Accounting 2 Dersi 8. Ünite Özet

The Statement of Cash Flows: Purpose and Format

Cash flows can be defined as cash inflows and cash outflows in a certain period of time. Every company needs cash to pay its bills, business expenses and to pay off scheduled liabilities on time.

• Cash generally comes from the sources that mentioned below:
• Capital - setting up business, or getting new partners; Borrowing - customers, vendors, employees, and financial institutions;
• Conversion of assets to cash - selling inventory, equipment, plant, property or collection of accounts receivable.

Importance of Cash Flows

A successful business must get more cash than it spends to produce its goods or services. However, due to timing differences, profit and cash flows act differently. If the profit is insufficient but the cash flows are sufficient, the business can carry out its activities in the short term, but might face problems in the long term. Therefore, business must have strong cash flows as well as the net profit.

Profit and cash flows may not move in the same direction.

The inventory turnover ratio shows how effectively inventory is managed by comparing cost of goods sold with average inventory for a period. Also, it measures how many times a company sold its total average inventory amount during the year. The equation for inventory turnover equals the cost of goods sold divided by the average inventory.

The days’ sales in accounts receivable ratio also known as the number of days of receivables tells you the average number of days it takes to collect an account receivable. The calculation for the days’ sales in accounts receivable is the number of days in the year (usually 360 or 365 days is used) divided by the accounts receivable turnover ratio for a specific year. Receivables turnover ratio can be calculated by dividing the net value of sales (if possible credit sales) during a given period by the average accounts receivable during the same period.

Reporting Cash Flows Information: Statement of Cash Flows

When you compare the balance sheets for two periods, you can only see either the cash is increased or decreased. But the balance sheet does not show why cash is increased or decreased. The statement of cash flows reports cash receipts (where the cash came from) and cash payments (how cash was spent) for a period.

The statement of cash flows reports:

• Where cash came from (receipts) and how cash was spent (payments)
• Why cash increased or decreased during period
• Covers a span of time and is dated the same as the income statement

Cash and profit are different concepts and reflect different amounts. Thus, so increase/ decrease amount of profit isn’t equal to increase/decrease amount of cash and cash equivalents.

Cash flows statement takes into account the transactions that require cash, related to the activities whether or not they provide income.

Income statement takes into account expenses or revenues whether or not they create cash movements.

The statement of cash flows helps to do the following:

• Predict future cash flows,
• Evaluate management,
• Predict ability to pay debts and dividends.

Classification of Cash Flows

In the statement of cash flows, there are three basic types of cash flow activities. These activities have a separate section which reports cash inflows and cash outflows in the statement of cash flows. These activities are:

• Operating activities
• Investing activities
• Financing activities

Operating Activities

The most important part of the statement of cash flows is operating cash flows as they reflect the basis of the business. A successful business must generate most of its cash from operating activities. Operating activities create revenues, expenses, gains, and losses net income, which is a product of accrual basis accounting.

Operating activities create revenue or expense in entity’s business and these activities affect the income statement.

Only the activities that involve receipt of cash or payment of cash are reported in Cash Flows Statement. Any transaction that doesn’t involve cash will not be reported in any section of Cash Flows Statement.

Investing Activities

Investing activities are the activities that increase or decrease long term assets such as property, plant, equipment, notes receivable and investments.

Investing activities are purchases and sales of non-current assets, which are important for an entity’s medium and long term operations.

Financing Activities

Financing activities are the activities that increase or decrease long term liabilities and equity. So in the cash flow statement, financing activities include cash inflows and outflows involved in long term liabilities and equity such as issuing shares, paying dividends and buying and selling treasury shares, borrowing money and paying off long term liabilities such as notes payable, bonds payable.

Financing activities relate to noncurrent liabilities and shareholders’ equity. These activities may include to obtain cash and pay cash to investors and creditors. Issuing shares, borrowing money, buying and selling treasury shares, paying cash dividends are financing activities.

Cash Flows from Operating Activities

Two different methods can be used for reporting operating cash flows. These are;

• Indirect Method
• Direct Method

These two methods differ in the calculation manner for reporting operating cash flows.

The indirect method adjusts accrual basis net profit or loss for the effects of non-cash transactions.

The direct method shows each major class of gross cash receipts and gross cash payments.

