Prepared by: Robert G. Ducharme, MAcc, CA University of Waterloo, School of Accounting and Finance

1. FINANCIALACCOUNTINGThird Canadian EditionLIBBY, LIBBY, SHORT, KANAAN, GOWING Prepared by: Robert G. Ducharme, MAcc, CAUniversity of Waterloo, School of Accounting and Finance

2. Chapter 5 Reporting and Interpreting Cash Flows

3. Business Background Positive cash flows permit a company to . . . pay dividends to owners expand its operations take advantage of market opportunities replace needed assets Financial analysts consider cash flow an important indicator of a company’s financial health.

4. Classifications on the Cash Flow Statement Cash Equivalents Currency Cash • Short-term, highly liquid investments. • Readily convertible into cash. • So near maturity that market value is unaffected by interest rate changes (i.e., less than 3 months to maturity).

5. Classifications on the Cash Flow Statement The Cash Flow Statement must include the following three sections: • Operating Activities • InvestingActivities • Financing Activities

6. Classifications of the Cash Flow Statement Cash inflows and outflows directly related to earnings from normal operations. Cash inflows and outflows related to the acquisition or sale of productive facilities and investments in the securities of other companies. Cash inflows and outflows related to external sources of financing (owners and creditors) for the enterprise. Operating Activities Investing Activities Financing Activities

7. Operating Activities Investing Activities Financing Activities Sale of operational assets Sale of investments Collections of loans Issuance of shares Issuance of bonds and notes Cash received from revenues Cash paid for expenses Purchase of operational assets Purchase of investments Loans to others Payment of dividends Repurchase of shares Repayment of debt CASH INFLOWS Business CASH OUTFLOWS

8. Statement continued . . . The indirect method is used by most companies. Andrew Peller Limited uses the indirect method.

9. This ending cash balance should be the same amount that appears on the balance sheet.

10. Cash Flows from Operating Activities The Direct Method of presenting the Operating Activities section of the cash flow statement reports components of cash flows from operating activities as gross receipts and gross payments. The Indirect Method of presenting the Operating Activities section of the cash flow statement adjusts net income to compute cash flows from operating activities.

11. Cash Flows from Operating Activities The CICA Handbook recommends the direct method, but it is rarely seen in practice. Many financial executives have reported that they do not use it because it is more expensive to implement than the indirect method.

12. Cash Flows from Operating Activities - Direct Method + _ Inflowsfrom: • Sales to customers • Interest and dividends received Cash Flows from Operating Activities Outflowsto: • Purchase goods (for resale) and services • Salaries and wages • Income taxes • Interest on liabilities

13. Reporting Cash Flows from Operating Activities—Indirect Method +/- Changes in current assets and current liabilities. + Losses and - Gains + Noncash expenses such as depreciation and amortization. The indirect method adjusts net income by eliminating non-cash items. Cash Flows from Operating Activities - Indirect Method Net Income

14. Direct Method vs. Indirect Method Direct Method Indirect Method Reports the cash effects of each operating activity Starts with accrual net income and converts to cash basis Two Formats for Reporting Operating Activities Note that no matter which format is used, the same amount of net cash flows from operating activities is generated.

15. Cash Flows from Investing Activities Inflowsfrom: Sale or disposal of property, plant, and equipment. Sale or maturity of investments in securities. + _ Cash Flows from Investing Activities Outflowsto: • Purchase property, plant, and equipment. • Purchase investments in securities.

16. Cash Flows from Financing Activities + _ Inflowsfrom: • Borrowing on notes, mortgages, bonds, etc. from creditors • Issuing equity securities to shareholders Cash Flows from Financing Activities Outflowsto: • Repay principal to creditors (excluding interest) • Repurchase equity securities from owners • Pay dividends to shareholders

17. Relationships to the Balance Sheet and the Income Statement Information needed to prepare a cash flow statement: • Comparative Balance Sheets • Income Statement • Additional details concerning different types of transactions and events

18. Relationships to the Balance Sheet and the Income Statement Derives from . . . Assets = Liabilities Shareholders’ Equity  Cash = Liabilities Shareholders’ Equity Non-cash Assets

19. Relationships to the Balance Sheet and the Income Statement

20. Relationships to the Balance Sheet and the Income Statement Use this table when adjusting Net Income to Operating Cash Flows using theindirect method.

