Understanding Cash Flows Sta

Statement Cash
Flows
12/17/2022 Prof.Dr. A.Eltemsahi 1

Statement of Cash Flows
Ø The statement of cash flows provides a summary

of the cash flows over the period of concern,
typically the year just ended.
Ø While an income statement measures a
company’s profits, profits are not the same as
cash flows; profits are calculated on an accrual
basis rather than a cash basis.

Statement of Cash Flows (cont.)
Why is it important???
Ø A positive net income on the income

statement is ultimately insignificant unless a
company can translate its earnings into cash.
Ø The only source in financial statement data
for learning about the generation of cash
from operations is the statement of cash
flows.

n It is also possible for a firm to be highly

profitable and go bankrupt!!!!!!!!!!!!!!!
How?
The problem is cash

Measuring Cash Flows
Ø Accrual-basis accounting records income
when its earned, whether or not the income
has been received in cash (sales is a good
example), and records expenses when they
are incurred, even if money has not actually
been paid out (inventory is a good example).

Measuring Cash Flows Cash Flows
Ø Also, under the accrual system:
Ø The purchase of equipment that last for more
than a year is not shown as an expense in the
income statement.
Ø Instead, the amount is recorded as an asset and
then depreciated.
Ø Annual deprecation (not cash) is recorded as a
way to match the use of the asset with sales
generated from its use.
Measuring Cash Flows Cash Flows
Ø Therefore, we are more interested in considering
cash flows from the perspective of the firm’s
shareholders and its investors, rather than from
an accounting view.
Ø We will instead measure the cash flow that is
free and available to be distributed to the firm’s
investor, both debt and equity investors, or what
we will call free cash flows (FCF).

Purpose of the Statement of Cash Flows
n To provide relevant information about the cash receipts

and cash payments of an enterprise during a period.
n The statement provides answers to the following

questions:
1. Where did the cash come from?
2. What was the cash used for?
3. What was the change in the cash balance?

Algebraic Formulation
Recall the basic accounting equation:
Assets = Liabilities + Shareholders’ Equity
or A = L + SE
Assets are either cash (C) or not cash assets (N$A), so
C + N$A = L + SE
 C +  N$A =  L +  SE
Where  means the change in the balance,
Rearranging gives the basic equation for the statement of
cash flows:
 C =  L +  SE -  N$A
Algebraic Formulation (Cont.)
 C =  L +  SE -  N$A
n The change in cash,  C, is the increase or
decrease in the cash account.
n This amount must equal changes in liabilities
plus changes in shareholders’ equity minus
changes in assets other than cash.
n Thus, we can identify the causes in the change
in the cash account by studying the changes in
non-cash accounts.

Constructing a Simplified Statement of Cash Flows
Ø Begins with a return to the balance sheet.

Ø Is prepared by calculating changes in all
of the balance sheet accounts.

Changes in Specific Accounts
increase decrease
If noncash assets If noncash assets
are increased, are decreased,
Non-
then cash was spent, then they provided cash
cash
so cash is an outflow, so cash is an inflow,
Assets
so negative sign. so positive sign.
If liab. or S.E. If liab. or S.E.
Liabilities increased, then cash decreased, then cash
and was obtained, was spent,
Shareholders’ so cash in an inflow, so cash in an outflow,
Equity so positive sign. so negative sign.

Constructing a Simplified Statement of Cash Flows (cont.)
Classifications of Cash Flows
1. Operations activities
cash flows related to selling goods and services; that
is, the principle business of the firm.
2. Investing activities
cash flows related to the acquisition or sale of
noncurrent assets.
3. Financing activities
long term and short term cash flows related to
liabilities and owners’ equity; dividends are a
financing cash outflow.
12/17/2022 Prof. Dr. A.Eltemsahi 13

Cash flows
are divided
into three
categories.

1. Cash Flows from Operations
General Rule:
Ø Any transactions that enter into the
determination of net income are classified
as operating activities.
Ø These transactions can result in either cash
inflows or cash outflows.

1.1 Cash Inflows
Cash receipt from:

Ø Sales of goods or providing of services
Ø Interest (from all sources)
Ø Dividends (on stock of other companies)
Ø Miscellaneous income (such as from rentals)

1.1 Cash Inflows
Ø Note that: dividends received on stock of

other companies considered as an operating
activities item while stock itself represents as
investment item for two reasons.
Ø First: dividends enter into the determination
of income.
Ø Second: investing activities are include only
the principal amount of stock purchased or
sold.
Prof.Dr. A.Eltemsahi 18
12/17/2022
1.2 Cash Outflows
Ø Cash payment to:

Ø Suppliers for purchase of inventory
Ø Employees for services
Ø Other entities for insurance, utilities, rent, ….
Ø Creditors for interest on debt
Ø Government agencies for taxes

1.2 Cash Outflows
Ø Note that: payment to banks and other lenders

for interest are included as part of operating
activities even though the loans themselves
are part of a company’s financing activities for
two reasons .
Ø First: Interest enters into the determination
of income.
Ø Second: Financing activities are include only
principal amount borrowed or repaid.
General Model of Net Cash provided by
Operation Activities
Net Income
+Depreciation and Amortization expense
Add (deduct) change in current assets accounts affecting
Add: Decrease in Acc. Rec. OR (deduct) Increase in Acc. Rec.
Add: Decrease in Inventory OR (deduct) Increase in Inventory
Add: Decrease in prepaid expenses OR (deduct) Increase in prepaid expenses
Add (deduct) change in current liability accounts affecting
Add: Increase in the Acc. Payable & Accrued Liabilities OR (deduct) the Decease
Add (deduct) gains or losses on sales assets
Add: loss on sales of assets OR (deduct) Gain on sales of assets
Add (deduct) change in the deferred income taxes accounts
Add: Increase in the account OR (deduct) Decrease in the account
Net Cash Provided by Operating Activities

