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CHAPTER 10
STATEMENT OF CASH FLOWS
AND
WORKING CAPITAL ANALYSIS
INTRODUCTION
The statement of cash flows and working capital analysis are discussed in this chapter. As you
will see, both statements have in common the analysis and evaluation of current assets and
current liabilities. The statement of cash flows (indirect method) converts an accrual income
statement to a cash basis statement. It adjusts net income (or net loss) by identifying cash inflows
and outflows as positive or negative adjustments. Non-cash expenses and non-operating gains or
losses from the disposal of non-current assets adjust the cash balance based on their effect on the
cash account. Day-to–day management of working capital is an important aspect of managing
any enterprise and such an analysis shares the same concept of identifying cash inflows and
outflows that increase or decrease working capital (current assets minus current liabilities). This
chapter demonstrates how a statement of cash flows and a statement of source inflows and use
outflows of working capital are developed. A good grasp of Chapters 2 and 3 will serve as a
solid foundation for this chapter. The discussion of working capital analysis in this chapter will
be of great assistance in Chapter 11 that discusses cash management.
TRUE or FALSE QUESTIONS
(Correct answer indicated by T for True answers and F for False answers)
1. Total current assets − total current liabilities = working capital.
T
2. The SCF is considered a major financial statement as is the balance sheet and the
income statement.
T
3. The financing activities section of a SCF evaluates transactions between the company
and its creditors and owners.
T
4. The operating activities section of a SCF, indirect method, evaluates only the disposal
of depreciable assets.
F
5. If a current asset account balance increases over an accounting period, the increase is
treated as a negative number in a SCF.
T
6. Depreciation and amortization for the period are treated as positive numbers and
added back in the operating section of a SCF, indirect method.
T
7. Gains on the disposal of non-current assets are treated as a positive number and losses
are treated as a negative number on a SCF.
F
8. The three sections of a SCF are: operating activities, investing activities and financing
activities.
T
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9. The payment of cash dividends is treated as a positive number in the financing
activities section of a SCF.
F
10. The operating activities section of a SCF, indirect method, generally evaluates current
assets, and liabilities, non-cash expenses, and gains or losses on the disposal of non–
current assets.
T
11. The increasing or decreasing of long-term debt is evaluated in the financing activity
section of a SCF.
T
12. The difference between the direct and indirect methods of preparing a SCF only
affects the operating section of the statement.
T
13. The statement of source inflows and use outflows of working capital shows certain
transactions that occurred at a specific point in time.
F
14. One of the purposes of a statement of source inflows and use outflows of working
capital is to provide prospective investors with information.
T
15. Depreciation expense is a use of working capital.
F
16. The purchase of a fixed asset is a source of working capital.
F
17. A loss from operations is a use of working capital.
T
18. Payment of dividends will decrease working capital.
T
19. A transaction affecting a current asset and a current liability account only will not
affect working capital.
T
20. When compiling a statement of source inflows and use outflows of working capital,
detailed information from the current asset and liability accounts on the balance sheet
is required.
F
21. Information in addition to that provided by the income statement, the retained earn–
ings statement, and the balance sheets is sometimes required to compile a statement of
source inflows and use outflows of working capital.
T
22. The net change in working capital figure from the statement of source inflows and use
outflows of working capital need not be reconciled with any other figures.
F
23. If an establishment sold a long-term asset for $3,000 and purchased a new one for
$20,000, only the difference of $17,000 will appear as a use of funds in the statement
of source inflows and use outflows of working capital.
F
24. The statement of changes in working capital accounts shows how individual current
asset and liability accounts increased or decreased during the period.
T
25. If the statement of changes in individual working capital accounts shows an increase
in current liabilities during the period, this will cause a decrease in total working
capital.
T
26. A statement of changes in individual working capital accounts must be prepared
before a statement of source inflows and use outflows of funds can be compiled.
F
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27. The actual amount of working capital is not as indicative of a company’s debt paying
ability as is its current ratio.