Indirect or direct methods are only used in the operating cash flows section. These methods use different computations but produce the same amount of cash from operating activities.

Both the direct and indirect methods require cash flows to be classified according to operating, investing and financing activities.

Indirect method starts with net income and reconciles to net cash provided by operating activities.

The direct method shows each major class of gross cash receipts and gross cash payments.

Reporting Operating Cash Flows: Indirect Method

Indirect method is based on the harmonization of accrual base by reconciliation of net income to net cash provided by operating activities. The additions or subtractions may not have a symmetrical relationship with the timing of cash movements in the income statement.

Depreciation Expenses : Depreciation has no effect on cash, but like all other expenses decreases net income.

Gains and Losses on the Sale of Long Term Assets : Selling out of long term assets such as buildings and lands are investing activities and this create gain or loss. But this gain or loss is included in determining net income.

Changes in the Current Asset and Current Liabilities: Most of the current assets and the current liabilities result from operating activities.

Some explanations about the changes in the current assets and current liability accounts that create adjustments to net income:

• An increase in a current asset other than cash causes a decrease in cash : If a current asset other than cash (like Accounts Receivable, Inventory, Prepaid Expenses) increases compared to previous year this shows an increase in current asset, then cash decreases.
• A decrease in a current asset other than cash causes an increase in cash: If inventory has decreased compared to previous year this means that the firm has sold some inventory and collected cash.
• A decrease in a current liability decreases cash: Payment of a current liability decreases cash and also liability.
• An increasein a current liability increases cash: If Accounts Payable increases compared to previous year this means that cash was not spent at the time the expense was incurred, but it will be paid later.

Direct method identify actual cash flows; indirect method reconciles net income to cash flow from operations.

Reporting Operating Cash Flows: Direct Method

In this method, cash flow items and amounts are reported. This method clearly demonstrates cash amounts paid and collected for business activities. This method requires more computations than indirect method. To compute operating cash flows, we use income statement and changes in balance sheet accounts.

To calculate operating cash flows for the direct method we will use income statement and the changes in the balance sheet accounts for the same company - Beta Inc.

To make easier computation you can follow the steps given below:

• Calculate cash collections from customers
• Calculate payments to suppliers
• Calculate payments for operating expenses
• Calculate payments to employees
• Calculate payments of interest and income taxes

Calculating Cash Collections from Customers: To calculate cash collections from customers you will need sales revenue (from income statement) and beginning and ending balance of accounts receivable.

Calculating Payments to Suppliers: This part includes two separate computations.

• Payments for operating expenses.
• Payments for inventory

To calculate payments for inventory you will need cost of goods sold (from income statement), Inventory and Accounts Payable (from balance sheet). This computation will convert cost of goods sold to cash basis.

Calculating Payments for Operating Expenses: These payments will exclude interest and income tax. To compute payments for operating expenses you will need Prepaid Expenses, Accrued Liabilities, and Other Operating Expenses.

Fundamental assumption for the prepayments is beginning prepayments will be used in period, and ending prepayment is the payment that we made during the year.

Fundamental assumption is beginning accrued liabilities will be paid for during year, ending balance will remain owing.

Total payments for operating expenses is the sum of payments for prepaid expenses, payments for accrued liabilities and payments for other operating expenses.

Cash Flows from Investing Activities

Investing activities affect long term assets such as Investments in Property, Plant and Equipment (PPE) assets, and etc. Thus, so investing cash flows is about cash inflows and cash outflows related with long term assets.

Calculating Purchase and Sales of PPE: To compute purchases and sales of PPE, you will need balance sheet (PPE, accumulated depreciation) income statement (depreciation expense, gain/loss on sale of PPE).

Cash Flows from Financing Activities

Financing activities affect the long term liability and equity accounts.

Cash inflows from finance activities include issuance of shares, proceeds from selling treasury shares, loans and borrowings. Cash outflows include repurchase of shares, repayment of loans and borrowings.

Calculate Issuances and Payments of Long Term Debt: To calculate payments of long term debt you will need balance sheet (New issuancesif known, Beginning and ending balances of Long Term Debt, Notes Payable, Bonds Payable).

We can also calculate receipts from issuance of share and payments to purchase treasury share and payments of dividends. These calculations can be made on the rationale that we made above about beginning and ending balances of related accounts.