Question

Preparing a Statement of Cash Flows (Indirect Method)

Rainbow Company's income statement and comparative balance sheets follow.

RAINBOW COMPANY Income Statement For Year Ended December 31, 2016
	Sales		$3,375,000
	Dividend Income		67,500
	Total Revenue		3,442,500
	Cost of Goods Sold	$1,980,000
	Wages and Other Operating Expenses	585,000
	Depreciation Expense	175,500
	Patent Amortization Expense	31,500
	Interest Expense	58,500
	Income Tax Expense	198,000
	Loss on Sale of Equipment	22,500
	Gain on Sale of Investments	(13,500)	3,037,500
	Net Income		$405,000

RAINBOW COMPANY Balance Sheets
		December 31, 2016	December 31, 2015
	Assets
	Cash and Cash Equivalents	$122,500	$112,500
	Accounts Receivable	180,000	135,000
	Inventory	463,500	346,500
	Prepaid Expenses	45,000	27,000
	Long-Term Investments	-	256,500
	Land	855,000	450,000
	Buildings	2,002,500	1,575,000
	Accumulated Depreciation-Buildings	(409,500)	(337,500)
	Equipment	805,500	1,012,500
	Accumulated depreciation-Equipment	(189,000)	(207,000)
	Patents	225,000	144,000
	Total Assets	$4,100,500	$3,514,500
	Liabilities and Stockholders’ Equity
	Accounts Payable	$127,000	$72,000
	Interest Payable	27,000	22,500
	Income Tax Payable	36,000	45,000
	Bonds Payable	697,500	562,500
	Preferred Stock ($100 par value)	450,000	337,500
	Common Stock ($5 par value)	1,705,500	1,638,000
	Paid-in capital in excess of par value-Common	598,500	558,000
	Retained Earnings	459,000	279,000
	Total Liabilities and Stockholders’ Equity	$4,100,500	$3,514,500

During 2016, the following transactions and events occurred:

1		Sold long-term investments costing $256,500 for $270,000 cash.
2		Purchased land for cash.
3		Capitalized an expenditure made to improve the building.
4		Sold equipment for $63,000 cash that originally cost $207,000 and had $121,500 accumulated depreciation.
5		Issued bonds payable at face value for cash.
6		Acquired a patent with a fair value of $112,500 by issuing 1,125 shares of preferred stock at par value.
7		Declared and paid a $225,000 cash dividend.
8		Issued 13,500 shares of common stock for cash at $8 per share.
9		Recorded depreciation of $72,000 on buildings and $103,500 on equipment.

Required

a. Compute the change in cash and cash equivalents that occurred during 2016.
$Answer

b. Prepare a 2016 statement of cash flows using the indirect method.

RAINBOW COMPANY STATEMENT OF CASH FLOWS FOR YEAR ENDED DECEMBER 31, 2016
Cash flows from operating activities
Patent amortizationIssuance of preferred stock to acquire patentIssuance of bonds payableNet incomeNet change in cashPurchase of landBeginning cash balance
Add (deduct) items to convert net income to cash basis
Depreciation
Patent amortizationIssuance of preferred stock to acquire patentIssuance of bonds payableNet incomeNet change in cashPurchase of landBeginning cash balance
Loss on sale of equipment
Gain on sale of investments
Accounts receivable increase
Inventory increase
Prepaid expenses increase
Accounts payable increase
Interest payable increase
Income tax payable decrease
Net cash provided by operating activities
Cash flows from investing activities
Sale of investments
Patent amortizationIssuance of preferred stock to acquire patentIssuance of bonds payableNet incomeNet change in cashPurchase of landBeginning cash balance
Improvements to building
Sale of equipment
Net cash used by investing activities
Cash flows from financing activities
Patent amortizationIssuance of preferred stock to acquire patentIssuance of bonds payableNet incomeNet change in cashPurchase of landBeginning cash balance
Issuance of common stock
Payment of dividends
Net cash provided by financing activities
Patent amortizationIssuance of preferred stock to acquire patentIssuance of bonds payableNet incomeNet change in cashPurchase of landBeginning cash balance
Patent amortizationIssuance of preferred stock to acquire patentIssuance of bonds payableNet incomeNet change in cashPurchase of landBeginning cash balance
Ending cash balance

c. Prepare separate schedules showing (1) cash paid for interest and for income taxes and (2) noncash investing and financing transactions.