T
28. The current ratio is total current liabilities divided by total current assets.
F
29. The current ratio in a hotel or restaurant should be higher than 2:1.
F
MULTIPLE CHOICE QUESTIONS
(Correct answer indicated by asterisk)
1. Working capital is:
(a) The amount of cash one has in the bank
(b) The amount of cash required for purchase of capital or fixed assets
2. The three major activities evaluated in a SCF are:
(c) Operating, investing, and managing
(d) Operating, profiting, and financing
3. If kitchen equipment were purchased for $24,400 during the current period, the cost of the
purchase would be shown as a:
(c) Negative number in the financing section of the SCF
(d) Positive number in the investing section of the SCF
4. Restaurant furnishings with an original cost of $38,000 and accumulated depreciation
account of $32,000, was sold for $4,200 cash. How will the proceeds of the sale be reported
in a SCF, indirect method?
(a) In the financing section, cash inflow of $1,800
(b) In the investing section, cash inflow of $1,800
5. A restaurant owner borrowed $150,000 from a bank on a long-tem note. This transaction
would be shown on a SCF as $150,000 cash?
(a) Inflow in the operations section
6. Depreciation expense on the income statement was $8,000. Which of the following
statements is correct?
(c) Depreciation is not reported in a SCF
(d) Accumulated depreciation is debited for $8,000
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7. The source inflows and use outflows of a working capital statement shows:
(c) How current assets and liabilities were increased during the year
(d) The source inflows and use outflows of the cash account during the period
8. A small corporate restaurant repurchased 5,000 shares of its own stock for $50,000 cash
during the current period. How is this shown in a SCF?
(a) A positive cash flow in the investing section
(b) A positive cash flow in the operating section
9. One of the following is not a use of working capital:
(c) Payment of principal on a long-term liability
(d) Loss from operations
10. Which of the following is not a source of working capital?
(a) Sale of a fully depreciated asset for $1,000
(b) Issuance of new stock
11. If marketable securities owned by a company were sold for cash, this would be a/an:
(a) Source of working capital
(b) Increase in current assets
12. If the furniture and equipment account balance was $50,000 at the beginning of the period
and $40,000 at the end of the period, we could assume that:
or more purchases and sales of assets
(c) More than $10,000 of assets were sold and some new assets were purchased
(d) Working capital has been decreased by $10,000
13. The statement of changes in working capital is a:
(a) Part of the statement of source inflows and use outflows of working capital
(b) Statement showing increases in current asset accounts and decreases in current liability
accounts
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14. If the statement of changes in working capital showed that a bank loan had been decreased
from the beginning to the end of the period, this would be a/an:
(c) Source of working capital
(d) Use of working capital
15. It is important to know the dollar amount of working capital at any time because it:
(a) Shows a company’s apparent ability to pay off current liabilities
(b) Is indicative of a company’s collection rate on accounts receivable
16. If two different companies had the same dollar amounts of working capital:
(c) They would be equally good short-term credit risks
(d) They will have identical statements of source and use of working capital
17. A motel can operate with a relatively low current ratio because:
(c) It operates on cash rather than a charge basis
(d) Its inventory turns over very rapidly
18. If current assets are $75,000 and current liabilities are $100,000, the current ratio is?
(a) 1:0.75
(b) Too low to continue in business
EXERCISE SOLUTIONS
E10.1 Identify category of account and the effect of a balance change.
Category
Account Balance
Account Title
CA or CL
Increased
Decreased
Credit card receivables
CA
Use
Source
Accounts payable
CL
Source
Use
Inventory (for resale)
CA
Use
Source
Accounts receivable
CA
Use
Source
Prepaid expenses
CA
Use
Source
Accrued payroll payable
CL
Source
Use
Interest payable
CL
Source
Use
Marketable securities
CA
Use
Source
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E10.2 Net income was $180,000. Inventory (for resale) increased $12,000 and Accounts
payable increased by $9,000. Determine the net cash flow from operations, indirect
method.
