This week its Accounting Theory 1-1 Session 1 Session 2 Tuesday Financial Statements/Expenses/Revenues Accounting Cycle & Accounts Wednesday The Income Statement The Balance Sheet Thursday The Cash Flow Statement Tools & Techniques Friday PresentationsPresentations

Why Cash Flow is Important: An Example

The company reported rising amounts of net income. The company failed to generate any cash from its operations. These deficits were offset by borrowings. The company went bankrupt in 2008.

Why Cash Flow is Important: An Example 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.

Why Cash Flow is Important: An Example The statement of cash flows: provides information about cash inflows and outflows during an accounting period and over time and is extremely important as an analytical tool.

Why Cash Flow is Important: An Example Cash flows are segregated by: operating activities, investing activities, and financing activities.

Statement of Cash Flows: Basic Principle The statement of cash flows is another way of presenting the balance sheet of the company. The balance sheet shows amounts at the end of the accounting period. The statement of cash flows shows changes in the balance sheet accounts between periods.

Statement of Cash Flows: Basic Principle Change in cash between periods is explained by changes in all other balance sheet accounts. Each balance sheet account is related either to an operating activity, an investing activity, or a financing activity. Change in cash between periods is equal to cash flow from operating activities, investing activities, or financing activities.

Statement of Cash Flows: Basic Principle

Cash account increased by $1,299 million between November 30, 2006 and  Operations used cash (net outflow) of $45,945 million.  Investing activities used cash (net outflow) of $1,698 million.  The company borrowed (net inflow) $48,592 million. The company borrowed to cover the cash deficit in operations and capital expenditures.

Preparing a Statement of Cash Flows Begins with a return to the balance sheet Requires 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

Preparing a Statement of Cash Flows

Four parts of a statement of cash flows Cash Operating activities Investing activities Financing activities

Preparing a Statement of Cash Flows Cash includes: cash highly liquid short-term marketable securities (cash equivalents) short-term investments

Preparing a Statement of Cash Flows Operating activities include: delivering or producing goods for sale providing services cash effects of transactions and other events that enter into the determination of income

Preparing a Statement of Cash Flows Investing activities include: 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 lending money and collecting on loans

Preparing a Statement of Cash Flows Financing activities include: borrowing from creditors and repaying principal obtaining resources from owners and providing them with a return on the investment

Preparing a Statement of Cash Flows Prepared by: 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, and categorizing the flows by operating, financing, or investing activities. The inflows less the outflows balance to and explain the change in cash.

Preparing a Statement of Cash Flows

The next step is to transfer the account changes to the appropriate area of a statement of cash flows. In doing so, a determination must be made of what constitutes an inflow and what constitutes an outflow.

Preparing a Statement of Cash Flows

Exhibit 4.2 (Inflows) Decrease in other assets Increase in long-term debt Increase in common stock and additional paid-in capital (Outflows) Increase in inventories Decrease in notes payable

Preparing a Statement of Cash Flows Accumulated depreciation appears in the asset section is actually a contra-asset reduces the amount of total assets shown in parentheses on the balance sheet has the same effect as a liability account

Preparing a Statement of Cash Flows Other complications Two transactions in one account Multiple transactions affecting other accounts

Calculating Cash Flow from Operating Activities Operating activities represent cash generated internally. Investing and financing activities provide cash from external sources.

Calculating Cash Flow from Operating Activities Firms may use one of two methods to calculate cash flow from operating activities:  Direct Method  Indirect Method Direct and indirect methods yield identical figures for net cash flow from operating activities.

Calculating Cash Flow from Operating Activities The direct method shows: cash collection from customers interest and dividends collected other operating cash receipts cash paid to suppliers interest paid taxes paid other operating cash payments

Calculating Cash Flow from Operating Activities The indirect method starts with net income and adjusts for: deferrals accruals noncash items nonoperating items

Calculating Cash Flow from Operating Activities

Cash Flow from Investing Activities Additions to property, plant, and equipment represent a cash outflow of $14.1 million. Decrease in other assets represents a cash inflow of $295 thousand.

Cash Flow from Financing Activities Sage Inc. issued new shares of stock during The total cash generated from stock sales amounted to $256 thousand.

Cash Flow from Financing Activities Short-term debt and current maturities of long-term debt jointly explain Sage Inc.’s net reduction in short-term borrowings:

Cash Flow from Financing Activities Long-term borrowings should be segregated into two components  Additions to long-term borrowings  Reduction of long-term borrowings Additions to long-term borrowings and reductions of long-term borrowings on the Sage Inc. statement of cash flows reconcile the change in the long-term debt account on the balance sheet.

Cash Flow from Financing Activities

Change in retained earnings results from net income recognition and the payment of cash dividends.  Payment of cash dividends is financing outflow.  Declaration of a cash dividend would not affect cash. This information is provided in the Sage Inc. Statement of Stockholders’ Equity.

Cash Flow from Financing Activities

Change in Cash In 2013, net cash provided by operating activities, less the net cash used by investing activities, plus the net cash provided by financing activities produced a net decrease in cash and cash equivalents for Sage Inc.:

Change in Cash The cash flows provided (used) by operating, investing, and financing activities vary considerably depending on: the company, its performance, its ability to generate cash, its financing and investing strategies, and its success in implementing financing and investing strategies.

Analyzing the Statement of Cash Flows The statement of cash flows helps to determine a firm’s: ability to generate cash flows in the future, capacity to meet cash obligations, future external financing needs, success in productively managing investing activities, and effectiveness in implementing financing and investing strategies.

