Financial Statements learning objectives (Slide 2-2)


Cash Flow Identity and the Statement of Cash Flows (Slides 2-11 to 2-20)



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2.2 Cash Flow Identity and the
Statement of Cash Flows (Slides 2-11 to 2-20)


The cash flow identity states that the cash flow from the left hand side of the balance sheet is equal to the cash flow on the right hand side of the balance sheet. That is,

Cash Flow from Assets Cash Flow to Creditors and Cash Flow to Owners

Where;


Cash Flow from Assets = Operating Cash Flow – Net Capital Spending - Change in Net Working Capital,

Operating Cash Flow = EBIT + Depreciation – Taxes;

Net Capital Spending = Ending Net Fixed Assets - Beginning Net Fixed Assets + Depreciation

Change in Net Working Capital = Ending NWC – Beginning NWC

Net Working Capital = Current Assets – Current Liabilities

Cash Flow to Creditors = Interest Expense – Net New Borrowing from Creditors

Net New Borrowing = Ending Long-term Liabilities – Beginning Long-term Liabilities



Cash Flow to Owners = Dividends – Net New Borrowing from Owners

Net New Borrowing from Owners = Change in Equity

Change in Equity = Ending Common Stock and Paid-in-Surplus - Beginning Common Stock and Paid-in-Surplus

For J.F. & Sons,

Operating Cash Flow = -$2000+$125,000-0 = $123,000

Net Capital Spending = $500,000 - 0 + $125,000 = $625,000

Change in Net Working Capital = $448,000 - $1,000,000 = -552,000

So, Cash Flow from Assets = 123,000 - 625,000 - (-552,000)

= 675,000 - 625,000 = $50,000

Cash Flow to Creditors = $50,000 - $0 (since the loan amount was neither increased nor decreased)

Cash Flow to Owners = 0 (since no shares were issued or repurchased nor were any dividends paid)

Hence, the cash flow identity holds,

i.e., Cash Flow from Assets = $50,000 = Cash Flow to Creditors and Owners



The Statement of Cash Flows, or the Sources and Uses of Cash Statement, as it is often called, is compiled by taking information from the Income Statement and the Balance Sheet and organizing it into three sections, i.e. cash flow from operating activities, cash flow from investment activities, and cash flow from financing activities, so as to reflect the change in the ending cash balance of the firm during that reporting period i.e., quarter or year. So the three sections of the cash flow identity explained above are related to the three sections of the statement of cash flows in the following manner:

Cash flow from Assets = Cash flow to Creditors + Cash flow to Owners


Cash flow from Cash flow from Cash flow from
operating activities investment activities financing activities

Note: Remind students that based on the accounting identity and double-entry accounting principles explained earlier, an increase in an asset (except cash) would result in a use of cash, while a decrease (sale) of an asset would result in a source of cash. Similarly, an increase in a liability or owners’ equity would bring in cash while a decrease would take away cash.

J. F. & Sons’ Statement of Cash Flow

Operating Cash Flow










EBIT







–2,000




Depreciation




125,000



















Increase in Inventory (Use)

–50,000




Increase in Accounts Receivable (Use)

–180,000




Increase in Accounts payable (Source)

100,000



















Cash Flow from Operating Activities




–7,000































Investment Cash Flow

























Invested in Plant & Equipment (Use)

–200,000




Invested in a Truck (Use)

–25,000




Land & Buildings (Use)

–400,000



















Cash Flow from Investment Activities




–625,000































Financing Cash Flow










Interest Paid




–50,000



















Cash flow from financing activities




–50,000

Net Sources (Uses) or Change in Cash Account




– 682,000

Beginning Cash Balance




1,000,000
















Net Cash Flow during current year




–682,000
















Ending Cash Balance







318,000

Cash flow from operating activities - would include the firm’s operating cash flow calculated as follows:

Operating Cash Flow (OCF) = EBIT + Depreciation – Taxes as well as the changes in the current assets (except cash) and current liabilities of the firm for that reporting period. For J.F. & Sons during the past year, cash flow from operations was -$7,000, indicating that the firm had to dip into it its cash account to fund its operations for the year.

Cash flow from investing activities - includes the cash used/generated in purchasing/disposing fixed assets and other investments. For J.F. & Sons, given that this has been its first year of operations, a fairly large use of cash ($625,000) has resulted from the purchase of its plant, equipment, land, buildings, and a delivery truck.

Note: Since we have already added back depreciation for the year ($125,000) as part of the sources of funds from operations, we account for the change in gross value of the assets
(–$625,000) in this section. Sometimes, the Balance Sheet shows only net fixed assets and accumulated depreciation figures. In such a case we would add together the change in value in each of the 2 items to represent the change in gross fixed assets.


Cash flow from financing activities- includes the payment of interest, dividends, reduction of the principal balance on debt, repurchase of stock, floating of new issues of stock and/or bonds and increase/decrease in treasury stock. For J.F. & Sons, this past year, the only cash flow from financing in the payment of interest of $50,000 on its outstanding loan.

Free Cash Flow: is another term used in conjunction with the cash flow from assets of a firm. It refers to the cash available to pay the creditors and owners once the firm has made the investments in working capital and capital assets necessary for continuing and growing the business. The timing and amount of free cash flow generated by a firm is critical to its valuation.


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