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1. The accounts receivable balance decreased
by $17, so this amount needs to be added to
net income.
2. The inventory balance increased by $49, so
this amount needs to be subtracted from
net income.
3. The accounts payable balance increased
by $44, so this amount needs to be added to
net income.
4. The accrued liabilities balance increased
by $3, so this amount needs to be added to
net income.
5. The income taxes payable balance
increased by $4, so this amount needs to be
added to net income.
iii. The third step is adjust for gains and losses
included in the income statement.
1. Apparel’s income statement includes a gain
of $3 million, so this amount must be
subtracted from net income.
2. Subtracting the gain on sale removes it from
the operating activities section of the
statement of cash flows. The entire amount
of the proceeds related to this sale will be
recorded in the investing activities section of
the statement.
iv. The operating activities section of Apparel’s
statement of cash flows would appear as
shown on this slide.
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C. Investing activities
i. To compute the gross cash flows in the
investing activities section of the statement,
we need to focus on the Property, Plant, and
Equipment account.
1. Apparel would record an $8 million cash
inflow related to the sale of the store.
2. The basic equation for asset accounts can
be used to determine that Apparel needs to
record a $138 million cash outflow related
to the purchase of property, plant, and
equipment.
D. Financing activities
i. To compute the gross cash flows in the
financing activities section of the statement,
we need to focus on the Bonds Payable,
Common Stock, and Retained Earnings
accounts.
1. The balance in Bonds Payable decreased
by $41 million. Because the assumptions
state that Apparel did not issue any bonds
during the year, the $41 million decrease
relates to retiring bonds and represents a
cash outflow.
2. The balance in Common Stock increased
by $2 million. Because the assumptions
state that Apparel did not repurchase any of
its own stock, the $2 million increase
relates to issuing common stock and
represents a cash inflow.
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3. The basic equation for stockholders’ equity
accounts can be used to determine that
Apparel paid dividends of $28 million
that need to be recorded as a cash
outflow.
E. Apparel Inc: statement of cash flows
i. Apparel’s completed statement of cash flows is
shown on this slide. Notice, the net increase in
cash and cash equivalents ($62) explains the
change in the cash balance.
F. Apparel Inc: seeing the big picture
i. T-accounts can be used to summarize how
changes in Apparel Inc.’s noncash balance sheet
accounts quantify the cash inflows and outflows
that explain the change in its cash balance.
1. The first entry records Apparel’s net
income ($140 million) in the credit side of
the Retained Earnings account and the debit
side of the Cash account.
2. The second entry adds depreciation of
$103 million to net income.
3. Entries 3-7 adjust net income for the
changes in the current asset and current
liability accounts.
4. Entries 8-11 summarize the cash outflows
and inflows related to property, plant, and
equipment, the retirement of bonds
payable, the payment of the cash
dividend, and the issuance of common
stock.
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5. The final entry records the sale of the store.
Notice, the gain on the sale ($5 million) is
recorded in the credit side of the cash
account so that the entire amount of the cash
proceeds from the sale ($8 million) can be
recorded as an investing activity.
IV. Interpreting the statement of cash flows
A. Consider a company’s specific circumstances
i. Start-up companies often have negative net cash
provided by operating activities, large spikes in
net cash used for investing activities and net cash
provided by financing activities.
ii. As start-up companies mature, the net cash
provided operating activities should swing from a
negative to a positive number. The net cash used
for investing activities should decline somewhat
and stabilize and the net cash provided by
financing activities should decrease.
B. Consider the relationships among the numbers
i. Some managers study their company’s trends in
cash flow margins by comparing net cash
provided by operating activities to sales.
ii. Managers also compare the net cash provided
by operating activities to the ending balance of
current liabilities to see if they generated enough
cash flow to pay their bills at the end of the
period.
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iii. Some managers compare the additions to
property, plant, and equipment in the investing
activities section of the statement to depreciation
included in the operating activities section.
1. If the additions to property, plant, and
equipment are less than depreciation, it
suggests the company is not investing
enough money to maintain its noncurrent
assets.
Learning Objective 3: Compute free cash flow.
iv. Free cash flow looks at the relationship among
three numbers from the statement of cash flows—
net cash provided by operating activities,
additions to property, plant, and equipment,
and dividends.
1. Free cash flow measures a company’s
ability to fund its capital expenditures
and dividends from its net cash provided
by operating activities.
2. The equation for computing free cash flow
is net cash provided by operating
activities minus capital expenditures and
dividends.
3. Apparel’s free cash flow of $93 million is
computed as shown.
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v. Managers and investors look at the relationship
between net income and net cash provided by
operating activities to assess earnings quality.
Managers perceive that earnings are of higher
quality when the earnings:
1. Are not unduly influenced by inflation.
2. Are computed using conservative
accounting principles and estimates.
3. Are correlated with net cash provided by
operating activities.
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