Net income $180,000
E10.3 Net income $280,000, depreciation expense $38,000, accounts receivable decreased
$2,400; credit card receivables decreased $2,600; prepaid insurance increased $2,880;
inventory decreased $3,700; accounts payable increased $4,700; other accrued payables
decreased $3,600. Complete net cash flow from operations, indirect method.
Net Income
$280,000
Depreciation expense
$38,000
Accounts receivable
2,400
Credit card receivables
2,600
Prepaid insurance
( 2,880)
Inventory
3,700
Accounts payable
4,700
Other accrued payables
( 3,600)
Net adjustments
44,920
Net cash flow from operations
$324,920
E10.4 Identify the inflows and outflows of working capital.
Net income
Inflow
Sale of equity stock
Inflow
Net loss
Outflow
Purchase of equipment
Outflow
Depreciation
Inflow
Repayment long-term debt
Outflow
Cash dividends
Outflow
Increasing long-term debt
Inflow
Sales of equipment
Inflow
Redemption of stock
Outflow
E10.5 Cash flow ratios: Cash flow from operating activities $178,200; average CL $58,800,
average total liabilities $666,500; sales revenue $2,555,450; and interest $59,000.
a. The cash flow from operating activities to current liabilities ratio
$178,200 / $58,800 = 3.03 times or 303%
=
+
=
Liabilities
Capital
January 1, 2008
$137,500
=
E10.6 Identify whether the transaction belongs to investing or financing and its effect as an
increase or decrease in a Statement of Cash Flows.
Investing or
Financing
Increase (+) or
Decrease (−)
Investing
Decrease (−)
Purchase equipment.
Financing
Increase (+)
Sold shares of equity stock.
Investing
Increase (+)
Sold office furniture.
Investing
Decrease (−)
Purchased a long-term investment.
Financing
Decrease (−)
Declared and paid a cash dividend.
Financing
Decrease (−)
Repurchased equity stock.
Financing
Increase (+)
Increased long-term debt.
E10.7 Determine the cash from operations by adjusting specific items of working capital.
Working capital $87,500; accounts receivable increased $4,600, inventory decreased
$7,754, and accounts payable increased by $3,737.
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E10.11 Determine the net cash flows from investing and financing activities.
Investing Activities
a. Equipment purchased: ($44,480)
Old equipment sold: $ 1,200
E10.12 Analyze each transaction and comment on transactional effects on working capital.
a. No effect to working capital (WC); Purchased inventory (CA) on account (CL).
The addition of both a CA and a CL of the same value does not change WC.
d. Working capital will increase since cash (CA) and marketable securities (CA)
would be reduced by the cost of the securities. The resulting gain of $4,800 is
charged to a non-current account.
PROBLEM SOLUTIONS
P10.1 Complete an evaluation of cash flows for operating activities only, using the indirect
method.
Net income
$43,900
Adjustments to reconcile Net Income:
Operating Activities
Accounts receivable, increased
($10,420)
Inventory, increased
( 1,875)
Depreciation (Automatic add back)
8,000
Accounts payable, decreased
( 5,782)
Other current liabilities, increased
3,500
Tax payable, decreased
( 1,970)
Net adjustments
( 8,547)
Net cash flow, operating activities
$35,353
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P10.2 Complete a SCF using the indirect method.