Analyzing the Statement of Cash Flows 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 invest in new equipment  not be able to service debt  go bankrupt

Analyzing the Statement of Cash Flows Cash Flow from Operations Ongoing operation depends on 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.

Analyzing the Statement of Cash Flows Cash Flow from Operations Periods of high interest rates and inflation contributed to the enhanced attention paid to cash flow by investors and creditors.  When interest rates are high, the cost of borrowing can be out of reach for many firms seeking to cover temporary cash shortages.  Periods of inflation distort the meaningfulness of net income.

Analyzing the Statement of Cash Flows Nocash Corporation Nocash Corporation had sales of $50,000 in its first year of operations. Nocash Corporation had sales of $100,000 in its second year of operations. Nocash Corporation had expenses of $40,000 in its first year of operations. Nocash Corporation had expenses of $70,000 in its second year of operations.

Analyzing the Statement of Cash Flows

Nocash Corporation The income statement does not show that:  Nocash eased its credit policies and attracted lower quality customers.  Nocash purchased a new line of inventory near the end of Year 1 and had to sell it below cost.  Rumors regarding problems with accounts receivable and inventory management prompted some suppliers to refuse the sale of goods on credit to Nocash. The effects of these factors can be found on the balance sheet.

Analyzing the Statement of Cash Flows

Nocash Corporation If Nocash’s net income is recalculated on a cash basis, the following adjustments would be made:

Analyzing the Statement of Cash Flows Nocash Corporation More sales revenue was recognized in computing net income than was collected in cash. The increase in accounts receivable is subtracted.

Analyzing the Statement of Cash Flows Nocash Corporation The increase in inventory is deducted, reflecting the cash outflow for inventory purchases in excess of the expense recognized through cost of goods sold.

Analyzing the Statement of Cash Flows Nocash Corporation Cash payments to suppliers in Year 2 were greater than the amount of expense recorded. The decrease in accounts payable is deducted.

Analyzing the Statement of Cash Flows Nocash Corporation Appearance of $10,000 note payable indicates that borrowing has enabled Nocash to operate. Unless Nocash can generate cash, its problems will compound. Bankers refer to this problem as a company’s “selling itself out of business.”

Sage Inc.: Analysis of the Statement of Cash Flows An analysis of the statement of cash flows should cover the following areas: Analysis of cash flow from operating activities Analysis of cash inflows Analysis of cash outflows

Sage Inc.: Analysis of the Statement of Cash Flows Cash Flow from Operating Activities The statement of cash flows provides the “net cash flow from operating activities.” The analyst should be concerned with:  the success or failure of generating cash from operations  the underlying causes of operating cash flow  the magnitude of operating cash flow  fluctuations in cash flow from operations

Sage Inc.: Analysis of the Statement of Cash Flows

Cash Flow from Operating Activities – Sage Inc. Negative cash flow from operations in 2012 Positive net income in 2012 Apparent cause was substantial growth in accounts receivable and inventories. Positive cash flow in 2013 It will be necessary to monitor cash flow operations and the management of inventories.

Sage Inc.: Analysis of the Statement of Cash Flows Summary Analysis of the Statement of Cash Flows Provides an approach to analyzing the statement of cash flows Provides comparative cash flow data Underlines the importance of internal cash generation from operations Highlights the implications for investing and financing activities when cash is not generated from operations

Sage Inc.: Analysis of the Statement of Cash Flows

Analysis of Cash Inflows – Sage Inc. Operations supplied 62% of needed cash in 2013 and 73% in The firm had to borrow heavily in 2012, with debt accounting for 98% of cash inflows. Sage Inc. also borrowed in 2013 and 2011 to obtain needed cash not supplied by operations.

Sage Inc.: Analysis of the Statement of Cash Flows Analysis of Cash Inflows Generating cash from operations is the preferred method for obtaining cash. Using external sources to generate the majority of cash year after year should be further investigated.

Sage Inc.: Analysis of the Statement of Cash Flows Analysis of Cash Outflows – Sage Inc. Purchases of property, plant, and equipment decreased in 2012 compared to Capital expenditures increased in dollars from 2012 to 2011 but not in percentage due to negative cash flow from operations. Dividends paid increased from 2011 to 2012 and decreased from 2012 to 2013, but percentages declined each year due to cash outflows.

Sage Inc.: Analysis of the Statement of Cash Flows Analysis of Cash Outflows – Sage Inc. Capital expenditures in 2011 were covered by cash from operations. Capital expenditures in 2012 were covered by borrowing. Capital expenditures in 2013 were covered by both cash from operations and borrowing.

Sage Inc.: Analysis of the Statement of Cash Flows Analysis of Cash Outflows When analyzing cash outflows, the analyst should consider:  the necessity of the outflow  how the outflow was financed Generally, it is best to finance:  short-term assets with short-term debt  long-term assets with long-term debt or issuance of stock

Sage Inc.: Analysis of the Statement of Cash Flows Analysis of Cash Outflows Repayment of debt is a necessary outflow.  Notes to the financial statements are useful in assessing how much cash will be needed in upcoming years to repay outstanding debt. Firms should only pay dividends if the company has excess cash not needed for:  expansion  property, plant, or equipment  repayment of debt

Qualitative Issues Relating to the Statement of Cash Flows Recording operating expenses as capital expenditures Management of current asset and liability accounts Accounting for vendor financing transactions Recording of purchases and sales of trading securities for nonfinancial companies