Course Title: Financial Statement Analysis Course Code: MGT-537 Course Instructor: Dr. Hafiz Muhammad Ishaq Total Lectures: 32

Previous Lecture Summary Statement of Cash Flows Financial Ratios and the Statement of Cash Flows, Practical Exercises

Today’s Lecture Topics Statement of Cash Flows Operating Cash Flow/Current Maturities of Long-Term Debt and Current Notes Payable, Operating Cash Flow/Total Debt, Operating Cash Flow Per Share, Operating Cash Flow/Cash Dividends Alternative Cash Flow, Procedures for Development of the Statement of Cash Flows Practical Exercises Today’s Lecture Topics

Financial Ratios and the Statement of Cash Flows Statement of cash flows is relatively new Required presentation began in 1987 Cash flow financial ratios were slowly developed Traditional ratios relate balance sheet to income statement

Operating Cash Flow/Current Maturities of Long-Term Debt and Current Notes Payable Indicates a firm’s abilities to meet its current maturities of debt Higher ratio indicates better liquidity

Operating Cash Flow to Total Debt Indicates a firm’s ability to cover total debt with the yearly operating cash flow Conservative approach is to include all possible balance sheet debt

Operating Cash Flow Per Share A better indication of a firm’s ability to make capital expenditure decisions and pay dividends than is earnings per share Does not reflect firm’s profitability Firms are prohibited from reporting this statistic in financial statements or in the notes thereto

Operating Cash Flow to Cash Dividends Indicates a firm’s ability to cover cash dividends with the yearly operating cash flow

Alternative Cash Flow No standard definition of cash flow A summary of the actual or anticipated incomings and outgoings of cash in a firm over an accounting period (month, quarter, year). No standard definition of cash flow Alternative definition Net income plus depreciation expense Less useful than the net cash flow from operating activities

Procedures to Develop the Statement of Cash Flows Analyze all balance sheet accounts other than cash and cash equivalents. Increase Decrease Current assets Operating outflow Operating inflow Noncurrent assets Investing outflow Investing inflow Current liabilities Long-term liabilities Financing inflow Financing outflow Stockholders’ equity

Procedures to Develop the Statement of Cash Flows (Cont’d) Determine change in cash and cash equivalents Compute the change in all other balance sheet accounts Classify as operating, investing, and financing

Procedures to Develop Direct Operating Cash Flows Operating section describes income statement accounts as receipts or payments Cash receipts From customers From other operating sources Cash payments For merchandise To employees For other operating expenses

Procedures to Develop Indirect Operating Cash Flows Begin with net income Eliminate gains and losses that relate to investing and financing activities Add back or deduct adjustments to change accrual-based net income to cash basis Current noncash assets Current liabilities

Practical Exercise Melvin Company Balance Sheet The following statements are presented for Melvin Company. Melvin Company Balance Sheet December 31, 2010, and 2009 Assets 2010 2009 Cash $ 625 $ 499 Marketable securities, 260 370 Trade accounts receivable, less allowances of 36 in 2010 and 18 in 2009 1,080 820 Inventories, FIFO 930 870 Prepaid expenses   230 220 Total current assets $3,125 $2,779 Investments  $  820  $  600

Practical Exercise (Cont’d) Property, plant, and equipment:   Land $ 130 $ 127 Buildings and improvements 760 670 Machinery and equipment 2,100  1,400 $2,990 $2,197 Less allowances for depreciation 1,100   890 $1,890 $1,307 Goodwill   500   550 Total assets $6,335 $5,236

Practical Exercise (Cont’d) Liabilities and Shareholders' Equity   Accounts payable $1,200 $  900 Accrued payroll 100 80 Accrued taxes   300   200 Total current liabilities $1,600 $1,180 Long-term debt 900 750 Deferred income taxes 300 280 Shareholders' equity: Common stock 1,000 Retained earnings 2,535 2,026 Total liabilities and shareholders' equity $6,335 $5,236

Practical Exercise (Cont’d) Melvin Company Income Statement For the Year Ended December 31, 2010 Net sales $8,000 Cost of goods sold 3,900 Gross profit $4,100 Selling, administrative, and general expenses 2,600 Operating income $1,500 Interest expense   100 Income before income taxes $1,400 Income taxes   400 Net income $1,000 Net income per share $ 2.00 Note: 500 shares of common stock were outstanding.