Statement of Cash Flows, Indirect Method
Net income
$112,400
Adjustments to reconcile Net Income:
Operating Activities
Credit card receivables, increased
($ 680)
Accounts receivable, increased
( 1,500)
Inventories, increased
( 1,200)
Prepaid expenses, decreased
800
Accounts payable, decreased
( 2,100)
Accrued payroll payable, increased
2,400
Taxes payable, decreased
( 900)
Depreciation expense
120,000
Gain on disposal, furnishings
( 3,200)
Loss on disposal of equipment
800
Net adjustments to reconcile Net Income
114,420
Net cash flow, operating activities
$226,820
Investing Activities
Sold furnishings
$ 8,600
Sold equipment
2,000
Purchased new furnishings
(16,800)
Purchased new equipment
(24,200)
Net Cash Flow from Investing Activities
($ 30,400)
Financing Activities
Reduction to long-term debt
($ 54,800)
Cash dividends declared and paid
( 122,400)
Net cash flow, financing activities
($177,200)
Net cash flow, increase
$ 19,220
Cash balance, December 31, 0007
$ 12,020
Cash balance, December 31, 0008
$ 31,240
P10.3 Calculate a statement of changes in working capital and prepare a statement of source-
inflows and uses-outflows for the year ended December 31, 0008.
Change in Working Capital
Year 0007
Year 0008
Current assets
$31,000
$33,000
Current liabilities
( 7,000)
( 8,000)
Working capital
$24,000
$25,000
Increase in working capital
1,000
$25,000
$25,000
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P10.3 (Continued)
Statement of Source Inflows and Use Outflows of Working Capital
Source inflows of working capital
Net income
$7,000
Depreciation expense
1,000
New shares of equity stock
1,000
Increase in loan
2,000
Total source inflows of working capital
$11,000
Use outflows of working capital
Purchase of new equipment
$4,000
Payment of cash dividends
6,000
Total use outflows of working capital
($10,000)
Net increase in working capital
$ 1,000
P10.4 Using information from P10.3, complete a SCF using the indirect method.
Statement of Cash Flows for the Year Ended December 31, 0008
Net income
$ 7,000
Adjustments to reconcile Net Income:
Operating Activities
Credit card receivables, decreased
$ 66
Accounts receivable, decreased
534
Food inventories, increased
( 1,350)
Beverage inventories, increased
( 450)
Depreciation expense
1,000
Accounts payable, increased
2,300
Accrued expenses payable, decreased
( 100)
Income tax payable, decreased
( 1,200)
1,100)
Net adjustments to reconcile Net Income
800
Net cash flow, operating activities
$ 7,800
Investing Activities
Purchased equipment
($4,000)
Net cash flow, investing activities
($ 4,000)
Financing Activities
Cash dividend distributed
($6,000)
Issued new shares of equity stock for cash
1,000
Loan-term loan increased
2,000
Net cash flow, financing activities
($ 3,000)
Net cash flow increase
$ 800
Cash balance, December 31, 0007
14,800
Cash balance, December 31, 0008
$15,600
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P10.5
Changes in Working Capital
Effect on Working Capital
12-31-07
12-31-08
Increase (WC)
Decrease (WC)
Current Assets
Cash
$ 4,100
$ 5,200
$1,100
Credit card receivables
4,700
5,500
800
Accounts receivable
1,200
700
500
Inventory
3,000
3,600
600
Marketable securities
8,000
7,000
$1,000
Prepaid expenses
1,200
1,500
300
Totals
$22,200
$23,500
$2,800
$1,500
Current Liabilities
Accounts payable
$ 6,900
$ 7,000
100
Accrued expenses payable
1,400
1,700
300
Income tax payable
2,000
1,500
500
Current mortgage payable
11,500
10,400
1,100
______
Totals
$21,800
$20,600
$4,400
$1,900
Net working capital
$ 400
$ 2,900
Net change
2,500
_______
2,500
Totals
$ 2,900
$ 2,900
$4,400
$4,400
P10.6 Prepare a statement of source-inflows and use-outflows of working capital for the year
ending December 31, 0008.
Statement of Source Inflows and Use Outflows of Working Capital
Source inflows of working capital
Net income
$ 6,800
Depreciation [From P10.5: $8,300 + $3,700]
12,000
12,000
Total source inflows of working capital
$18,800
Use outflows of working capital
Cash dividends distributed
$ 3,200
Purchased new furniture [From P10.5: $25,400 – $22,700]
2,700
Mortgage reduction
10,400
Total use outflows of working capital
($16,300)
Net change, increase to working capital
$ 2,500
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P10.7 Prepare a SCF, indirect method. P10.5 and P10.6 are referred to for the necessary
information.
