CHAPTER 5
Understanding Cash Flow Statements

Solutions

1. B is correct. Operating, investing, and financing are the three major classifications of activities in a cash flow statement. Revenues, expenses, and net income are elements of the income statement. Inflows, outflows, and net flows are items of information in the statement of cash flows.
2. B is correct. Purchases and sales of long-term assets are considered investing activities. Note that if the transaction had involved the exchange of a building for other than cash (for example, for another building, common stock of another company, or a long-term note receivable), it would have been considered a significant non-cash activity.
3. B is correct. The purchase and sale of securities considered cash equivalents and securities held for trading are considered operating activities even for companies in which this activity is not a primary business activity.
4. C is correct. Payment of dividends is a financing activity under US GAAP. Payment of interest and receipt of dividends are included in operating cash flows under US GAAP. Note that IFRS allow companies to include receipt of interest and dividends as either operating or investing cash flows and to include payment of interest and dividends as either operating or financing cash flows.
5. C is correct. Non-cash transactions, if significant, are reported as supplementary information, not in the investing or financing sections of the cash flow statement.
6. C is correct. Because no cash is involved in non-cash transactions, these transactions are not incorporated in the cash flow statement. However, non-cash transactions that significantly affect capital or asset structures are required to be disclosed either in a separate note or a supplementary schedule to the cash flow statement.
7. C is correct. Interest expense is always classified as an operating cash flow under US GAAP but may be classified as either an operating or financing cash flow under IFRS.
8. C is correct. Taxes on income are required to be separately disclosed under IFRS and US GAAP. The disclosure may be in the cash flow statement or elsewhere.
9. A is correct. The operating section may be prepared under the indirect method. The other sections are always prepared under the direct method.
10. A is correct. Under the indirect method, the operating section would begin with net income and adjust it to arrive at operating cash flow. The other two items would appear in the operating section under the direct method.
11. C is correct. The primary argument in favor of the direct method is that it provides information on the specific sources of operating cash receipts and payments. Arguments for the indirect method include that it mirrors a forecasting approach and it is easier and less costly
12. C is correct. The amount of cash collected from customers during the quarter is equal to beginning accounts receivable plus revenues minus ending accounts receivable: $66 million + $72 million − $55 million = $83 million. A reduction in accounts receivable indicates that cash collected during the quarter was greater than revenue on an accrual basis.
13. B is correct. An addition to net income is made when there is a loss on the retirement of debt, which is a non-operating loss. A gain on the sale of an asset and a decrease in deferred tax liability are both subtracted from net income.
14. A is correct. Revenues of $100 million minus the increase in accounts receivable of $10 million equal $90 million cash received from customers. The increase in accounts receivable means that the company received less in cash than it reported as revenue.
15. A is correct.

    Operating cash flows = Cash received from customers − (Cash paid to suppliers + Cash paid to employees + Cash paid for other operating expenses + Cash paid for interest + Cash paid for income taxes)

    Cash received from customers = Revenue + Decrease in accounts receivable

     = $37 + $3 = $40 million

    Cash paid to suppliers = Cost of goods sold + Increase in inventory + Decrease in accounts payable

     = $16 + $4 + $2 = $22 million

    Therefore, the company’s operating cash flow = $40 − $22 − Cash paid for salaries − Cash paid for interest − Cash paid for taxes = $40 − $22 − $6 − $2 − $4 = $6 million.

