Case Study: Statement of Cash Flows

1. Case Study: Legacy Clothing

Our case study subject company, Legacy Clothing, is a sole proprietorship, which is a type of company that is owned by a single individual, and where that individual and the business are legally treated as the same.

The purpose of Legacy Clothing as a business is to own and operate clothing/merchandise stores. Think of it like a department store chain, selling men's, women's, and children's clothing and other related items.

Legacy Clothing has locations throughout Washington, DC, and they have a staff of 50 people employed in their stores.

Legacy Clothing needs a statement of cash flows to help them understand the business cash position--how the business used cash in the form of cash payments that were made, and how the business generated cash, referring to the cash receipts that the business received.

We can categorize this activity into three main areas in order to fully understand the cash performance:

• Operating: Activities found on the income statement
• Investing: Transactions involving the sale or purchase of long-term assets, loaning money, and collecting the principal amounts of monies loaned
• Financing: Cash received from financing to fund operations, as well as cash paid to owners

2. Case Study: Statement of Cash Flows

Now, let's turn our attention to preparing a statement of cash flows for our subject company, Legacy Clothing, keeping in mind those three main areas of business.

Here is our statement of cash flows for Legacy Clothing. Note, the starting point for our statement of cash flows is our header, where we put our company name, "Statement of Cash Flows," and, since this is a period-based or activity-based statement, "For the period ending December 31, 2012."

2a. Operating Activities

The first section is the cash flows from operating activities.

We start with net income of $304,000, then make the following adjustments to reconcile net income to cash provided by operating activities:

a) The first adjustment we make, typically, is for depreciation expense. Depreciation is a non-cash event, and since that expense was recorded to determine net income, we need to add it back.

Next is our current assets.

b) If there was a decrease in our accounts receivable, that means that we collected on our accounts receivable, so it needs to go up, adjusted for the cash that we received.

c) An increase in merchandise inventory means that we purchased merchandise inventory; it was a cash event. Therefore, we need to subtract that out.

d) The same applies to supplies; if we purchased supplies, it was a cash event and we need to subtract it out.

Now, let's look at our current liabilities.

e) If there was a decrease in accounts payable, that means that we paid off our accounts payable. It was a cash outflow, so we need to subtract it.

f) If there was an increase in sales tax payable, that means that we recorded an expense for sales tax, which is included here. However, since it wasn't paid, we need to add it back.

g) The decrease in unearned revenue is similar to our decrease in accounts payable, in that it was simply an adjustment when we moved unearned revenue into revenue, because we've already received the cash. Therefore, we need to subtract out this $5,000 from our net income.

Now you will see that all of these transactions offset, meaning our net cash provided by operating activities was $304,000.

2b. Investing Activities

Moving down to our investing activities, the only thing that Legacy Clothing did was purchase a new building. This is a cash outflow, because they spent cash on that building.

In this case, we have net cash used by investing activities, because it is a cash outflow.

2c. Financing Activities

The next section reflects cash flows from financing activities. In this case, Legacy Clothing received a loan from a major bank in order to purchase that building. This is a cash inflow, meaning they brought cash in to make that purchase.

In addition, the owners pulled money out of the business, which is a cash outflow.

So, if we total those together, we see that net cash provided by financing activities equals $250,000.

Now, if we total all three of those sections together--net cash provided by operating activities, net cash used by investing activities, as well as net cash provided by financing activities--it gives us a change in cash of $204,000.

The final step is to take that net change in cash and add our beginning cash balance, which gets us to our ending cash balance--in this case, $324,000.

Remember, this ending cash balance will equal the cash balance on our balance sheet.