Practical Exercise (Cont’d) Melvin Company Statement of Cash Flows For the Year Ended December 31, 2010 Cash flows from operating activities: Net income $1,000  Adjustments to reconcile net income to net cash provided by Operating activities:   Depreciation $210  Amortization 50  Increase in accounts receivable (260) Increase in inventories (60) Increase in prepaid expenses (10) Increase in accounts payable 300 Increase in accrued payroll 20 Increase in accrued taxes 100   350  Net cash provided by operating activities $1,350 

Practical Exercise (Cont’d) Cash flows from investing activities:   Outflow for investments $(220) Outflow for property, plant, and equipment (793) Net cash outflow for investing activities (1,013) Cash flows from financing activities: Inflow from issuance of bonds $ 150  Inflow from deferred taxes 20  Dividends paid (491) (321) Net increase in cash and cash equivalents $   16 

Practical Exercise (Cont’d) a. Compute the following for 2010: 1. working capital 2. current ratio 3. acid-test ratio (conservative) 4. operating cash flow/current maturities of long-term debt and current notes payable 5. operating cash flow/total debt 6. operating cash flow per share b. 1. Review the statement of cash flows and comment on significant items. 2. Comment on cash dividends in relation to net income and net cash provided by operating activities. c. 1. Which items appearing on the cash flow statement do not directly represent cash flow? 2. Why are these items disclosed on the cash flow statement?

B. (1) Net cash provided by operating activities was $1,350, cash outflow for investing was $1,013, and net cash outflow for financing activities was $321. Cash outflow for property, plant, and equipment was significant in relation to cash provided by operations. B. (2) Cash dividends represent 49% of net income and 36% of cash provided by operating activities.

C. (1) Depreciation; Amortization. C. (2) The cash flows from operating activities is presented using the indirect approach. This approach starts with net income and adjusts to net cash provided by operating activities. Since the noncash items of depreciation and amortization have been considered to be expenses on the income statement, they need to be added back.

Practical Exercise Arrowbell Company is a growing company. Two years ago it decided to expand in order to increase its production capacity. The company anticipates that the expansion program can be completed in another two years. Financial information for Arrowbell Company follows: Arrowbell Company Sales and Net Income Year Sales Net Income 2001 $2,568,660 $145,800 2002 $2,660,455 $101,600 2003 $2,550,180 $ 52,650 2004 $2,625,280 $ 86,800 2005 $3,680,650 $151,490

Practical Exercise (Cont’d) Arrowbell Company Balance Sheet December 31, 2005 and 2004 2005 2004 Assets Current assets: Cash $ 250,480 $260,155 Accounts receivable (net) $760,950 $690,550 Inventories at lower of cost or market $725,318 $628,238 Prepaid expenses $ 18,555 $ 20,250 Total current assets $1,755,303 $1,599,193 Plant and equipment: Land, building, machinery, and equipment $3,150,165 $2,646,070 Less Accumulated depreciation $ 650,180 $ 525,650 Net plant and equipment $2,499,985 $2,120,420 Other assets: Cash surrender value of life insurance $ 20,650 $ 18,180 Other $ 40,660 $ 38,918 Total other assets $ 16,310 $ 57,098 Total assets $4,316,598 $3,776,711

Practical Exercise (Cont’d) Liabilities and Stockholders’ Equity Current liabilities: Notes and mortgages payable, current portion $ 915,180 $ 550,155 Accounts payable and accrued liabilities $1,150,111 $ 851,080 Total current liabilities $ 2,075,291 $ 1,401,235 Long term notes and mortgages payable Less current portion above $ 550,000 $ 775,659 Total liabilities $2,625,291 $2,176,894 Stockholders’ equity: Capital stock, par value $1.00; authorized 800,000; issued and outstanding 600,000 (2005 and 2004) $600,000 $600,000 Paid in excess of par $890,000 $890,000 Retained earnings $201,307 $109,817 Total stockholders’ equity $1,691,307 $1,599,817 Total liabilities and stockholders’ equity $4,316,598 $3,776,711

