Question

CP 16-5 Analysis of statement of cash flows Dillip Lachgar is the president and majority shareholder of Argon Inc., a small retail chain store. Recently, Dillip submitted a loan application for Argon Inc. to Compound Bank. It called for a $600,000, 9%, 10-year loan to help finance the construction of a building and the purchase of store equipment, costing a total of $750,000. This will enable Argon Inc. to open a store in the town of Compound. Land for this purpose was acquired last year. The bank's loan officer requested a statement of cash flows in addition to the most recent income statement, balance sheet, and retained earnings statement that Dillip had submitted with the loan application. As a close family friend, Dillip asked you to prepare a statement of cash flows. From the records provided, you prepared the following statement:

Answer 1

ANSWER:-

a. Response to each of the Dillip's questions 1. Mere appearance of depreciation on the cash flow statement does not denote that depreciation is a cash flow. In determination of net cash flow from operating activities, we make certain adjustments to the net income to arrive at the net cash flow from operating activities. Because the net income is calculated on accrual basis, which takes into account, the non-cash and non-operating transactions like depreciation, gain/loss on sale of fixed assets. But since the cash flow statement is prepared on the cash basis, the non-cash and non-operating items are adjusted to the net income to arrive at the net cash flow from operating activities. Here, the depreciation is non-cash expenditure; hence it is added back to the net income to get the correct amount of cash flow from operating activities.

2. Noncash investing and financing activities do not directly affect the cash. In our case, common stock is issued for purchasing land, which is a noncash activity. Although this transaction does not directly affect cash, it will eliminate the cash payment for purchase of land. Because this transaction indirectly affects cash flows, it is reported in a separate section of the statement of cash flows, at the bottom of the statement. This transaction should not be eliminated from the statement since it affects the cash flows indirectly

3. As we already discussed earlier, non-cash and non-operating items are adjusted to the net income to arrive at the net cash flow from operating activities. Gain on sale of investments is a non-operating profit. Net income is arrived after addition of gain on sale of investments in the income statement. But non operating profit should not be included in net income in order to get the cash flow from operating activities. Hence it is deducted from the net income to arrive at the net flow from operating activities.

4. The bank needs the statement of cash flows, because it provides the bankers, the information about the company's ability in generating cash from operations, maintaining and expanding the operating capacity, and information about meeting financial obligations. Cash flow statement reports the company's cash inflows and cash out flows from operating, investing and financing activities in detail. But the bank could not get all this information about the cash flows of the company by simply computing the increase in cash from the balance sheets of the last two years.