(1) Supplemental Cash Flow Disclosures
Cash paid for interest
Cash paid for income taxes
(2) Schedule of noncash investing and financing activities:
Patent amortizationIssuance of preferred stock to acquire patentIssuance of bonds payableNet incomeNet change in cashPurchase of landBeginning cash balance

d. Compute its (1) operating cash flow to current liabilities ratio, (2) operating cash flow to capital expenditures ratio, and (3) free cash flow.
Round your answers to (1) and (2) to two decimal places.

(1)	Operating cash flow to current liabilities ratio
(2)	Operating cash flow to capital expenditures ratio
(3)	Free cash flow

Answer 1

a) Change in Cash and Cash Equivalents during 2016 = Balance in 2016 - Balance in 2015

= $122,500 - $112,500 = $10,000

There is a net increase in cash and cash equivalents by $10,000.

b)

RAINBOW COMPANY STATEMENT OF CASH FLOWS FOR YEAR ENDED DECEMBER 31, 2016
Cash flows from operating activities
Net income		405,000
Add (deduct) items to convert net income to cash basis
Depreciation	175,500
Patent amortization	31,500
Loss on sale of equipment	22,500
Gain on sale of investments	(13,500)
Accounts receivable increase (180,000-135,000)	(45,000)
Inventory increase (463,500-346,500)	(117,000)
Prepaid expenses increase (45,000-27,000)	(18,000)
Accounts payable increase (127,000-72,000)	55,000
Interest payable increase (27,000-22,500)	4,500
Income tax payable decrease (36,000-45,000)	(9,000)	86,500
Net cash provided by operating activities (A)		491,500
Cash flows from investing activities
Sale of investments	270,000
Purchase of land (855,000-450,000)	(405,000)
Improvements to building (2,002,500-1,575,000)	(427,500)
Sale of equipment	63,000
Net cash used by investing activities (B)		(499,500)
Cash flows from financing activities
Issuance of bonds payable (697,500-562,500)	135,000
Issuance of common stock (13,500*$8)	108,000
Payment of dividends	(225,000)
Net cash provided by financing activities (C)		18,000
Net change in cash (A+B+C)		10,000
Beginning cash balance		112,500
Ending cash balance		122,500

Notes:-

a) all non cash expenses and non operating expense & incomes are adjusted from net income (i.e. depreciation, patent amortization, loss and gain on sale of equipment).

b) Increase in current assets is deducted, increase in current liabilities is added, decease in current liabilities is deducted and decrease in current assets is added to net income for calculating cash flows from operating activities by indirect method.

c) Supplement cash flow disclosures are shown as follows:

(1) Supplemental Cash Flow Disclosures
Cash paid for interest (Beg Balance+Interest expense-Ending Balance)	54,000 (22,500+58,500-27,000)
Cash paid for income taxes (Beg Balance+Income tax expense-Ending Balance)	207,000 (45,000+198,000-36,000)
(2) Schedule of non cash investing and financing activities:
Issuance of preferred stock to acquire patent	112,500

d) 1) Current Liabilities for 2016 = Accounts Payable+Interest Payable+Income tax Payable

= $127,000+$27,000+$36,000 = $190,000

Operating cash flows to current liabilities ratio = Operating Cash flows/Current Liabilities for 2016

= $491,500/$190,000 = 2.59

2) Operating cash flows to capital expenditures ratio = Operating cash flows/Capital expenditures

Capital expenditures = Purchase of Land+Improvements to Building - Net Book Value of equipment sold

= $405,000+$427,500-($207,000 Cost-$121,500 Acc Dep.)

= $405,000+$427,500-$85,500 = $747,000

Operating cash flows to capital expenditures ratio = 491,500/747,000 = 0.66

3) Free cash flow = Cash flows from operating activities - Capital Expenditures

= $491,500 - $747,000 = ($255,500)