Practical Exercise (Cont’d) Arrowbell Company Cash Flow statement December 31, 2005 and 2004 Cash flows from operating activities 2005 2004 Net Income $151,490 $86,800 Noncash expenses revenues losses And gains included in income: Depreciation 134,755 102,180 Increase in accounts receivable (70,400) (10,180) Increase in inventories (97,080) (15,349) Decrease in prepaid expenses In 2005, increase in 2004 1,695 (1,058) Increase in accounts payable And accrued liabilities 309,031 15,265 Net cash provided by operating activities 429,491 177,658

Practical Exercise (Cont’d) Cash flows from investing activities: Proceeds from retirement of Property plant and equipment 10,115 3,865 Purchase of property plant And equipment (524,435) (218,650) Increase in cash surrender Value of life insurance (2,470) (1,845) Other (1,742) (1630) Net cash used for investing activities (518,532) (218,263) Cash flows from financing activities: Retirement of long term debt (225,659) (50,000) Increase in notes and mortgages payable 365,025 159,155 Cash dividends (60,000) (60,000) Net cash provided by financing activities 79,366 49,155 Net increase (decrease) in cash $(9,675) $8,550

Practical Exercise (Cont’d) Required: Comment on the short term debt position, including computations of current ratio, acid test ratio, cash ratio and operating cash flow /current maturities of long term debt and current notes payables If you were a supplier to this company what would you be concerned about? Comment on the long term debt position including computations of the debt ratio, debt/equity, and debt to tangible net worth and operating cash flow/total debt. Review the statement of operating cash flows. If you were a banker, what would you be concerned about if this company approached you for a long term loan to continue its expansion program? What should management consider doing at this point in regard to the company’s expansion program?

A. Comment The usual guideline for the current ratio is two to one. Arrowbell Company had a 1.14 to 1 ratio in 2004 and a .85 to 1 ratio in 2005. The usual guideline for the acid-test ratio is one to one. Arrowbell Company had a .68 to 1 ratio in 2004 and a .49 to 1 ratio in 2005. The cash ratio dropped from .19 in 2004 to .12 in 2005. The working capital in 2004 was $197,958, and in 2005 it had declined to a negative $319,988. The short-term debt position appears to be very poor.

B. Supplier Concern Suppliers will be concerned that Arrowbell Company will not be able to pay its creditors and, if payment is made, it will be later than the credit terms. The short-term creditors are financing the expansion program.

C. Comments The debt ratio has increased in 2005 to .61 from .58 in 2004. The debt/equity ratio has increased in 2005 to 1.55 from 1.36 in 2004. (A similar increase in the debt to tangible net worth as the increase in the debt/equity ratio.) There was an improvement in the operating cash flow/total debt, but this ratio remains very low. This indicates that a substantial amount of funds are coming from creditors. In general the dependence on creditors worsened in 2005.

Comments (Cont’d) Not enough information is available to compute the times interest earned, but we can estimate this to be between 2 and 3, based on the earnings and the debt. We would like to see the times interest earned to be higher than this amount. The review of the Statement of Cash Flows indicates that long-term creditors are going to be concerned by the use of debt to expand property, plant, and equipment. They also are going to be concerned by the payment of a dividend while the working capital is in poor condition

D. Banker Concern A banker would be especially concerned about the short-term debt situation. This could lead to bankruptcy, even though the firm is profitable. A banker would be particularly concerned why management had used short-term credit to finance long-term expansion.

E. Management Consideration Management should consider the following or a combination of the following: Discontinue the expansion program at this time and get the short-term debt situation in order. Tighten control of accounts receivable and inventory, along with using funds from operations to reduce short-term debt. Issue additional stock to improve the short-term liquidity problem and the long-term debt situation. Because of the poor record on profitability and the way that management has financed past expansion, additional stock will probably not be well-accepted in the market place at this time.

Lecture Summary Statement of Cash Flows Operating Cash Flow/Current Maturities of Long-Term Debt and Current Notes Payable, Operating Cash Flow/Total Debt, Operating Cash Flow Per Share, Operating Alternative Cash Flow Procedures for Development of the Statement of Cash Flows Practical Exercises Lecture Summary