Statement of Cash Flows for the Year Ended December 31, 0008
Net income
$ 6,800
Adjustments to reconcile Net Income
Operating Activities
Credit card receivables, increased
(800)
Accounts receivable, decreased
500
Inventory, increased
(600)
Marketable securities, decreased
1,000
Prepaid expenses, increased
(300)
Depreciation, building
8,300
Depreciation, furniture and equipment
3,700
Accounts payable, increased
100
Accrued expenses payable, increased
300
Income taxes payable, decreased
(500)
Current mortgage payable, decreased
( 1,100)
Net adjustments to reconcile Net Income
10,600
Net cash flow, operating activities
$17,400
Investing Activities
Purchased furniture and equipment
($2,700)
Net cash flow, investing activities
( 2,700)
Financing Activities
Reduced long-term mortgage
($11,500)
Cash dividends paid
( 3,200)
Net cash flow, financing activities
(14,700)
Net cash flow increase
$ 1,100
Cash balance, December 31, 0007
4,100
Cash balance, December 31, 0008
$ 5,200
P10.8 Determine the changes in working capital and prepare the catering company’s statement
of source inflows and use outflows for the year ended December 31, 0008.
Change in Working Capital
Year 0007
Year 0008
Current assets
$35,700
$38,800
Current liabilities
( 28,700)
( 41,300)
$ 7,000
($ 2,500)
Decrease in working capital
9,500
$ 7,000
$ 7,000
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Statement of Source Inflows and Use Outflows of Working Capital
Source inflows of working capital
Net mortgage
$140,000
New stock shares
10,000
Depreciation: Building
7,500
Depreciation: New equipment
4,500
Total source inflows of working capital
$162,000
Use outflows of working capital
Operating loss
$ 8,100
New equipment
6,300
Purchase of building
150,000
Reduction of mortgage
7,100
Total use outflows of working capital
($171,500)
Net change, decrease in working capital
$ 9,500
P10.9 Change in Working Capital
Year 0007
Year 0008
Current assets
$28,100
$36,100
Current liabilities
( 6,700)
( 20,700)
Working Capital
$21,400
$15,400
Decrease in working capital
6,000
Totals
$21,400
$21,400
Statement of Source Inflows and Use Outflows of Working Capital
Source inflows of working capital
Net income
$16,800
Depreciation
10,000
New mortgage
30,000
Total source inflows of working capital
$56,800
Use outflows of working capital
Purchase of building
$50,000
Dividends
12,800
Total use outflows of working capital
($62,800)
Net change, decrease in working capital
$ 6,000
The working capital was reduced by $6,000 during the year even though net income was
earned. As well, liquidity was greatly reduced. Reduction of liquidity is due to more
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CASE 10 SOLUTION
Complete a SCF from the pro-forma balance sheet for Year 2008 (Case 2 balance sheet).
4C Company
Statement of Cash Flows for Year Ending, December 31, 2008
Cash Flows from Operations
Net income
$46,410
Adjustments to reconcile Net Income
Operating Activities
Depreciation
$20,124
Credit card receivables, increased
( 3,819)
Accounts receivable, increased
( 2,413)
Food inventory, increased
( 437)
Beverage inventory, decreased
16
Prepaid expenses, increased
( 40)
Accounts payable, decreased
( 2)
Accrued payroll, increased
702
Income tax payable, increased
3,404
Net adjustments to reconciled net income
17,535
Net cash flow, operating activities
$63,945
Financing Activities
Common stock repurchased
($20,000)
Repayment of long-term debt
( 38,260)
Net cash flows, financing activities
($58,260)
Net cash flow increase
$ 5,685
Beginning cash, December 31, 2007
$36,218
Ending cash, December 31, 2008
$41,903