Chapter 12: Basics of Cash Flow Reporting

Distinguishing Between Operating, Investing, and Financing Activities: 1. Operating Activities: o Operating activities are the primary revenue-generating activities of a business and include transactions that affect net income. These activities relate to the day-to-day operations of the company. Cash flows from operating activities generally include:  Cash receipts from customers for sales of goods and services.  Cash payments to suppliers for inventory.  Cash payments for expenses such as wages, rent, and utilities.  Cash received for interest or dividends on investments. o Essentially, operating activities focus on cash generated from the core business operations. 2. Investing Activities: o Investing activities involve the purchase and sale of long-term assets, investments, and lending money. They are associated with changes in investments and long-term assets. Cash flows from investing activities typically include:  Cash payments for the purchase of property, plant, and equipment.  Cash received from the sale of investments or fixed assets.  Cash paid for lending money (e.g., notes receivable) or received from repayments of loans. o These activities provide insight into the investment in and divestment of long-term resources. 3. Financing Activities: o Financing activities involve transactions that affect long-term liabilities and equity. These activities include raising capital through debt or equity and returning it to investors. Common cash flows from financing activities are:  Cash received from issuing stocks or bonds.  Cash paid to repay borrowings or to repurchase stock.  Cash payments of dividends. o Financing activities illustrate how a business finances its operations and growth. Disclosure of Noncash Investing and Financing Activities: Noncash investing and financing activities do not involve direct cash flows and include activities like: • • • Purchasing assets through issuing stock or taking on debt. Converting debt to equity. Acquiring a business through issuing shares. These transactions are disclosed at the bottom of the statement of cash flows or in the accompanying notes, ensuring that users are aware of significant financial activities not affecting cash. Purpose of the Statement of Cash Flows: The statement of cash flows serves several key purposes: • • • • It explains changes in cash balances over a period. Provides insights into how cash is generated and used. Helps assess the ability of the company to generate cash and meet obligations. Reveals the relationship between net income and cash flows. The statement is essential for understanding the liquidity and financial flexibility of a company. Importance of Cash Flows: Cash flow information is crucial for decision-making: • • • It helps in evaluating a company’s ability to pay debts, invest, and grow. Enables managers to plan for both short-term and long-term financial strategies. Distinguishes companies with strong operational cash generation from those relying on external financing. The case of W.T. Grant Co. highlights the importance of cash flow analysis. Despite reporting net income for three consecutive years, the company faced bankruptcy due to negative cash flow. Measurement of Cash Flows: Cash flows include cash and cash equivalents (short-term investments that are easily convertible to cash with a maturity of 90 days or less). Transactions between cash and cash equivalents are not reported in the statement, focusing only on actual cash inflows and outflows. Classification of Cash Flows and Their Links to the Balance Sheet: The classification of cash flows is connected to different parts of the balance sheet: • • • Operating activities: Linked to changes in current assets and liabilities. Investing activities: Linked to changes in long-term assets. Financing activities: Linked to changes in long-term liabilities and equity. Noncash Investing and Financing: Noncash activities are those that impact investing and financing but do not involve actual cash transactions. Examples include acquiring assets using loans or converting bonds to stocks. These are disclosed separately from the main cash flow activities. Preparing the Statement of Cash Flows: To prepare the statement: • • • Start by computing the net increase or decrease in cash. Analyze the cash account for inflows and outflows. Examine noncash accounts and the balance sheet for changes that affect cash. The information is derived from comparative balance sheets, the current income statement, and additional transaction details.