash Flows • Operating activities include those transactions and events that enter into the determination of net income.  Cash receipts from selling goods or from providing services.  Receipts from Interest, dividends, and similar items.  Payments to purchase inventory and to pay wages, taxes, and similar expenses. 5-10