21. Cash Flow StatementExample of Indirect Method Use the following financial statements for Andrew Peller Limited and prepare the Cash Flow Statement for the quarter ended on September 30, 2006.

23. The Statement of Cash Flows will begin with Andrew Peller’s Net income from the Statement of Earnings.

24. The Net income number will be adjusted for non-cash items. In the case of Andrew Peller, those adjustments included amortization expense ($1,908) These numbers may not be obvious in the Income Statement, so often they must be derived from other sources, such as the Notes to the Financial Statements, or the General Ledger Trial Balance.

25. With the indirect method, always start with the net income or net loss for the period. Next, adjust for the non-cash items included in net income.

26. To complete the Cash flows from operating activities section, you must examine a comparative balance sheet to determine the changes in current assets and current liabilities from the beginning of the period to the end of the period.

27. Now, make adjustments for changes in current assets and current liabilities using the decision table below.

28. Subtract the $6,005 increase in Accounts Receivable.

29. Subtract the $1,739 increase in Inventory.

30. Subtract the $1,172 increase in Prepaid Expenses.

31. Add the $6,213 increase in Accounts Payable.

32. Add the $565 increase in Accrued Liabilities.

33. Subtract the $470 decrease in Income Taxes Payable.

34. Statement continued . . .

35. Interpreting Cash Flows from Operating Activities Managers sometimes attempt to boost declining sales by extending credit terms or by lowering credit standards. The resulting increase in accounts receivable can cause net income to outpace cash flows from operations. Accounts Receivable Changes Inventory growth can be a sign that planned sales growth did not materialize. A decline in inventory can be a sign that the company is anticipating lower sales in the next quarter. Inventory Changes

36. Quality of Income Ratio In general, this ratio measures the portion of income that was generated in cash. All other things equal, a higher quality of income ratio indicates greater ability to finance operating and other cash needs from operating cash inflows. Quality of Income Ratio Cash Flow from Operating Activities Net Income =

37. The balance sheet indicates that Property, Plant and Equipment increased by $1,770 during the quarter.

38. Long-term investments decreased by a net $88 during the quarter.

39. In general, this ratio reflects the portion of purchases of property, plant and equipment financed from operating activities. A high ratio indicates less need for outside financing for current and future expansions. Capital Acquisition Ratio Capital Acquisition Ratio Cash Flow from Operating Activities Cash Paid for Property, Plant, and Equipment =

40. In general, this measures a firm’s ability to pursue long-term investment opportunities. Free Cash Flow Cash Flow from Operating Activities – Dividends – Capital Expenditures

41. $1,563 was repaid on the long-term debt during the period.

42. $2,098 in additional borrowings were incurred on the bank indebtedness.

43. $778 in cash dividends were paid during the period.

44. Interpreting Cash Flows from Financing Activities The long-term growth of a company is normally financed from three sources: internally generated funds, the issuance of shares, and money borrowed on a long-term basis. The statement of cash flows shows how management has elected to fund its growth. This information is used by analysts who wish to evaluate the capital structure and growth potential of a business.

45. Cash Flow Statement – Reconciliation Section Now we can reconcile the change in cash to the ending cash balance that appears on the Balance Sheet.

46. Additional Cash Flow Disclosures • Required Supplemental Information • Reconciliation of net income to cash flow from operations. • Cash paid for income taxes and interest. • Significant non-cash investing and financing activities. Significant non-cash investing and financing transactions do not involve cash. Example: Purchase of a building with a mortgage.

47. Chapter Supplement A Adjustment for Gains and Losses: Indirect Method

48. Adjustment for Gains and Losses Transactions that cause gains and losses should be classified on the cash flow statement as operating, investing, or financing activities, depending on their dominate characteristics. For example, if the sale of equipment produced a gain, it would be classified as an investing activity. Gains must be subtracted from net income to avoid double counting the gain. Gains Losses must be added to net income to avoid double counting the loss. Losses

49. Chapter Supplement B Reporting Cash Flows From Operating Activities - Direct Method

50. Reporting Cash Flows from Operating Activities—Direct Method