Question

Prepare a statement of cash flows--indirect method Presented below are the financial statements of Warner Company.

WARNER COMPANY Comparative Balance Sheet December 31 Assets 2022 2023 Cash $35,000 $20,000 Accounts receivable 20,000 14,000 Inventory 28,000 20,000 Property, plant, and equipment 60,000 78,000 Accumulated depreciation (32,000) (24,000) Total $111,000 $108,000 Liabilities and Stockholders' Equity Accounts payable $19,000 $15,000 Income taxes payable 7,000 8,000 Bonds payable 17,000 33,000 Common stock 18,000 14,000 Retained earnings 50,000 38,000 Total $111,000 $108,000 WARNER COMPANY Income Statement For the Year Ended December 31, 2022 Sales Revenue $242,000 Cost of goods sold 175,000 Gross profit 67,000 Selling expenses $18,000 Administrative expenses 6,000 24,000 Income from operations 43,000 Interest expense 3,000 Income before income taxes 40,000 Income tax expense 8,000 Net income $32,000

Additional data: 1. Depreciation expense was $17,500. 2. Dividends declared and paid were $20,000. 3. During the year equipment was sold for $8,500 cash. This equipment cost $18,000 originally and had accumulated depreciation of $9,500 at the time of sale.

Instructions for Problem 3 (a) Prepare a statement of cash flows using the indirect method. (b) Compute free cash flow.

Answer 1

a) Statement of cashflow using Indirect Method

Cash flow from Operating activities	$
Net profit before Tax and Extra-ordinary items	40,000.00
Adjustments For-
Add:	Depreciation	17,500.00
Add:	Gain or Loss on Sale of Fixed Assets	-
Add:	Interest Dividend	3,000.00
Operating profit before working capital changes	60,500.00
Add:	Decrease in receivables	6,000.00
Add:	Decrease in Inventories	8,000.00
Add:	Trade payables	-
Cash generated from Operations	74,500.00
Less:	Interest Paid	(3,000.00)
Less:	Direct Taxes	(8,000.00)
Net Cash flow from operating activities	63,500.00

Cash flow from Investing activities
Less:	Purchase of fixed assets	-
Add:	Proceeds of Sale of Fixed Assets	8,500.00
Add:	Interest Received	-
Add:	Dividend Received	-
Net cash flow from Investing Activities	8,500.00
Cash flow from Financing activities
Add:	Proceeds from Issue of Share Capital	4,000.00
Add:	Proceeds from Long term Borrowings	16,000.00
Less:	Repayment of Long term Borrowings	-
Less:	Interest Paid	(3,000.00)
Less:	Dividend Paid	(20,000.00)
Net cash flow from financing activities	(3,000.00)

Net Cash flow from operating activities	60,500.00
Add: Cash flow from Investing activities	8,500.00
Add: Cash flow from Financing activities	(3,000.00)
Net Increase or Decrease in Cash	66,000.00

Step 1:  Indirect Method of Cash flow statement should be prepared based on the operating, investing and financing activities of a company.

Step 2: Net cash flow from Operating activities can be calculated by adding depreciation, gain on disposal of asset and interest dividend to net pofit before tax amount. Depreciation is added back to net profit as it is non-cash expenses.

There is no gain or loss in the disposal of assets. Because equipment cost $18,000 and accumalated depreciation is $9,500. Therefore, net amount of asset is $18,000 - $9,500 = $8,500. Net value of asset is $8,500 and this asset is sold for $8,500. Therefore, $8,500 - $8,500 = $0, no gain or loss on disposal of asset.

Therefore, operating profit before working capital changes should be, $40,000+$17,500= $57,500

Step 3:  Then, working capital changes should be added or deducted to $57,500 (operating profit before working capital changes)

Here, inventory and receivables decrease in 2023 by $6,000 and $8,000 and no trade payables for the Warner Company.

Decrease or Increase in Working Capital
	2022	2023	Dec/Inc
Accounts receivables	20,000.00	14,000.00	(6,000.00)
Inventory	28,000.00	20,000.00	(8,000.00)
Trade Payable	0.00	0.00	0.00

Decrease in inventory means more of the inventory has converted to finished goods and increase sales therefore more cash inflow to company.  Decrease in accounts recivables means customers are paying cash to company quickly and there is only less credit sales. Therefore, decrease in inventory and receivables should be added to cash flow operating activities.

So, cash generated from operations should be $57,500+$6,000+$8,000 = $ 71,500

Step 4: Deduct interest paid and tax paid, which has actually paid or there is outflow of cash.

  Therefore, net cash flow from operating activities should be $71,500- $3,000-$8,000 = $60,500

Step 5: In investing activities, purchase of assets should be deducted because cash is paid to buy the asset and add back when an asset is sold because the company receives cash while selling the assets. In the same way, interest and dividends received should be added as there is cash inflow.

Here, net cashflow from investing activities is the amount that is derived only through disposal of assets $8,500

Step 6: Cash flow from financing activities are calculated by adding proceeds from issue of share capital and long term borrowing and deduction of repayment of borrowing, interest paid and dividen paid. Bonds payable increase by $16,000 in 2023 which means more debt has been taken which resulted in cash inflow and stock has reduced by $4,000 which means stock has been sold which also proves cash inflow.

Decrease or Increase in Share Capital and Long Term Debt
	2022	2023	Dec/Inc
Bonds payable	17,000.00	33,000.00	16,000.00
Common stock	18,000.00	14,000.00	(4,000.00)

So, net cash flow from financing activities is $16,000+$4,000+(3,000) + $(20,000) = $(3,000)

Step 7: Add net cash flow from investing and financing activities to net cash flow from operating activities to derive net cash flow of Warner Company for the year 2023.

Therefore, net increase in cash flow should be $60,500+$8,500-$3,000 = $66,000

b) Free Cash flow Method
Cash flows from Operating Activities
	Cash received from customers	242,000.00
Less:	Cash paid for suppliers	(175,000.00)
Less:	Cash paid to employees	-
Less:	Cash paid for interest	(3,000.00)
Less:	Cash paid for income taxes	(8,000.00)
Net cash from operating activities	56,000.00
Cash flows from Investing Activities
Less:	Purchase of assets	-
Net cash used in investing activities	-
Cash flows from Financing Activities
Add:	Issuance of common stock	4,000.00
Add:	Payments on long-term debt	16,000.00
Less:	Dividends paid	(20,000.00)
Net cash used in financing activities	-
Net increase/decrease in cash	56,000.00

In free cash flow method depreciation, working capital changes and disposal of assets has not that makes the difference of $10,000 between two cash flow methods