Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1 Understanding Financial Statements NINTH EDITION Lyn M. Fraser Aileen Ormiston

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-2 Copyright Notice All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-3 Chapter 4: Statement of Cash Flows “Joan and Joe: A Tale of Woe” Joe added up profits and went to see Joan, Assured of obtaining a much-needed loan. When Joe arrived, he announced with good cheer: “My firm has had an outstanding year, And now I need a loan from your bank.” Eyeing the statements, Joan’s heart sank. “Your profits are fine,” Joan said to Joe. “But where, oh where, is your company’s cash flow? I’m sorry to say: the answer is ‘no’.” --L. Fraser

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-4 Statement of Cash Flows It is possible for a company to post a healthy net income but not have cash needed to pay its employees, suppliers, and bankers. Positive net income on the income statement is ultimately insignificant unless a company can translate its earnings into cash.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-5 Statement of Cash Flows Provides information about cash inflows and outflows during an accounting period Extremely important as an analytical tool Only source in financial statement data for learning about the generation of cash from operations

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-6 Preparing a Statement of Cash Flows Begins with a return to the balance sheet Requires a reordering of the information presented on a balance sheet Shows changes over time rather than the absolute dollar amount of the accounts at a point in time

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-7 Preparing a Statement of Cash Flows Prepared by calculating changes in all of the balance sheet accounts, including cash calculating changes in all of the balance sheet accounts, including cash listing the changes in all of the accounts except cash as inflows or outflows listing the changes in all of the accounts except cash as inflows or outflows categorizing the flows by operating, financing, or investing activities categorizing the flows by operating, financing, or investing activities The inflows less the outflows balance to and explain the change in cash.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-8 Four Parts of a Statement of Cash Flows Cash Cash Operating activities Operating activities Investing activities Investing activities Financing activities Financing activities

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-9 Four Parts of a Statement of Cash Flows Cash Cash and highly liquid short-term marketable securities Cash and highly liquid short-term marketable securities Also called cash equivalents Also called cash equivalents If a company separates marketable securities into two accounts (cash and cash equivalents and short-term investments), the short-term investments are classified as investing activities. If a company separates marketable securities into two accounts (cash and cash equivalents and short-term investments), the short-term investments are classified as investing activities.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-10 Four Parts of a Statement of Cash Flows Operating activities Delivering or producing goods for sale and providing services Delivering or producing goods for sale and providing services Cash effects of transactions and other events Cash effects of transactions and other events

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-11 Four Parts of a Statement of Cash Flows Investing activities Acquiring and selling or otherwise disposing of securities that are Acquiring and selling or otherwise disposing of securities that are − not cash equivalents − productive assets that are expected to benefit the firm for long periods of time Lending money and collecting on loans Lending money and collecting on loans

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-12 Four Parts of a Statement of Cash Flows Financing activities Borrowing from creditors and repaying the principal Borrowing from creditors and repaying the principal Obtaining resources from owners and providing them with a return on the investment Obtaining resources from owners and providing them with a return on the investment

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-13 Preparing a Statement of Cash Flows First Step: Look at changes in balance sheet accounts from the beginning to the end of an accounting period. Next Step: Transfer the account changes to the appropriate area of a statement of cash flows.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-14 Preparing a Statement of Cash Flows InflowOutflow - Asset account + Asset account + Liability account - Liability account + Equity account - Equity account

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-15 Preparing a Statement of Cash Flows Operating activities – inflows Revenue from sales of goods Revenue from sales of goods Revenue from services Revenue from services Returns on equity securities (dividends) Returns on equity securities (dividends) Returns on interest-earning assets (interest) Returns on interest-earning assets (interest)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-16 Preparing a Statement of Cash Flows Operating activities – outflows Payments for purchases of inventory Payments for purchases of inventory Payments for operating expenses (salaries, rent, etc.) Payments for operating expenses (salaries, rent, etc.) Payments for purchases from suppliers, other than inventory Payments for purchases from suppliers, other than inventory Payments to lenders (interest) Payments to lenders (interest) Payments for taxes Payments for taxes

