Week 15 · Chapter

Chapter 15 — The Statement of Cash Flows, Analysis, and the Course Synthesis

Financial Accounting Free sample edition

The module's primary reading · ~45–55 minutes · Objective 9 (prepare a statement of cash flows by the indirect method, compute and interpret basic financial ratios, and read a public company's annual report), with Objective 4 (complete the accounting cycle: prepare an income statement, a statement of retained earnings, and a classified balance sheet, journalize closing entries, and prepare a post-closing trial balance) and Objective 5 (account for merchandising operations and inventory: record purchases and sales in a perpetual system, compute cost of goods sold and gross profit, and apply FIFO, LIFO, and weighted-average costing and the lower of cost and net realizable value) called back · Read it first this week; the lecture, the slides, the tutorial, the quiz, and the workshop all build on it.

In plain language

A business can earn a profit and still run short of money, because profit and cash move on different schedules. This week you build the statement of cash flows (the report of where a business's cash came from and where it went). You sort every dollar of cash into three groups: running the business, buying and selling long-lived assets, and dealing with owners and lenders. Then you compute four ratios (one figure from the statements divided by another) and read each one in a plain sentence. Last, you read the bicycle shop's whole story, from its first month to the end of its second year.

Why you already care about this

Picture the bicycle shop at the end of Year 2. Its income statement says it earned $69,000. Its bank balance says something else: cash grew from $22,000 at the start of the year to $71,000 at the end, an increase of $49,000. The owners want to know why those two numbers differ. So does the lender who holds the shop's note.

You have felt this gap yourself. Maybe you worked a summer job that paid every two weeks. You earned money on your first day, but the cash did not reach your account until payday. Maybe a friend sells crafts online and says, "I made $600 this month, but I'm broke, because I bought all my supplies up front." Earning and having cash are two different things, and a business needs a report for each.

By the end of this chapter you will be able to:

sort a business's cash flows into operating, investing, and financing activities;
prepare the operating section by the indirect method, starting from net income;
assemble the statement of cash flows and tie it to the change in cash;
explain why net income and cash flow differ;
compute the current ratio, debt to total assets, gross margin, and profit margin, and read each in one plain sentence;
find a public company's annual report on EDGAR and read it for the shape of its statements;
read the running case from Month 1 to Year 2, tying each statement to the next.

Carry this sentence with you: profit is what you earned — cash is what you have.

Where we are

Already covered: Week 1 named the four financial statements, including the statement of cash flows. Week 5 prepared the first three from the shop's Month 1 records and showed that net income is not cash. Week 6 computed gross profit and gross margin on the shop's first bicycle sale. Week 11 depreciated long-lived assets and measured a gain on a sale. Weeks 12 and 13 sorted liabilities into current and long-term, and Week 14 recorded the shop's Year 2 stock issue, dividend, and treasury stock.
This week: the statement of cash flows and its three sections, the indirect method, why net income and cash flow differ, four financial ratios, reading a public company's Form 10‑K on EDGAR, and the course synthesis.
How they connect: the statement of cash flows draws on every account the course has taught, so each line this week is one you have already recorded, now read for its cash.

This is the course's final teaching week, and it leans on three earlier ideas. From Week 4, accrual accounting records revenue when it is earned and expenses when they are incurred, whatever day cash moves. From Week 5, net income is a period's revenues minus its expenses, a measure of what the business earned, not the cash it has. From Week 11, depreciation allocates an asset's cost over the years that use it, and it is not a cash outflow.

1. Sort cash into three activities

Think about a food truck's first week (illustrative). The owner collects $2,400 from customers and pays $900 for ingredients. She also buys a $5,000 grill, and a family member lends her $3,000 to help. Every one of those events moved cash, but they are different kinds of events. Selling tacos is the business. Buying a grill is an investment in the business. A family loan is a way of paying for it.

The statement of cash flows sorts cash the same way, into three sections:

Operating activities are the cash effects of running the business day to day, such as collecting from customers and paying suppliers, employees, and rent.
Investing activities report cash paid to buy long-lived assets, such as equipment, and cash received from selling them.
Financing activities report cash received from and paid to the owners and lenders, such as issuing stock, buying treasury stock, paying dividends, and borrowing or repaying a loan.

