To understand a company’s cash flows, the relationships between the changesin balance sheet accounts and the company’s cash flows must be analyzed. A company’s inflowsof cash are caused by decreasesin its assets (other than cash) and by increasesin liabilities and in stockholders’ equity during an accounting period. A company’s outflowsof cash are caused by increases in its assets (other than cash) and by decreases in liabilities and in stockholders’ equity during the accounting period. The difference between the inflows and outflows is the change in cash during the accounting period. We show this relation- ship by the equations in Exhibit 22-1, starting with the basic accounting equation. Each equation is a modification of the previous equation, to eventually show the increases and decreases in cash. With this background in mind, we can refine the relationships we show in the last two equations of Exhibit 22-1.
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Cash Inflows and Outflows
Changes in Assets Changes in Liabilities
Changes in Cash Changes in Liabilities
Changes in Cash Changes in Liabilities
Where: Increases in Cash Increases in Liabilities
And: Decreases in Cash Decreases in Liabilities
Changes in
Stockholders’ Equity
Changes in Assets Changes in
Other Than Cash Stockholders’ Equity
Changes in Changes in Assets Stockholders’ Equity Other Than Cash Increases in Decreases in Assets Stockholders’ Equity Other Than Cash Decreases in Increases in Assets Stockholders’ Equity Other Than Cash
=
=
=
=
=
= +
+ + + + +
+
– +
+
Assets Liabilities Stockholders’ Equity
Equations for Change in Cash EXHIBIT 22-1
2 Know the categories of inflows and outflows of cash.
6. Alternatively, as we discuss later, the increase in a liability such as accounts payable results, in effect, in a
“savings” (i.e., increase) in cash because of a smaller cash payment.
Outflows of Cash
There are also three categories of a company’s outflows (decreases) of cash:
1. Increases in Assets Other Than Cash. The acquisition of assets (other than cash) causes a decrease in cash because cash is paid in exchange for the assets.7
2. Decreases in Liabilities. The payment of liabilities causes a decrease in cash because cash is paid to satisfy the liabilities.
3. Decreases in Stockholders’ Equity. Stockholders’ equity may decrease as a result of several transactions. Two common transactions are the payment of dividends and the acquisition of treasury stock. In each case, a decrease in stockholders’ equity is accompanied by a decrease in cash.
Classifications of Cash Flows
We can further classify the cash inflows and outflows we just discussed into operating, investing, and financing cash flows.
1. Operating Cash Flows
A. Inflows of Cash. Increases in stockholders’ equity (i.e., retained earnings) because of revenues, adjusted for changes in current assets and current liabili- ties that are related to the operating cycle, as well as changes in certain noncur- rent assets and liabilities (e.g., deferred taxes).
B. Outflows of Cash. Decreases in stockholders’ equity (i.e., retained earnings) because of expenses, adjusted for changes in current assets and current liabili- ties that are related to the operating cycle, as well as changes in certain noncur- rent assets and liabilities (e.g., deferred taxes).
2. Investing Cash Flows
A. Inflows of Cash. Decreases in noncurrent assets and certain current assets (e.g., notes receivable and temporary investments related to investing activities).
B. Outflows of Cash. Increases in noncurrent assets and certain current assets (e.g., notes receivable and temporary investments).
3. Financing Cash Flows
A. Inflows of Cash. Increases in noncurrent liabilities, stockholders’ equity (other than net income), and certain current liabilities (e.g., notes payable related to financing activities).
B. Outflows of Cash. Decreases in noncurrent liabilities, stockholders’ equity (other than a net loss), and certain current liabilities (e.g., notes payable and divi- dends payable).
Changes in assets (other than cash), liabilities, and stockholders’ equity may be the result of investing and financing activities notaffecting cash. Examples of these transactions include
• acquisitions of assets by issuing equity securities (noncash investing and financing activities),
• acquisitions of assets by assuming liabilities such as capital lease obligations (non- cash investing and financing activities),
• exchanges of debt securities for equity securities such as the conversion of bonds to common stock (noncash financing activities),
• exchanges of assets for assets (noncash investing activities),
• exchanges of liabilities for liabilities (noncash financing activities), and
• exchanges of equity securities such as the conversion of preferred stock to common stock (noncash financing activities).
3 Classify cash flows as operat- ing, investing, or financing.
7. Alternatively, as we discuss later, the increase in an asset such as accounts receivable results, in effect, in a decrease in cash because of a smaller cash receipt.
Although these transactions are relatively rare, they do involve “simultaneous” investing activities and/or financing activities not affecting cash. They generally have a significant effect on the prospective cash flows of a company, so that the company reports them in a schedule (or narrative explanation) that accompanies its statement of cash flows, as we discussed earlier.
The operating cash flows involve several adjustments for items relating to the operating cycle. We further explain the net cash flow from operating activities in the next section.
SE C U R E YO U R KN O W L E D G E 22-1
• The statement of cash flows provides relevant information about a company’s cash receipts and cash payments that is useful for assessing its liquidity, financial flexibility, operating capability, and risk.
• A company’s cash flows are reported as:
■ Operating activities—cash receipts and cash payments relating to the earning activities of the company (generally resulting from transactions that enter into the determination of income).
■ Investing activities—cash receipts and cash payments relating to the acquisition and disposition of assets such as property, plant, and equipment, notes receivable, and investments in other companies.
■ Financing activities—cash receipts and cash payments relating to the external financing of a company such as the issuance and repurchase of common stock, issuance and repayment of bonds, and payment of dividends.
• A company’s statement of cash flows must clearly show the three categories above as well as the net increase or decrease in cash and a reconciliation of the beginning and ending cash balance reported on the balance sheet. Furthermore, the disclosure of significant non-cash activities is required to be reported in either a separate schedule or narrative explanation that accompanies the statement of cash flows.
• A company’s cash flow is related to the changes in its balance sheet accounts as follows:
■ Increases in cash are caused by decreases in assets (other than cash), increases in liabilities, and increases in stockholders’ equity.
■ Decreases in cash are caused by increases in assets (other than cash), decreases in liabilities, and decreases in stockholders’ equity.
• These cash flows can be further classified (consistent with the reporting guidelines above) as:
■ Operating activities—increases or decreases in stockholders’ equity (e.g., retained earnings) because of certain revenues or expenses, adjusted for changes in the related current assets or current liabilities, and certain noncur- rent assets and liabilities,
■ Investing activities—decreases or increases in noncurrent assets and certain cur- rent assets (e.g., notes receivable and marketable securities), or
■ Financing activities—increases or decreases in noncurrent liabilities, stockhold- ers’ equity and certain current liabilities (e.g., notes payable and dividends payable).
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