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-17 Preparing a Statement of Cash Flows Investing activities – inflows Revenue from sales of long-lived assets Revenue from sales of long-lived assets Returns from loans (principal) to others Returns from loans (principal) to others Revenue from sales of debt or equity securities of other entities (except securities traded as cash equivalents) Revenue from sales of debt or equity securities of other entities (except securities traded as cash equivalents)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-18 Preparing a Statement of Cash Flows Investing activities – outflows Acquisitions of long-lived assets Acquisitions of long-lived assets Loans (principal) to others Loans (principal) to others Purchase of debt or equity securities of other entities Purchase of debt or equity securities of other entities

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-19 Preparing a Statement of Cash Flows Financing activities – inflows Proceeds from borrowing Proceeds from borrowing Proceeds from issuing the firm’s own equity securities Proceeds from issuing the firm’s own equity securities Financing activities – outflows Repayments of debt principal Repayments of debt principal Repurchase of a firm’s own shares Repurchase of a firm’s own shares Payments of dividends Payments of dividends

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-20 Calculating Cash Flow from Operating Activities Operating activities represent cash generated internally. Investing and financing activities provide cash from external sources. Firms may use one of two methods to calculate cash flow: Direct Method Direct Method Indirect Method Indirect Method

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-21 Calculating Cash Flow from Operating Activities Direct and indirect methods yield identical figures for net cash flow from operating activities, because the underlying accounting concepts are the same. 594 firms out of 600 used the indirect method in 2007 according to Accounting Trends and Techniques.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-22 Direct Method Shows cash collections from customers cash collections from customers interest and dividends collected interest and dividends collected other operating cash receipts other operating cash receipts cash paid to suppliers and employees cash paid to suppliers and employees interest paid interest paid taxes paid taxes paid other operating cash payments other operating cash payments

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-23 Indirect Method Starts with net income and adjusts for deferrals deferrals accruals accruals noncash items, such as depreciation and amortization noncash items, such as depreciation and amortization nonoperating items, such as gains and losses on asset sales nonoperating items, such as gains and losses on asset sales

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-24 Net Cash Flow from Operating Activities – Indirect Method Depreciation and amortization are added to net income. Increase in deferred tax liability is added. Decrease in deferred tax liability is deducted. Increase in deferred tax asset is deducted. Decrease in deferred tax asset is added.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-25 Net Cash Flow from Operating Activities – Indirect Method Increase in investment account from equity income is deducted. Decrease in investment account from equity income is added. Gain on sale of assets is deducted. Loss on sale of assets is added.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-26 Net Cash Flow from Operating Activities – Indirect Method Increase in accounts receivable is deducted. Decrease in accounts receivable is added. Increase in inventory is deducted. Decrease in inventory is added. Increase in prepaid expenses is deducted. Decrease in prepaid expenses is added.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-27 Net Cash Flow from Operating Activities – Indirect Method Increase in interest receivable is deducted. Decrease in interest receivable is added. Increase in accounts payable is added. Decrease in accounts payable is deducted.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-28 Net Cash Flow from Operating Activities – Indirect Method Increase in accrued liabilities is added. Decrease in accrued liabilities is deducted. Increase in deferred revenue is added. Decrease in deferred revenue is deducted.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-29 Analyzing the Statement of Cash Flows The statement of cash flows is an important analytical tool for creditors, investors, and other users of financial statement data.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-30 Analyzing the Statement of Cash Flows Statement of cash flows helps to determine a firm’s ability to generate cash flows in the future ability to generate cash flows in the future capacity to meet cash obligations capacity to meet cash obligations future external financing needs future external financing needs success in productively managing investing activities success in productively managing investing activities effectiveness in implementing financing and investing strategies effectiveness in implementing financing and investing strategies