(cont.)
Note that:
n Gains of sales of assets has to be deducted to

avoid double counting (counted once as part of
net income and then counted a second times as
part of the cash proceeds arising from sale
transactions)
n Losses are non-cash deductions and like
depreciation, reduce net income but do not
involve an outflow of cash.

(cont.)
2. Investing Activities
n General Rule:
Any transaction that are involved in the acquisition
or disposition of non-current assets are classified as
investing activities.
n These transactions include :

(cont.)
2. Investing Activities cont.
n Cash provided by:

n Sales of property, plant, and equipment
n Sales of securities, such as bonds and stocks of
other companies
n Collection of a loan made to another company

Constructing a Simplified Statement of Cash
Flows (cont.)
2. Investing Activities cont.
n Cash used to:

n Purchase property, plant, and equipment.
n Purchase securities, such as bonds and stocks of
other companies.
n Lend money to another company, such as
subsidiary.

Effects of a Sale of a Long-Term Assets on Cash Flows
n A few transactions complicate the derivation of a cash flow

statement from a comparative balance sheet, for example, the
sale of a long-term (or fixed) asset.
n Recall the journal entry for the sale of an asset:
Cash ###
Accumulated Depreciation ###
Asset ###
Gain (or loss) on sale ###
Effects of a Sale of a Long-Term Assets on Cash Flows(Cont.)
n Each of the four parts of the above journal entry require an

adjustment in the cash flow statement.
n The first line, cash, adds a line to the investing section.
n The second line, a debit to accumulated depreciation,
increases the depreciation expense above the change in the
change in the accumulated depreciation account.
n The third line, a credit to the asset, increases the amount of
cash invested in long-lived assets above the change in the
fixed asset accounts.
n The fourth line, a gain or loss, is reversed out in the operating
sections
12/17/2022
since this is not a cash flow.
Prof.Dr. A.Eltemsahi 27
Flows (cont.)
3. Financing Activities
n General Rule:
Any transactions involving borrowing from
creditors (other than the payment of interest),
and
n Any transactions involving the owners of the
company (except stock dividends and stock
splits), are classified as financing activities.
These transactions include:

Flows (cont.)
n Cash inflows from financing activities include:
n (Amounts obtained from creditors). Borrowing
from short-term or long-term creditors through
notes, bonds, mortgages, and similar forms of debt.
n Sale of capital stock to owners
n Cash outflows from financing activities include :

n (Repayment of amounts borrowed). Note, bonds,
mortgages and similar forms of short-term and
long-term debt.
n Repurchase capital stock from owners
n Pay cash dividends to owners

Flows (cont.)
n Note that:
n The payment of cash dividends is classified as a
financing item, rather than as an operating
because dividends do not enter into the
determination of income.

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Statement Cash

12/17/2022 Prof.Dr. A.Eltemsahi 1

Ø The statement of cash flows provides a summary

12/17/2022 Prof.Dr. A.Eltemsahi 2

Ø A positive net income on the income

12/17/2022 Prof.Dr. A.Eltemsahi 3

n It is also possible for a firm to be highly

The problem is cash

12/17/2022 Prof.Dr. A.Eltemsahi 4

12/17/2022 Prof.Dr. A.Eltemsahi 5

12/17/2022 Prof.Dr. A.Eltemsahi 7

n To provide relevant information about the cash receipts

n The statement provides answers to the following

12/17/2022 Prof.Dr. A.Eltemsahi 8

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Ø Begins with a return to the balance sheet.

12/17/2022 Prof.Dr. A.Eltemsahi 11

12/17/2022 Prof.Dr. A.Eltemsahi 12

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Cash receipt from:

Ø Interest (from all sources)

Ø Dividends (on stock of other companies)

Ø Miscellaneous income (such as from rentals)

12/17/2022 Prof.Dr. A.Eltemsahi 17

Ø Note that: dividends received on stock of

Ø Cash payment to:

12/17/2022 Prof.Dr. A.Eltemsahi 19

Ø Note that: payment to banks and other lenders

12/17/2022 Prof.Dr. A.Eltemsahi 21

n Gains of sales of assets has to be deducted to

12/17/2022 Prof.Dr. A.Eltemsahi 22

12/17/2022 Prof.Dr. A.Eltemsahi 23

n Cash provided by:

n Sales of securities, such as bonds and stocks of

12/17/2022 Prof.Dr. A.Eltemsahi 24

n Cash used to:

n Purchase securities, such as bonds and stocks of

12/17/2022 Prof.Dr. A.Eltemsahi 25

n A few transactions complicate the derivation of a cash flow

n Each of the four parts of the above journal entry require an

12/17/2022 Prof.Dr. A.Eltemsahi 28

n Cash outflows from financing activities include :

n Pay cash dividends to owners

12/17/2022 Prof.Dr. A.Eltemsahi 30

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