For the food truck: operating cash is 2,400 − 900 = $1,500, investing cash is (5,000) for the grill, and financing cash is 3,000 from the loan. In total, 1,500 − 5,000 + 3,000 = −$500, so the truck ended the week with $500 less cash than it started with.

Worked example — the shop's investing and financing activities (Dataset L). In Year 2 the bicycle shop (illustrative) paid $40,000 for new equipment. It also received $7,000 from selling old equipment. Net cash used by investing activities is (40,000) + 7,000 = (33,000).

Its financing activities are the moves you recorded in Week 14, plus one loan repayment:

Issuance of common stock: 45,000.
Purchase of treasury stock: (10,000).
Payment of cash dividends: (7,000).
Repayment of a note payable: (20,000).

Net cash provided by financing activities is 45,000 − 10,000 − 7,000 − 20,000 = $8,000. In words: the owners and lenders put $8,000 more into the shop than the shop paid back to them.

Misconception check. Students often put the $7,000 dividend in operating activities, because cash went out and it feels like a cost. A dividend is a distribution to owners, never an expense, as Week 2 settled. The cash paid for it is a financing activity, the same section as the stock the owners bought.

2. Start the indirect method with net income

Imagine a tutoring business (illustrative) that bought three laptops last year for $3,600. This year it records $1,200 of depreciation on them. The depreciation lowers its net income by $1,200, but no money leaves its bank account this year for the laptops. The cash left last year, when it bought them.

That gap is why the operating section needs adjusting. The indirect method is a way of reporting operating activities that starts with net income and adjusts it to cash. It adds back depreciation, subtracts gains and adds back losses, subtracts increases in current operating assets, and adds increases in current operating liabilities. Most businesses present their operating cash this way.

Worked example — the first two adjustments (Dataset L). Start with the shop's Year 2 net income of $69,000.

Add back depreciation expense: 12,000. It was subtracted to reach net income, but no cash left the shop for it.
Subtract the gain on sale of equipment: (2,000). The sale's whole $7,000 of cash already appears in investing activities.

Why subtract the gain? Week 11 showed that a gain is cash received minus book value. The equipment's book value was 7,000 − 2,000 = $5,000. The $2,000 gain sits inside net income, and the full $7,000 sits in investing. If you left the gain in operating, you would count $2,000 of that cash twice.

Misconception check. Students often read the depreciation add-back as a source of cash, because it is a plus sign on the statement. Depreciation brings in no cash at all. Adding it back only undoes a subtraction that used no cash. If the shop recorded $1 more of depreciation, its net income would fall by $1 and the add-back would rise by $1, and its cash would not change.

3. Adjust for current operating assets and liabilities

Picture a plant nursery (illustrative) that sells $8,000 of shrubs to landscapers on account at the end of its year. The $8,000 is revenue, so it is in net income. But the landscapers have not paid yet, so the cash is still waiting in Accounts Receivable. The nursery earned more than it collected.

Current operating assets are the current assets that come from running the business, such as Accounts Receivable, Inventory, and Prepaid Insurance. Current operating liabilities are the current liabilities that come from running the business, such as Accounts Payable and Wages Payable. Their changes during the year tell you how far cash ran ahead of, or behind, net income:

An increase in a current operating asset means cash is tied up, so you subtract it.
A decrease in a current operating asset frees cash, so you add it.
An increase in a current operating liability means cash has not yet been paid for something already expensed, so you add it.

For the nursery, the $8,000 rise in Accounts Receivable is subtracted from net income.

Worked example — the shop's operating section (Dataset L). Continue from the two adjustments in Section 2.

Increase in accounts receivable: (3,000). Customers owe the shop more at year end, so less of its revenue arrived as cash.
Increase in inventory: (5,000). The shop paid for more bicycles and parts than it sold.
Decrease in prepaid expenses: 1,000. The shop used up prepayments it had paid for in an earlier year.
Increase in accounts payable: 2,000. The shop owes suppliers more, so it has not yet paid cash for some of what it bought.