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-31 Cash Flow from Operations It is possible for a firm to be highly profitable and not be able to pay dividends not be able to pay dividends not be able toinvest in new equipment not be able to invest in new equipment not be able toservice debt not be able to service debt go bankrupt go bankrupt How? The problem is cash.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-32 Cash Flow from Operations Ongoing operation depends upon its success in generating cash from operations. Firms need cash to satisfy creditors and investors. Temporary shortfalls of cash can be satisfied by borrowing or other means, but ultimately a firm must generate cash.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-33 Nocash Corporation The Nocash Corporation had sales of $100,000 in its second year of operations, up from $50,000 in the first year. Expenses, including taxes, amounted to $70,000 in year 2, compared with $40,000 in year 1.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-34 Nocash Corporation The comparative income statements for the two years indicate substantial growth. Nocash Corporation Income Statement for Year 1 and Year 2 Year 1 Year 2 Sales$50,000$100,000 Expenses40,00070,000 Net income $10,000$30,000

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-35 Nocash Corporation Other relevant facts that do not appear on income statement. Nocash eased credit policies in year 2, attracting customers of lower quality. eased credit policies in year 2, attracting customers of lower quality. purchased a new line of inventory near the end of year 1 and had to sell it below cost. purchased a new line of inventory near the end of year 1 and had to sell it below cost. had problems with accounts receivable causing suppliers to refuse the sale of goods on credit. had problems with accounts receivable causing suppliers to refuse the sale of goods on credit. The effect of these factors can be found on Nocash’s balance sheet.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-36 Nocash Corporation Balance Sheet at December 31 Year 1 Year 2 $Change Cash$2,000$2,0000 Accounts Receivable 10,00030,000+20,000 Inventories10,00025,000+15,000 Total Assets $22,000$57,000+35,000 Accounts payable 7,0002,000-5,000 Notes payable – to banks 010,000+10,000 Equity15,00045,000+30,000 Total liabilities and equity $22,000$57,000+35,000

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-37 Nocash Corporation If Nocash’s net income is recalculated on a cash basis, the following adjustments would be made: Net income $30,000 Accounts receivable (20,000) Inventories(15,000) Accounts payable (5,000) Cash Income ($10,000)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-38 Nocash Corporation Increase in accounts receivable is subtracted, because more sales revenue was recognized in computing net income than was collected in cash. Increase in inventory is deducted, reflecting the cash outflow for inventory purchases in excess of the expense recognized through cost of goods sold.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-39 Nocash Corporation Decrease in accounts payable is deducted, because the cash payments to suppliers in year 2 were greater than the amount of expense recorded. Appearance of a $10,000 note payable indicates that borrowing has enable Nocash to operate, but unless it can generate cash, its problems will compound.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-40 Analysis of the Statement of Cash Flows Should, at a minimum, cover the following areas: Cash flow from operating activities Cash flow from operating activities Cash inflows Cash inflows Cash outflows Cash outflows

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-41 Analysis of the Statement of Cash Flows – Analyst Concerns Success or failure of the firm in generating cash from operations Underlying causes of the positive or negative operating cash flow Magnitude of positive or negative operating cash flow Fluctuations in cash flow from operations over time

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-42 Summary Analysis of the Statement of Cash Flows – Summary Table Provides an approach to analyzing a statement of cash flows that can be used for any firm that provides comparative cash flow data Underlines the importance of internal cash generation and the implications for investing and financing activities when this does and does not occur

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-43 Summary Analysis of the Statement of Cash Flows – Summary Table A way to common size the cash flow statement Shows the cash inflows as a percentage of total inflows Shows the cash outflows as a percentage of total outflows

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-44 Analysis of Cash Inflows Generating cash from operations is the preferred method for obtaining excess cash to finance capital expenditures and expansion capital expenditures and expansion repayment of debt repayment of debt payment of dividends payment of dividends

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-45 Analysis of Cash Outflows When analyzing the cash outflows, the analyst should consider the necessity of the outflow the necessity of the outflow how the outflow was financed how the outflow was financed Generally, it is best to finance short-term assets with short-term debt short-term assets with short-term debt long-term assets with long-term debt or issuance of stock long-term assets with long-term debt or issuance of stock

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall4-46 Analysis of Cash Outflows Repayment of debt is a necessary outflow. Notes reveal future debt repayments and are useful in assessing how much cash will be needed in upcoming years to repay outstanding debt.