4.5 Chapter Summary

LO 3: Explain the purpose of the statement of cash flows and prepare a SCF in good form.

The statement of cash flows (SCF) provides the means to assess the business’s capacity to generate cash and to determine where the cash flows come from. The statement combines with the SFP/BS to evaluate a company’s liquidity and solvency; when com- bined, these represent a company’s financial flexibility.  This information  can be used  to predict the future financial position and cash flows of the company based on past events. The SCF can be prepared using either the direct or indirect method. Regarding the indirect method, the statement is presented in three distinct sections, which follow the basic structure of the balance sheet classifications: operating activities (current assets, and current liabilities), investing activities (non-current assets), and financing activities (long-term debt and equity). The changes between the opening and closing balances of the SFP/BS accounts are reported in the SCF as either cash inflows or cash outflows. The three sections net to a single net cash change amount that, when combined with the cash and cash equivalent opening balances, results in the same amount as the ending balances reported in the SFP/BS.

An important section in the SCF is the operating activities section because it reports the cash flows resulting from daily operations which is the reason why the company is in business. If cash flows are negative in this section, management must determine if this is due to a temporary condition or if fundamental changes are needed to better manage activities such as the collections of accounts receivables or levels of unsold inventory. If a company is in a negative cash flow position from operating activities, it will usually either increase its debt by borrowing, increase its equity by issuing more shares, or sell off some of its assets. If these activities are undertaken, they will be detected as cash inflows from either the investing or financing sections. None of these three options are ideal and can be done in the short run, but they cannot be sustained in the long run. Even positive cash flows from operating activities must be evaluated to determine if they are sustainable and will continue into the future.

LO 4: Identify and describe the types of analysis techniques that can be used for the statement of financial position/balance sheet and the statement of cash flows.

Several analytical techniques can be applied when reviewing the SFP/BS. For example, comparative years’ data can be presented to help identify trends. Using a percentage for each line item will help highlight items that may possess unusual characteristics for further analysis. Ratio analysis is the most often used technique but is of limited value if no benchmarks such as historical ratios or industry standards exist. Ratios typically focus on an aspect of a company such as liquidity, profitability, effectiveness of assets used, and ability to service short- and long-term debts. Care must be taken when interpreting the results of ratio analysis, and management must be aware that differences in ratios from competitors’ financial statements can result from changes in accounting policies or the application of different accounting estimates and methods.