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1242 CHAPTER 23 STATEMENT OF CASH FLOWS LEARNING OBJECTIVES After studying this chapter, you should be able to: Describe the purpose of the statement of cash flows. Identify the major classifications of cash flows. Differentiate between net income and net cash flows from operating activities. Contrast the direct and indirect methods of calculating net cash flow from operating activities. Determine net cash flows from investing and financing activities. Prepare a statement of cash flows. Identify sources of information for a statement of cash flows. Discuss special problems in preparing a statement of cash flows. Explain the use of a worksheet in preparing a statement of cash flows. 9 8 7 6 5 4 3 2 1 Investors usually look to net income as a key indicator of a company’s financial health and future prospects. The following graph shows the net income of one company over a seven-year period. Don’t Take Cash Flow for Granted 1 Year Millions of Dollars 40 50 30 0 30 60 234567 Income Cash Flow from Operations PDF Watermark Remover DEMO : Purchase from to remove the watermark
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The company showed a pattern of consistent profitability and even some periods of income growth. Between years 1 and 4, net income for this company grew by 32 percent, from $31 million to $41 million. Would you expect its profitability to continue? The company had consistently paid dividends and interest. Would you expect it to continue to do so? Investors answered “yes” to these questions, by buying the company’s stock. Eighteen months later, this company— W. T. Grant —filed for bankruptcy, in what was then the largest bankruptcy filing in the United States. How could this happen? As indicated by the second line in the graph, the company had experienced several years of negative cash flow from its operations, even though it reported profits. How can a company have negative cash flows while reporting profits? The answer lay partly in the fact that W. T. Grant was having trouble collecting the receiv- ables from its credit sales, causing cash flow to be less than the net income. Investors who analyzed the cash flows would have been likely to find an early warning signal of W. T. Grant’s operating problems. Source : Adapted from James A. Largay III and Clyde P. Stickney,“Cash Flows, Ratio Analysis, and the W. T. Grant Company Bankruptcy,” Financial Analysts Journal (July–August 1980), p. 51. 1243 PREVIEW OF CHAPTER 23 As the opening story indicates, examination of W. T. Grant ’s cash flows from opera- tions would have shown the financial inflexibility that eventually caused the company’s bankruptcy. This chapter explains the main components of a statement of cash flows and the types of information it provides. The content and organization of the chapter are as follows.
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