👨‍🏫 Notes

Statement of Cash Flows

The statement of cash flows is divided into three sections which roughly correspond to the three major jobs of the financial manager:

1. Operating activities
2. Investment activities
3. Financing activities

Statement of Cash Flows: Operating Activities

Depreciation:

• We also add depreciation to net income, since it is not a cash outflow

Accounts receivable:

• Adjust the cash flows by deducting the increases in accounts receivable
• This increase represents additional lending by the firm to its customers and it reduces the cash available to the firm

Accounts payable:

• Similarly, we add increases in accounts payable
• Accounts payable represents borrowing by the firm from its suppliers
• This borrowing increases the cash available to the firm

Inventory:

• Finally, we deduct increases to inventory
• Increases to inventory are not recorded as an expense and do not contribute to net income
• However, the cost of increasing inventory is a cash outflow for the firm and must be deducted on the statement of cash flows.

Statement of Cash Flows: Investment and Financing Activities

Investment Activity

• Subtract the actual capital expenditure that the firm made
• Also deduct other assets purchased or investments made by the firm, such as acquisitions

Financing Activity

• The last section of the statement of cash flows shows the cash flows from financing activities
• Subtract Dividends paid
• Add cash received from sale of stock
• Subtract cash spent repurchasing your own stock
• Add changes to short-term and long-term borrowing

✏️ The Impact of Depreciation on Cash Flow

• Suppose Global had an additional $1 million depreciation expense in 2019
• If Global’s tax rate on pretax income is 26%, what would be the impact of this expense on Global’s earnings?
• How would it impact Global’s cash at the end of the year? ✔ In the end, accelerating depreciation cuts your tax bill and thereby increases cash flows. It lowers your earnings, but in a “non-cash” manner.

Depreciation decreases Pretax income by $1M. This also decreases your tax bill by $0.26M. On the statements of Cash Flows, we add the $1M of depreciation back in, so that the final incremental cash flows are exactly +$0.26M.

Income Statement and Statement of Cash Flows

• Recall that depreciation is not an actual cash outflow, even though it is treated as an expense, so the only effect on cash flow is through the reduction in taxes
• Global’s operating income, EBIT, and pretax income would fall by $1 million because of the $1 million in additional operating expense due to depreciation
• This $1 million decrease in pretax income would reduce Global’s tax bill by 26% ´ $1 million = $0.26 million
• Therefore, net income would fall by 1 - 0.26 = $0.74 million
• On the statement of cash flows, net income would fall by $0.74 million, but we would add back the additional depreciation of $1 million because it is not a cash expense
• Thus, cash from operating activities would rise by -0.74 + 1 = $0.26 million
• Thus, Global’s cash balance at the end of the year would increase by $0.26 million, the amount of the tax savings that resulted from the additional depreciation deduction
• The increase in cash balance comes completely from the reduction in taxes
• Because Global pays $0.26 million less in taxes even though its cash expenses have not increased, it has $0.26 million more in cash at the end of the year