LM05 Understanding Cash Flow Statements

Part 2

9. Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet

Link between the Cash Flow Statement and the Balance Sheet

Cash is an asset and is reported on the balance sheet. The cash flow statement explains the change in cash during an accounting period. This can be illustrated through a simple scenario. Assume that beginning cash is 1,100. This is reported on the balance sheet. The cash flow statement will show the cash receipts and cash payments. For the scenario presented below, the cash receipts equal 3,200 and the cash payments equal 3,300 which means that the net change in cash is -100. This explains how the cash balance went from 1,100 at the start of the period to 1,000 at the end of the period.

Link between Cash Flow Statement, Balance Sheet and Income Statement

Let’s consider an example of how items on the balance sheet are related to the income statement and the cash flow statement. Suppose the beginning accounts receivable is 200, the revenue during the year is 5,000 and the cash collected from customers is 4,800. What is the ending accounts receivables? The table below makes it easy to compute the missing amount. We see that the ending accounts receivables will be 400.

This example clearly shows that receivables (balance sheet item), revenue (income statement item) and cash collected from customers (cash flow item) are related as follows:

Ending receivables = Beginning receivables + Revenue – Cash collected from customers

10 – 14: Preparing the Cash Flow Statement

Only cash flow from operating activities is presented differently under the two methods. Presentation of cash flow from investing activities and cash flow from financing activities is the same under both methods.

Operating Cash Flow

Direct method:

In the direct method, we take each item from the income statement and convert it to its cash equivalent by removing the impact of accrual accounting.

The rules to adjust are:

• Increase in assets is use of cash (-ve adjustment) and decrease in asset is source of cash (+ve adjustment).
• Increase in liability is source of cash (+ve adjustment) and decrease in liability is use of cash (-ve adjustment).

Cash collected from customers: Adjust sales for changes in accounts receivable and unearned revenue.

Cash for inputs: Adjust COGS for changes in inventory and accounts payable.

Cash operating expenses: Adjust SG&A for changes in related accrued liabilities or prepaid expenses.

Cash interest paid: Adjust interest expense for changes in interest payable.

Cash taxes paid: Adjust tax expense for changes in tax payable and changes in deferred tax assets and liabilities.

Example

Consider a company that reported sales of $10 million.  Accounts receivable for the year went up from $2 million to $4 million. Unearned revenue went up from $1 million to $2 million. Calculate cash collected from customers.

Solution:

Δ Accounts receivable = $2 million. This is an asset and increase in asset is use of cash so –ve adjustment.

Δ Unearned revenue = $1million. This is a liability and increase in liability is source of cash so +ve adjustment.

Cash collected from customers = + $10 million – $2million + $1million = $9 million.

Example

Consider a company with COGS of $20 million for a particular period. During this period inventory increased by $4 million and accounts payable went up by $2 million. Calculate the cash paid for inputs.

Solution:

Δ Inventory = $4 million. This is an asset and increase in asset is use of cash so –ve adjustment.

Δ Accounts payable = $2 million. This is a liability and increase in liability is source of cash so +ve adjustment.

Cash paid for inputs = – $20 million – $4 million + $2 million = – $22 million

Indirect method:

Indirect method shows how cash flow from operations can be obtained from reported net income as a result of a series of adjustments.

The steps are:

• Begin with net income.
• Add back all non-cash charges to income and subtract all non-cash components of revenue (For example, add depreciation and amortization).
• Subtract any gains that resulted from financing or investing cash flows (For example, gain on the sale of an equipment).
• Add or subtract changes to related balance sheet operating accounts.
• Decrease in operating assets (source of cash) should be added and increase in operating assets (use of cash) should be subtracted.
• Similarly, increase in current liabilities (source of cash) should be added and decrease in current liabilities (use of cash) should be subtracted.

Example

Consider a company with net income of $100 million in 2001. Depreciation expense is $10 million. Gain on sale of equipment is $4 million.  Increase in A/R is $8 million. Increase in A/P is $4 million. Increase in inventory is $10 million. Calculate CFO using the indirect method.

Solution:

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