The Statement of
THE THIRD CRITICAL FINANCIAL STATEMENT, along with the balance sheet and the income statement, is called the statement of cash flows. In the past it was called the sources and uses of funds statement, which is a more accurate description of the information it contains. It describes in summary form how the company generated the cash flows it needed (sources) to finance its various financial opportunities and responsibilities (uses) during the past year. The sources and uses of funds statement for
Metropolitan Manufacturing Company is shown in Exhibit 3-1. As you go through it, notice that the line items appear on the balance sheet in the column labeled “Changes.” In fact, the sources and uses of funds statement describes the changes in the balance sheet between two successive years, in this case 2002 and 2001. What we will do in this chapter is:
1. Present a sources and uses of funds statement.
2. Discuss the meaning of each number.
3. Describe how each number was developed, relating it back to its source on the balance sheet.
4. Restate the numbers in the statement of cash flows format.
Exhibit 3-1. Metropolitan Manufacturing Company, Inc.
Sources and Uses of Funds for the Year Ending December 31, 2002
Sources of Funds
34. Net Income $156,000
35. Depreciation 56,000
36. Increase in Bank Notes 130,000
37. Increase in Accounts Payable 110,000
38. Increase in Other Current Liabilities 39,000
39. Decrease in Investments 3,000
40. Total Sources of Funds $494,000
Uses of Funds
41. Capital Expenditures $ 34,000
42. Increase in Inventory 298,000
43. Increase in Accounts Receivable 40,000
44. Decrease in Long-Term Debt 50,000
45. Payment of Cash Dividends 46,000
46. Total Uses of Funds $468,000
47. Net Increase in Cash Balance in 2002 26,000
48. 2001 Ending Cash
49. 2002 Ending Cash Balance $133,000
Sources of Funds
34. Net Income, $156,000
The company’s profits are a major source of funds. Therefore, net income is traditionally listed first. This number is also the “bottom-line” number in the income statement (line 31). In addition, it strongly affects the retained earnings amount on the balance sheet (line 21). Net income causes retained earnings to increase. Payments of cash dividends cause retained earnings to decrease. Therefore, the $110,000 change in retained earnings (income statement, line 33) is the net of:
Net Income $156,000 (31 and 34)
– Dividends – 46,000 (32)
= Change in Retained Earnings $110,000 (33)
35. Depreciation Expense, $56,000
In a more formal version of this statement, this item would be preceded by the heading “Add Back Items Not Requiring the Disbursement of Cash.” The explanation of this is related to the discussion of expenses and expenditures in Chapter 1. When net income was calculated, an expense item was subtracted (line item 28) that did not require a cash expenditure during this period and will never require one in the future. The item is depreciation expense. The expenditures related to this expense – i. e., capital expenditures – have already taken place.
The depreciation expense was subtracted on line 28 for two reasons. First, generally accepted accounting principles (GAAP) require this. Second, depreciation expense is deductible as an expense for corporate income tax purposes, and so including it provides tax benefits.