16. C is correct. Cost of goods sold of $80 million plus the increase in inventory of $5 million equals purchases from suppliers of $85 million. The increase in accounts payable of $2 million means that the company paid $83 million in cash ($85 million minus $2 million) to its suppliers.
17. A is correct. Cost of goods sold of $75 million less the decrease in inventory of $6 million equals purchases from suppliers of $69 million. The increase in accounts payable of $2 million means that the company paid $67 million in cash ($69 million minus $2 million).
18. C is correct. Beginning salaries payable of $3 million plus salaries expense of $20 million minus ending salaries payable of $1 million equals $22 million. Alternatively, the expense of $20 million plus the $2 million decrease in salaries payable equals $22 million.
19. C is correct. Cash received from customers = Sales + Decrease in accounts receivable = 254.6 + 4.9 = 259.5. Cash paid to suppliers = Cost of goods sold + Increase in inventory − Increase in accounts payable = 175.9 + 8.8 − 2.6 = 182.1.
20. C is correct. Interest expense of $19 million less the increase in interest payable of $3 million equals interest paid of $16 million. Tax expense of $6 million plus the decrease in taxes payable of $4 million equals taxes paid of $10 million.
21. B is correct. All dollar amounts are in millions. Net income (NI) for 2018 is $35. This amount is the increase in retained earnings, $25, plus the dividends paid, $10. Depreciation of $25 is added back to net income, and the increases in accounts receivable, $5, and in inventory, $3, are subtracted from net income because they are uses of cash. The decrease in accounts payable is also a use of cash and, therefore, a subtraction from net income. Thus, cash flow from operations is $25 + $10 + $25 − $5 − $3 − $7 = $45.
22. A is correct. Selling price (cash inflow) minus book value equals gain or loss on sale; therefore, gain or loss on sale plus book value equals selling price (cash inflow). The amount of loss is given—$2 million. To calculate the book value of the equipment sold, find the historical cost of the equipment and the accumulated depreciation on the equipment.
    • Beginning balance of equipment of $100 million plus equipment purchased of $10 million minus ending balance of equipment of $105 million equals the historical cost of equipment sold, or $5 million.
    • Beginning accumulated depreciation of $40 million plus depreciation expense for the year of $8 million minus ending balance of accumulated depreciation of $46 million equals accumulated depreciation on the equipment sold, or $2 million.
    • Therefore, the book value of the equipment sold was $5 million minus $2 million, or $3 million.
    • Because the loss on the sale of equipment was $2 million, the amount of cash received must have been $1 million.
23. A is correct. The increase of $42 million in common stock and additional paid-in capital indicates that the company issued stock during the year. The increase in retained earnings of $15 million indicates that the company paid $10 million in cash dividends during the year, determined as beginning retained earnings of $100 million plus net income of $25 million minus ending retained earnings of $115 million, which equals $10 million in cash dividends.
24. B is correct. To derive operating cash flow, the company would make the following adjustments to net income: Add depreciation (a non-cash expense) of $2 million; add the decrease in accounts receivable of $3 million; add the increase in accounts payable of $5 million; and subtract the increase in inventory of $4 million. Total additions would be $10 million, and total subtractions would be $4 million, which gives net additions of $6 million.
25. C is correct. An overall assessment of the major sources and uses of cash should be the first step in evaluating a cash flow statement.
26. B is correct. The primary source of cash is operating activities. Cash flow provided by operating activity totaled €13,796 million in the most recent year. The primary use of cash is investing activities (total of €10,245 million). Dividends paid are classified as a financing activity.
27. A is correct. The amount of cash paid to suppliers is calculated as follows:

    = Cost of goods sold − Decrease in inventory − Increase in accounts payable

    = $27,264 − $501 − $1,063

    = $25,700.

28. B is correct. An appropriate method to prepare a common-size cash flow statement is to show each line item on the cash flow statement as a percentage of net revenue. An alternative way to prepare a statement of cash flows is to show each item of cash inflow as a percentage of total inflows and each item of cash outflows as a percentage of total outflows.
29. B is correct. Free cash flow to the firm can be computed as operating cash flows plus after-tax interest expense less capital expenditures.
30. A is correct. This ratio is an interest coverage ratio, measuring a company’s ability to meet its interest obligations and indicating a company’s solvency. This coverage ratio is based on cash flow information; another common coverage ratio uses a measure based on the income statement (earnings before interest, taxes, depreciation, and amortization).