Net cash provided by operating activities is 69,000 + 12,000 − 2,000 − 3,000 − 5,000 + 1,000 + 2,000 = $74,000. In words: running the shop brought in $74,000 of cash in Year 2, $5,000 more than its net income.

In practice (your tools). In a free spreadsheet such as Google Sheets, type net income in B2 and each adjustment below it, with subtractions entered as negative numbers. In B9 enter =SUM(B2:B8) to total the operating section. Do the same for investing and financing, and then add the three section totals. If that sum does not equal the change in cash, a sign is wrong somewhere, so check each adjustment's sign against the three rules above.

Misconception check. Students often add an increase in Accounts Receivable, because "receivables went up, so the business has more." The business has more claims on customers, not more cash. Ask yourself which way the cash moved: a sale on account raised net income with no cash, so the increase is subtracted.

4. Assemble the statement and tie it to cash

Think about a monthly bank statement. It starts with a balance, lists what came in and went out, and ends with a new balance. If the ending figure does not match the starting figure plus the changes, something is wrong. The statement of cash flows works the same way, and that is its built-in check.

The total of the three sections is the net increase in cash, which equals the change in cash from the beginning to the end of the period. Net cash provided by operating activities is the total of the operating section: the cash the business's day-to-day operations brought in, after the cash they paid out.

Worked example — the shop's Year 2 statement of cash flows (Dataset L). Here is the whole statement, with its three-line heading.

The bicycle shop's statement of cash flows for Year 2, indirect method, in dollars (illustrative, Dataset L)
The bicycle shop — Statement of Cash Flows — For Year 2
Operating activities (indirect method)
Net income		$69,000
Depreciation expense	12,000
Gain on sale of equipment	(2,000)
Increase in accounts receivable	(3,000)
Increase in inventory	(5,000)
Decrease in prepaid expenses	1,000
Increase in accounts payable	2,000
Net cash provided by operating activities		74,000
Investing activities
Purchase of equipment	(40,000)
Sale of equipment	7,000
Net cash used by investing activities		(33,000)
Financing activities
Issuance of common stock	45,000
Purchase of treasury stock	(10,000)
Payment of cash dividends	(7,000)
Repayment of a note payable	(20,000)
Net cash provided by financing activities		8,000
Net increase in cash		49,000
Cash, beginning of Year 2		22,000
Cash, end of Year 2		$71,000

Foot it. The three sections total 74,000 − 33,000 + 8,000 = $49,000. Then the beginning cash plus that increase is 22,000 + 49,000 = $71,000, the cash on the balance sheet at the end of Year 2. The statement reconciles: it explains every dollar of the change from $22,000 to $71,000.

Now read the three figures side by side. Net income was $69,000. Operating cash was $74,000. Total cash grew by $49,000. They differ because accrual accounting records revenues and expenses when earned and incurred, not when cash moves. On top of that, investing and financing cash never touch net income at all.

Misconception check. Students often read net income as the cash the business made from operations. Net income is $69,000, versus $74,000 of operating cash, a gap of $5,000. In other years the gap can run the other way: a profitable business can run short of cash when customers pay slowly or inventory piles up.

Pause and think (choose one). (a) Imagine you are the lender holding the shop's note. Which line of this statement would you read first, and why? (b) Imagine you are one of the founders. Which line surprises you most, and what would you ask your bookkeeper about it?

5. Compute the current ratio and debt to total assets

Picture a landlord deciding whether to rent a storefront to a small business. One question matters most: can it pay the bills that come due this year? A second question follows: how much of what the business owns was paid for with borrowed money? Two ratios answer those questions.

A financial ratio is one amount from the financial statements divided by another, read in one plain sentence to describe the business. It is never good or bad on its own. The first two ratios read the balance sheet:

The current ratio is current assets divided by current liabilities. It describes how many dollars of current assets the business holds for each dollar of current liabilities.
Debt to total assets is total liabilities divided by total assets, written as a percentage. It describes the share of the business's assets that creditors have a claim on.

