© 1999 by Robert F. Halsey Agenda Review Accrual Basis Income Statements Importance of Cash Flow Preparation of Statement of Cash Flows Interpretation of Statement of Cash Flows

© 1999 by Robert F. Halsey Accrual accounting has two principal components: Ê The Revenue Recognition Principle, which states that revenue is recorded when it is “earned”, and Ë The Matching Principle, which states that expenses recognized when “incurred” Neither the recognition of revenue nor that of expense necessarily involves the receipt or payment of cash. Accrual basis earnings, therefore, do not convey much information about cash inflows to and outflows from the business.

© 1999 by Robert F. Halsey Information about cash inflows and outflows is important, however: Dividends and Debt Payments are made with cash, not profit, and Investors and creditors may be interested in the firm’s sources of cash (will they be recurring or are they one- time events, like the sale of assets) and where the firm is investing its cash inflows (into areas for which the company has some management expertise, as outflows to the company’s investors or creditors, etc.) Over the life of the firm, profit equals net cash flow. In any one period, as we have seen, however, the two will not be equal because of accrual accounting. Analysts have learned that the difference between reported earnings and cash flows may provide clues about the “quality of earnings” (i.e., whether the firm is managing its earnings)

© 1999 by Robert F. Halsey As a first step in learning to prepare the statement of cash flows, you need to understand that è Cash is generated by reductions in assets or increases in liabilities. »Collection of accounts receivable increase cash and reduce receivables, an asset, and »Increases in a bank loan increases cash and liabilities è Cash is used to increase assets or to pay liabilities »Cash is reduced to purchase fixed assets »Cash is also reduced for Debt repayment Preparation of the Statement of Cash Flows

© 1999 by Robert F. Halsey Think of assets as dividing up the pie Cash A/R Inventories PP&E Cash A/R Inventories PP&E As A/R gets bigger Cash decreases

© 1999 by Robert F. Halsey Cash A/R Inventories PP&E Cash A/R Inventories PP&E and, increases in liabilities and equity affect the size of the pie

© 1999 by Robert F. Halsey The statement of cash flows is divided into three sections: » Net cash from Operations - cash inflows and outflows relating to the firm’s normal business activities (i.e., cash operating profit and new cash flows from current assets and current liabilities) » Net cash from Investing activities - purchases and sales of long-term assets and marketable securities » Net cash from Financing activities - changes in long-term debt and equity, and the payment of dividends Notice that the statement of cash flows combines both the income statement and the balance sheet. The sum of the three sections, therefore, yields the net change in cash for the period. There is always a built in check on the accuracy of the statement. Net cash flow plus the beginning balance in cash (last year’s ending balance) will always equal the ending balance in cash this year.

© 1999 by Robert F. Halsey The first section of the statement, net cash from operations, begins with net income and adjusts reported profit for depreciation and gains and losses on sales of assets. Next, cash generated from changes in current assets and current liabilities is added. The sum of all of these items is the net cash flows from operating activities, as follows: Net Income + Depreciation - Gains (+Losses) on asset sales  Changes in Current Assets and Liabilities ———————————————————— = Net Cash Flows from Operating Activities

© 1999 by Robert F. Halsey The adjustment to net income for depreciation and gains (losses) on the sale of assets may, at first, be difficult to understand. Let’s consider first the issue of depreciation. The cash relating to the purchase of fixed assets flows out of the firm on the date the assets are purchased. Depreciation expense is merely the allocation of this cost over the useful life of the asset to match its expense with the revenues it produces. There is no cash relating to depreciation expense and, as a result, we do not want to consider it in the preparation of the statement of cash flows. Since depreciation expense was deducted in the computation of net profit, we add it back in order to zero it out.

© 1999 by Robert F. Halsey Sales - wage expense - depreciation expense - tax expense net income + depreciation expense  changes in current assets and current liabilities = net cash flow from operating activities This can be more easily seen by the use of an example. If we expand net income, the beginning of the statement of cash flows would look like this: Since depreciation expense is deducted in computing net income It must be added back in order to zero it out in the statement of cash flows

© 1999 by Robert F. Halsey The next section is the net cash flow from investing activities. In this section, we are concerned with changes in the long- term portion of the asset section of the balance sheet: property, plant and equipment, and other long-term investments. As with previous changes in balance sheet accounts, increases in these assets are recorded as cash outflows and decreases are recorded as cash inflows.

© 1999 by Robert F. Halsey The last section deals with net cash flows from financing activities. These include changes in long-term debt, sales and repurchases of stock, and dividends. Increases in liabilities and equity are recorded as cash inflows and decreases as cash outflows. Dividends are also reflected as a cash outflow.

© 1999 by Robert F. Halsey So, we have included the income statement through net income and the associated adjustments for non-cash expenses or gains and losses. And we have included all of the balance sheet accounts: Current assetsCurrent Liabilities Long-term AssetsLong-Term Liabilities Stockholder’s Equity Used for net cash flow from financing activities Used for net cash flow from operations Used for net cash flow from investing activities

© 1999 by Robert F. Halsey But, what about accumulated depreciation and retained earnings? We can ignore accumulated depreciation because we are ignoring depreciation expense (it is non-cash). And we have already considered retained earnings by our inclusion of net income and dividends. So, all of the components of the balance sheet have been accounted for.

