Chapter 16: Study Notes

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Chapter 16: Study Notes

16.1 – Purpose of the Statement of Cash Flows

  • The statement of cash flows is designed to summarize an entity’s cash inflows and outflows during a period of time.
  • Two purposes of the statement of cash flows: show sources and uses of cash flow and help users determine liquidity of the entity.

16.2 – Cash and Cash Equivalents Defined

Cash: money in coins or currency or in a bank account that is available upon demand.

Cash equivalent: Convertible into a specific amount of cash within a short period of time and low risk.

16.3 – Structure of The Statement of Cash Flows

The statement of cash flows has three sections:

  • Operating Activities: Cash flows from this source include cash inflows and outflows that occur from the company’s primary business operations.
  • Investing Activities: This section involves the sale and purchase of noncurrent assets (long-term assets).
  • Financing Activities: This section involves liabilities related to investors, shareholders or creditors.

16.4 – Operating Section

The operating section is focused on cash inflows and outflows from primary operations which impacts current assets and current liabilities.

Two methods can be used to prepare the operation section: the indirect method and the direct method.

16.5 – Operating Section: Indirect Method

The indirect method begins with net income as reported on the income statement. We then adjust that amount by adding or subtracting non-cash accounts that were originally used to calculate net income.

The following chart summarizes these adjustments based on account:

Add to Net Income Deduct from Net Income
Depreciation
Amortization of intangible assets
Decrease in receivables Increase in receivables
Losses on Assets Gains on Assets
Decrease in inventory Increase in inventory
Increase in accounts payable Decrease in accounts payable
Increase in accrued liabilities Decrease in accrued liabilities
Decrease in prepaid expenses Increase in prepaid expenses
Increase in income tax payable Decrease in income tax payable

16.6 – Operating Section: Direct Method

The direct method is quite simple in theory: We take the operating cash inflows and then subtract the operating cash outflows.

Step 1: Add up Cash Received from Customers

Step 2: Subtract Cash Payments to Suppliers

Step 3: Subtract Cash Payments for General Expenses

Step 4: Less Cash Payments for Income Taxes

16.7 – Investing Section

The investing section shows changes in cash inflows and outflows that relate to a company’s long-term assets, such as, fixed assets or investments.

Step 1: Add up all Investing Cash Inflows

Step 2: Subtract all Investing Cash Outflows

16.8 – Financing Section

The financing section of the statement of cash flows shows cash inflows and outflows related to stockholder’s equity and long-term liabilities.

Step 1: Add up all Financing Cash Inflows

Step 2: Subtract all Financing Cash Outflows

16.9 – Disclosure of Noncash Activities

Noncash activities often impact the financing and investing section of the statement of cash flows. These are transactions which indirectly impact cash inflows or outflows and don’t directly impact cash. Noncash activities must be disclosed.

16.10 – Statement of Cash Flows Financial Ratios and Analysis

Two important ratios to understand: operating cash flow and cash debt coverage.

Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities

Cash Debt Coverage = Operating Cash Flow / Average Total Liabilities

 

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