Worked example — the shop's balance sheet ratios, end of Year 2 (Dataset L). The shop's current assets are $100,000 and its current liabilities are $40,000.

Current ratio: 100,000 ÷ 40,000 = 2.5.
Total liabilities: the current liabilities plus a long-term note, 40,000 + 20,000 = $60,000.
Total assets: liabilities plus Week 14's stockholders' equity, 60,000 + 140,000 = $200,000.
Debt to total assets: 60,000 ÷ 200,000 = 0.30, or 30 percent.

Read each in one plain sentence. The shop holds $2.50 of current assets for each $1 of current liabilities. Creditors have a claim on 30 percent of the shop's assets, and the owners' claim covers the other 70 percent.

Misconception check. Students often think a higher current ratio is always better. Look at the shop's own history. At the end of Month 1, its current assets were $20,700 and its current liabilities were $1,600, so its current ratio was 20,700 ÷ 1,600, or about 12.9. That high figure came from a brand-new shop holding most of its founders' cash before spending it. A very high ratio can mean cash sitting unused or customers slow to pay, so you always read a ratio beside the business's own story.

6. Compute gross margin and profit margin

Think about a used-book seller at a weekend market (illustrative). Over a year it sells $80,000 of books. The books cost it $50,000, so its gross profit is 80,000 − 50,000 = $30,000. After rent for the booth and other costs, its net income is $6,000. Two ratios turn those figures into cents per sales dollar.

Gross margin, from Week 6, is gross profit divided by sales revenue, written as a percentage: the share of each sales dollar left after the cost of the goods sold.
Profit margin is net income divided by net sales, written as a percentage. It describes how many cents of each sales dollar remain as net income after every expense.

For the book seller, gross margin is 30,000 ÷ 80,000 = 0.375, or 37.5 percent, and profit margin is 6,000 ÷ 80,000 = 0.075, or 7.5 percent.

Worked example — the shop's income ratios, Year 2 (Dataset L). The shop's net sales (its sales revenue after any returns and allowances) were $690,000, and its gross profit was $276,000.

Gross margin: 276,000 ÷ 690,000 = 0.40, or 40 percent.
Cost of goods sold, Year 2: 690,000 − 276,000 = $414,000.
Profit margin: 69,000 ÷ 690,000 = 0.10, or 10 percent.

In words: of each sales dollar, the shop kept 40 cents after the cost of the goods it sold, and 10 cents after every expense.

Here is a caveat. In Week 6, the shop's first bicycle sale (Dataset C) had a gross margin of 50 percent. A whole year's sales of many bicycles, parts, and repairs give a different figure. The gap between those two margins is measured in percentage points, and neither margin is good or bad by itself.

Misconception check. Students often treat a ratio as a recommendation, as in "a 10 percent profit margin means you should invest." A ratio describes what happened; it never tells anyone to buy, sell, or lend. This course gives no investment advice. It teaches you to read the figures accurately.

7. Read a public company's 10‑K on EDGAR

Imagine you are curious about a company whose products you use every day, such as a phone maker or a grocery chain. You do not need a login or a paid service to see its financial statements. They are public, and the law requires them.

Most U.S. public companies file a Form 10‑K with the SEC each year, and every filed 10‑K is public on the SEC's EDGAR website. A Form 10‑K is the annual report that most U.S. public companies file with the Securities and Exchange Commission each year, containing the company's financial statements. EDGAR is the SEC's public website of company filings, where every filed Form 10‑K can be read free of charge.

In practice (your tools). Open EDGAR's company search on sec.gov and type the name of a public company you choose. In its list of filings, open one marked 10‑K. Scroll to the financial statements and find the statement of cash flows. The Readings & Resources page links the SEC's own guide to reading a 10‑K.

Worked example — reading for structure. You open the 10‑K of a company you chose. Its statement of cash flows has a heading with the company's name, the statement's title, and the year. Its operating section starts with net income and adds back depreciation. Below it you find an investing section and a financing section, then the net change in cash. In words: the largest companies use the same three sections the bicycle shop uses, only with bigger numbers.