© 1999 by Robert F. Halsey Let’s look at a simple example to give you some practice. Consider the following comparative balance sheet and income statement:

© 1999 by Robert F. Halsey Change Assets Cash25,5004,40021,100 Accounts Receivable59,00035,00024,000 Inventories30,00050,00020,000 Fixed Assets165,000180,00015,000 Accumulated Depreciation(61,900)(80,400)18,500 Fixed Assets (net)103,10099,6003,500 Total Assets217,600189,00028,600 Liabilities Accounts Payable62,60040,50022,100 Bonds Payable (long-term)50,00040,00010,000 Equity Common Stock100,000 0 Retained Earnings5,0008,5003,500 Total Liabilities and Equity217,600189,00028,600 Sales185,500 Expenses: Cost of Goods sold 87,500 Salaries expense 56,000 Depreciation Expense 23,500 Loss on sale of fixed assets 5,000 Net income 13,500 Note: Fixed assets originally costing $35,000 with Accumulated Depreciation of $5,000 were sold for $25,000 Dividends declared and paid during the year were $10,000 Try to compute the statement of cash flows yourself before looking at the solution…

© 1999 by Robert F. Halsey Net income Depreciation Loss on sale 5000 Accounts Receivable Inventory(20000) Accounts Payable (22100) Net cash from operations Sale of fixed assets Purchase of fixed assets (50000) Net cash flow – investing (25,000) Bonds(10000) Dividends(10000) Net cash flow – financing (20000) Net change in cash (21100) Beginning cash Ending cash 4400 Then we add back depreciation and the loss on sale of assets (we are only concerned with the cash proceeds, not the loss) Accounts receivable went down, so this generated cash. Inventories went up, so this used cash Accounts payable decreased, thus using cash This is the statement of cash flows We start with net income

© 1999 by Robert F. Halsey Net income Depreciation Loss on sale 5000 Accounts Receivable Inventory(20000) Accounts Payable (22100) Net cash from operations Sale of fixed assets Purchase of fixed assets (50000) Net cash flow – investing (25,000) Bonds(10000) Dividends(10000) Net cash flow – financing (20000) Net change in cash (21100) Beginning cash Ending cash 4400 The sale of the fixed assets resulted in the following journal entry: Cash25000 Accum dep 5000 Loss 5000 Assets35000 And since fixed assets reported a net increase (at cost) of $15,000, after a reduction of $35,000, there must have been purchases of $50,000

© 1999 by Robert F. Halsey Net income Depreciation Loss on sale 5000 Accounts Receivable Inventory(20000) Accounts Payable (22100) Net cash from operations Sale of fixed assets Purchase of fixed assets (50000) Net cash flow – investing (25,000) Bonds(10000) Dividends(10000) Net cash flow – financing (20000) Net change in cash (21100) Beginning cash Ending cash 4400 Finally, bonds decreased by $10,000 and we used $10,000 for the payment of dividends. The net change in cash, therefore, is a reduction of $21,100 (23, , ,000) When we subtract this from the beginning balance of $25,500, we get the ending balance of $4,400 that appears on the balance sheet at year- end

© 1999 by Robert F. Halsey Let’s take a look at the statement of cash flows from Toys R Us to get some practice interpreting the information it is telling us

© 1999 by Robert F. Halsey During FY1999, even though the company lost $132 million, Toys R Us generated $964 million in cash from operations. Part of the difference is because the loss includes $255 million of depreciation expense on its store buildings, fixtures and equipment. Most of it, however, is due to restructuring charges of $546 million that reduced profits, but did not involve a cash outflow since they related to the write-off of assets and the accrual of employee severance expense

© 1999 by Robert F. Halsey The company also spent $422 million on capital expenditures Finally, the company borrowed a net amount of $359 million and used the proceeds together with its operating cash flow to repurchase $723 million of common stock. Why? Perhaps the company felt its stock was undervalued since it was trading at about $15, down from $35 fifteen months earlier.

© 1999 by Robert F. Halsey Components of Earnings From the operating section of the statement of cash flows we see the following relation: Net Income + Accruals = Net Cash Flows from Operating Activities Or, Net income = NCFO + Accruals. Net Income is comprised of two components: cash earnings and accruals

© 1999 by Robert F. Halsey Accruals are of two types: è Long-term (like d epreciation), and è Short-term (c hanges in current assets and liabilities) Remember this - *Short-term accruals generally reverse in the next accounting period. –Therefore, it is very difficult to shift income more than one period. –Companies can change income in the current period, but when the accruals reverse income will also reverse. That is why analysts look to the relation between profit and cash flow to get clues whether the company is managing its earnings. When the relation between the two figures changes significantly, we need to know why the accruals are behaving the way they are.

© 1999 by Robert F. Halsey The End