Principles of Financial Accounting: Statement of Cash Flows - Steps to Prepare, the Statement of Cash Flows

What It Is

The Statement of Cash Flows is a financial statement that presents a company's inflows and outflows of cash and cash equivalents over a specific period. It's essential for investors, creditors, and analysts to understand a company's ability to generate cash and meet its financial obligations. For example, if a company buys $10,000 of inventory on credit, it will need to pay for it later, which affects its cash flows.

Key Concepts & Formulas

• Direct Method: A method of presenting cash flows from operating activities by showing major classes of gross cash receipts and payments. For example, Cash Received from Customers = Sales Revenue - Accounts Receivable.
• Indirect Method: A method of presenting cash flows from operating activities by adjusting net income to reconcile it with net cash provided by operating activities. For example, Net Cash Provided by Operating Activities = Net Income + Depreciation + Accounts Receivable - Accounts Payable.
• Cash Flow from Operating Activities: The net cash inflows or outflows from a company's core business operations. For example, Cash Flow from Operating Activities = Cash Received from Customers - Cash Paid to Suppliers.
• Cash Flow from Investing Activities: The net cash inflows or outflows from a company's investments in assets, such as property, plant, and equipment. For example, Cash Flow from Investing Activities = Cash Received from Sale of Assets - Cash Paid for New Assets.
• Cash Flow from Financing Activities: The net cash inflows or outflows from a company's financing activities, such as borrowing or repaying debt. For example, Cash Flow from Financing Activities = Cash Received from Borrowing - Cash Paid for Dividends.
• Operating Cash Flow Ratio: A ratio that measures a company's ability to generate cash from its core business operations. For example, Operating Cash Flow Ratio = Cash Flow from Operating Activities / Total Assets.
• Cash Conversion Cycle: The length of time it takes for a company to sell its inventory, collect its accounts receivable, and pay its accounts payable. For example, Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding - Days Payable Outstanding.
• Free Cash Flow: The cash flow available to a company's investors after deducting its capital expenditures. For example, Free Cash Flow = Cash Flow from Operating Activities - Cash Paid for Capital Expenditures.

Journal Entry Examples

1. Dr. Cash $10,000 Cr. Accounts Payable $10,000 Explanation: This journal entry records the payment of $10,000 to a supplier.

2. Dr. Accounts Receivable $5,000 Cr. Sales Revenue $5,000 Explanation: This journal entry records the sale of $5,000 worth of goods on credit.

3. Dr. Cash $20,000 Cr. Borrowings $20,000 Explanation: This journal entry records the borrowing of $20,000 from a bank.

Common Mistakes

1. Mistake: Confusing debits and credits for expense accounts. Correction: Remember that debits increase assets and expenses, while credits increase liabilities and equity.
2. Mistake: Failing to consider the impact of non-cash items on cash flows. Correction: Remember to add back non-cash items, such as depreciation and amortization, when preparing the statement of cash flows.
3. Mistake: Ignoring the effect of changes in working capital on cash flows. Correction: Remember to consider the impact of changes in accounts receivable, accounts payable, and inventory on cash flows.

Exam Tips

1. Tip: When preparing the statement of cash flows, remember to use the indirect method to reconcile net income with net cash provided by operating activities.
2. Tip: Be careful when dealing with non-cash items, such as depreciation and amortization, which can affect cash flows.
3. Tip: Consider the impact of changes in working capital on cash flows, as they can significantly affect a company's cash position.

Quick Practice

1. What is the adjusting entry for accrued salaries of $5,000? Answer: Dr. Accrued Salaries $5,000, Cr. Cash $5,000 Explanation: This journal entry records the accrual of $5,000 worth of salaries.

2. What is the effect of a $10,000 increase in accounts receivable on cash flows? Answer: Decrease in cash flows by $10,000 Explanation: An increase in accounts receivable means that customers have not yet paid for their purchases, which reduces cash flows.

3. What is the cash conversion cycle for a company with a 30-day inventory turnover, 60-day sales outstanding, and 30-day payable outstanding? Answer: 60 days Explanation: The cash conversion cycle is calculated by adding the days inventory outstanding and days sales outstanding, then subtracting the days payable outstanding.

Last-Minute Cram Sheet

1. Dividends are NOT an expense – they go directly to retained earnings.
2. Cash flows from operating activities are presented using the direct or indirect method.
3. The operating cash flow ratio measures a company's ability to generate cash from its core business operations.
4. Free cash flow is the cash flow available to a company's investors after deducting its capital expenditures.
5. The cash conversion cycle is the length of time it takes for a company to sell its inventory, collect its accounts receivable, and pay its accounts payable.
6. Non-cash items, such as depreciation and amortization, are added back when preparing the statement of cash flows.
7. Changes in working capital can significantly affect a company's cash position.
8. The statement of cash flows is presented in a three-section format: operating, investing, and financing activities.
9. Cash flows from investing activities include the sale and purchase of assets, such as property, plant, and equipment.
10. Cash flows from financing activities include borrowing and repaying debt, as well as paying dividends.