Here is a limitation to keep in mind. This course reads a real filing for its shape only. A real company's figures change every year, and the course never keys one.

Misconception check. Students often think the quiz will ask for a real company's figures, so they copy numbers from a filing. No real company's figure is ever something this course keys. You read the filing for its structure, and every keyed number in this course comes from the shop's illustrative datasets.

8. Read the running case from Month 1 to Year 2

Think about a photo album that starts on the day a business opened its doors and ends two years later. Each page shows the same business, a little bigger. The course synthesis is a reading of the running case from its first month's transactions to its second year's statement of cash flows, tying each statement to the next.

Worked example — Month 1's cash, sorted (Datasets A and B). In Month 1 the shop recorded twelve transactions and reached total assets of $33,200 (Dataset A). After the six adjustments (Dataset B), its Month 1 net income was $1,400 and its cash was $17,100. The shop started with no cash, so all $17,100 is the month's net increase. Sort it:

Operating receipts: 1,200 + 3,500 + 1,000 = $5,700, from the cycling club's advance, the walk-in repairs, and the delivery company's payment.
Operating payments: 2,400 + 1,500 + 600 + 1,600 = $6,100, for insurance, rent, supplies, and wages.
Operating cash: 5,700 − 6,100 = (400).
Investing cash: (12,000), for the repair equipment.
Financing cash: the founders' 30,000 less the 500 dividend, 30,000 − 500 = $29,500.

The sections total −400 − 12,000 + 29,500 = $17,100, the whole of Month 1's cash.

The bicycle shop's cash flows by section for Month 1 and Year 2, in dollars (illustrative, Datasets A, B, and L)
Section	Month 1	Year 2
Net cash from operating activities	(400)	74,000
Net cash from investing activities	(12,000)	(33,000)
Net cash from financing activities	29,500	8,000
Net increase in cash	17,100	49,000
Cash, end of period	17,100	71,000

The indirect method reaches the same Month 1 operating figure. Start with net income of $1,400 and add back the $200 of depreciation. Every balance started at zero, so each Month 1 ending balance is its increase. Subtract the increases in Accounts Receivable (1,050), Supplies (350), and Prepaid Insurance (2,200). Add the increases in Accounts Payable (300), Wages Payable (400), and Unearned Revenue (900). The result is 1,400 + 200 − 1,050 − 350 − 2,200 + 300 + 400 + 900 = (400).

Then follow the story forward. By the end of Year 1 the shop had $22,000 of cash and $13,000 of retained earnings. In Year 2 it sold new shares, paid a dividend, bought back shares, and earned $69,000. By the end of Year 2 it held $71,000 of cash, $200,000 of total assets, and $140,000 of stockholders' equity.

Now say the whole course in one plain sentence. In Month 1 the shop earned $1,400 while its operations used $400 of cash, and in Year 2 it earned $69,000 while its operations provided $74,000, because net income and cash flow measure different things.

Misconception check. Students often think a business that loses cash from operations in its first month must be failing. The shop's Month 1 operations used $400 because it prepaid a year of insurance and bought supplies before using them, while it still earned $1,400. Read the cash flow beside net income and beside the balance sheet; no single statement tells the whole story.

Key terms

Operating activities — The section of the statement of cash flows that reports the cash effects of running the business day to day. (first used: 1. Sort cash into three activities)
Investing activities — The section that reports cash paid to buy long-lived assets and cash received from selling them. (first used: 1. Sort cash into three activities)
Financing activities — The section that reports cash received from and paid to the owners and lenders. (first used: 1. Sort cash into three activities)
Indirect method — A way of reporting operating activities that starts with net income and adjusts it to cash. (first used: 2. Start the indirect method with net income)
Current operating assets — Current assets that come from running the business, such as Accounts Receivable, Inventory, and Prepaid Insurance. (first used: 3. Adjust for current operating assets and liabilities)
Current operating liabilities — Current liabilities that come from running the business, such as Accounts Payable and Wages Payable. (first used: 3. Adjust for current operating assets and liabilities)
Net increase in cash — The total of the three sections, which equals the change in cash during the period. (first used: 4. Assemble the statement and tie it to cash)
Net cash provided by operating activities — The total of the operating section: the cash operations brought in, after the cash they paid out. (first used: 4. Assemble the statement and tie it to cash)
Financial ratio — One amount from the statements divided by another, read to describe the business, never as good or bad on its own. (first used: 5. Compute the current ratio and debt to total assets)
Current ratio — Current assets divided by current liabilities. (first used: 5. Compute the current ratio and debt to total assets)
Debt to total assets — Total liabilities divided by total assets, written as a percentage. (first used: 5. Compute the current ratio and debt to total assets)
Profit margin — Net income divided by net sales, written as a percentage. (first used: 6. Compute gross margin and profit margin)
Form 10‑K — The annual report most U.S. public companies file with the SEC each year, containing their financial statements. (first used: 7. Read a public company's 10‑K on EDGAR)
EDGAR — The SEC's public website of company filings, where every filed 10‑K can be read free. (first used: 7. Read a public company's 10‑K on EDGAR)
Course synthesis — A reading of the running case from its first month to its second year, tying each statement to the next. (first used: 8. Read the running case from Month 1 to Year 2)

Summary

The statement of cash flows has operating, investing, and financing sections.
Dividends paid are financing cash, not operating cash.
The indirect method starts with net income and adjusts it to cash.
Depreciation is added back because it used no cash, not because it made any.
Increases in current operating assets are subtracted; increases in current operating liabilities are added.
The net increase in cash ties the statement to the balance sheet's cash.
Net income and cash flow differ because accrual accounting ignores when cash moves.
Each ratio is read in one plain sentence, never as good or bad on its own.
A 10‑K is read for its structure; no real figure is keyed.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

A dog-grooming service (illustrative) reports net income of $18,000 and depreciation of $3,000. During the year its Accounts Receivable rose by $1,500 and its Wages Payable rose by $400. Compute its net cash provided by operating activities by the indirect method.
A landscaping company (illustrative) collects $4,500 from customers, buys a mower for $6,000 cash, borrows $10,000 on a note, and pays a $1,200 dividend. Sort each into its section and compute the net change in cash.
A farmers' market stall (illustrative) has current assets of $9,000, current liabilities of $6,000, total liabilities of $12,000, and total assets of $48,000. Compute its current ratio and debt to total assets, and read each in one plain sentence.
A coffee roaster (illustrative) sells a roasting machine with a book value of $4,000 for $5,500 cash. Explain where the $5,500 appears on the statement of cash flows, and why the gain is subtracted in the operating section.

Answers (worked reasoning — read after attempting)

Start with net income of $18,000 and add back the $3,000 of depreciation, because it used no cash. Subtract the $1,500 rise in Accounts Receivable, because those sales have not been collected. Add the $400 rise in Wages Payable, because those wages are expensed but not yet paid. The result is 18,000 + 3,000 − 1,500 + 400 = $19,900.
The $4,500 from customers is operating. The $6,000 mower is investing, shown as (6,000). The $10,000 note and the (1,200) dividend are both financing, for net financing cash of 10,000 − 1,200 = $8,800. The net change in cash is 4,500 − 6,000 + 8,800 = $7,300. The dividend is financing because it is a distribution to owners, not an expense.
The current ratio is 9,000 ÷ 6,000 = 1.5, so the stall holds $1.50 of current assets for each $1 of current liabilities. Debt to total assets is 12,000 ÷ 48,000 = 0.25, or 25 percent, so creditors have a claim on a quarter of its assets. Neither figure is good or bad on its own.
The gain is 5,500 − 4,000 = $1,500, and it sits inside net income. The whole $5,500 of cash is reported in investing activities as the sale of equipment. Subtracting the $1,500 gain in the operating section keeps that cash from being counted twice.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, the quiz, the discussion, and the assignment; next week the cumulative final asks you to apply each method again.

Built with The Course Maker · samples.thecoursemaker.com