FINANCIAL ACCOUNTING Prepared by L. de Grace C.A. a user perspective Sixth Canadian Edition John Wiley & Sons Canada, Ltd. ©2011 Chapter 5 The Statement of Cash Flows

Cash Flows versus Accrual Accounting  Accrual accounting measures performance at a point in the cycle  Ignores timing differences between revenues and expenses and the related cash flows  Not useful in tracking cash flows 2 John Wiley & Sons Canada, Ltd. ©2011

Discussion Question  The income statement measures performance; therefore, the accrual method provides the best information to the user. Why then do we prepare a cash flow statement? Why Another Flow Statement? 3 John Wiley & Sons Canada, Ltd. ©2011

User Relevance  Operating Activities: The reason the company exists – regular operations should generate positive cash flows  Investing Activities: Users can evaluate the company’s decisions to buy and sell long-term assets, as well as any long-term investments in other companies.  Financing Activities: Enables users to evaluate the company’s financial strength and strategy, and to estimate its reliance on debt versus equity financing in the future. John Wiley & Sons Canada, Ltd. ©2011 4

Ajax Company  Ajax Co. was established in December 2010 with an investment of $150,000. Its only activities in December were to spend $132,000 on capital assets and $4,000 on inventory, so as to be ready to commence sales in January The capital assets will be depreciated at a rate of $2,000 per month, starting in January  Product line Ajax Co sells circuit board components The components cost Ajax $4 each however Ajax has no supplier credit – all inventory must be paid for in cash when it is ordered 5 John Wiley & Sons Canada, Ltd. ©2011

Ajax Company  Sales/Customer credit  Ajax is a new company and is expecting rapid growth in sales. The company expects its sales  to continue to grow at the rate of 1,000 units per month for at least the next year. Ajax sells the components for $7 each Ajax allows customers up to 30 days to pay For simplicity assume that customers pay 30 days after a sale 6 John Wiley & Sons Canada, Ltd. ©2011

Ajax Company  Inventory policy Ajax must maintain sufficient inventory for meeting customer requirements Components take four weeks to arrive from overseas Therefore Ajax must purchase the units one month in advance for the following month’s sales. 7 John Wiley & Sons Canada, Ltd. ©2011

Ajax Company Sales & Inventory Data (in units)JanuaryFebruaryMarch Units in beginning inventory1,000 2,000 3,000 New inventory purchases 2,000 3,0004,000 Units available for sale 3,000 5,0007,000 Units sold 1,000 2,0003,000 Units in ending inventory 2,000 3,0004,000 8 John Wiley & Sons Canada, Ltd. ©2011

Ajax Company Statement of Earnings JanuaryFebruaryMarch Revenues $7,000 $14,000$21,000 Cost of goods sold (4,000) (8,000)(12,000) Depreciation expense(2,000) Net income $1,000 $4,000$7,000 9 John Wiley & Sons Canada, Ltd. ©2011

Ajax Company  Net income is growing  Increased level of sales is shown in: Accounts receivable Inventory 10 John Wiley & Sons Canada, Ltd. ©2011

Ajax Company Partial Balance SheetDec.31Jan.31Feb.28Mar.31 Cash$14,000$6,000$1,000$(1,000) Accounts receivable07,00014,00021,000 Inventory 4,0008,00012,20016,000 Cash is declining while accounts receivable and inventory are increasing. 11 John Wiley & Sons Canada, Ltd. ©2011

Cash-to-Cash Cycle Inventory Purchase (cash outflow) Sale of Inventory Collection (cash inflow) Cash 12 John Wiley & Sons Canada, Ltd. ©2011

Cash-to-Cash Cycle  Lead/lag relationship at Ajax Co. Cash paid out to buy inventory 30 days in advance of the month of sale, and Cash coming in from collections of accounts receivable takes another 30 days The total lag between cash outflow and cash inflow is two months Companies can directly influence the lead/lag relationship 13 John Wiley & Sons Canada, Ltd. ©2011

Ajax Company Cash Flow Statement DecemberJanuaryFebruaryMarch Operating Activities: Receipts (collections)007,00014,000 Payments (Inventory costs)(4,000)(8,000) (12,000)(16,000) (4,000)(8,000)(5,000)(2,000) Financing Activities: Cash received from owners150, Investing Activities: Purchase of capital assets(132,000)000 Net cash flow14,000 (8,000) (5,000)(2,000) Cash balance, beg. of month014,0006,0001,000 Cash balance, end of month$ 14,000$ 6,000$ 1,000$(1,000) 14 John Wiley & Sons Canada, Ltd. ©2011

Ajax Company  Cash flow will be negative at the end of March – March 31 cash balance: ($1,000)  Will the company run out of cash?  What will it do to continue doing business ?  The first step is to prepare a forecast. 15 John Wiley & Sons Canada, Ltd. ©2011

Ajax Company Net Income Forecast AprilMayJune Revenues $28,000 $35,000$42,000 Cost of goods sold(16,000)(20,000)(24,000) Depreciation expense(2,000) Net earnings$10,000$13,000$16, John Wiley & Sons Canada, Ltd. ©2011

Ajax Company Cash Flow ForecastAprilMayJune Operating Activities: Receipts (collections)(21,000)(28,000)(35,000) Payments (Inventory costs)(20,000)(24,000)(28,000) $1,000$4,000$7,000 Financing Activities: Cash received from owners0 00 Investing Activities: Purchase of capital assets000 Net cash flow$1,000$4,000$7,000 Cash balance, beg. of month(1,000)04,000 Cash balance, end of month0 4,00011, John Wiley & Sons Canada, Ltd. ©2011

Ajax Company  Net cash flow will be positive at the end of May and healthy at the end of June  The lead/lag relationship was responsible for the temporary cash shortage at Ajax.  Should the company take out a loan or establish a line of credit with the bank ? 18 John Wiley & Sons Canada, Ltd. ©2011

Solutions to Cash Flow Problems  Three fundamental causes for cash flow shortage in new companies: 1. High growth rates in sales 2. Significant lead/lag relationships 3. Undercapitalization 19 John Wiley & Sons Canada, Ltd. ©2011

Solutions to Cash Flow Problems  Under-capitalization Capitalization is the amount of cash the company starts with; Start-up companies tend to be under-capitalized; Companies can increase their capitalization through: Equity financing (issue more shares) – this option results in lower returns to the original owners; Debt financing – this option results in interest expense, which would then have to be factored into a revised cash flow forecast. 20 John Wiley & Sons Canada, Ltd. ©2011

Cash Flow Solutions  Reduce the high rate of growth: Reducing the growth rate at Ajax from 1,000 units per month to 750 units per month eliminates the cash flow problem. This option reduces net earnings; can be detrimental in the long run by diverting customers to competitors 21 John Wiley & Sons Canada, Ltd. ©2011

Cash Flow Solutions  Lead/lag relationships Change the relationships between cash inflows and outflows Make more sales for cash Reduce the credit terms for credit sales Hire a credit manager Reduce levels of inventory Increase the number of days to pay suppliers (this option has limits) 22 John Wiley & Sons Canada, Ltd. ©2011

Cash Flow Statement  Cash and Cash Equivalents Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash The maximum time frame suggested is 90 days. Examples – Canada Savings Bonds, treasury bonds, short term GIC’s 23 John Wiley & Sons Canada, Ltd. ©2011

Cash Flow Statement  Components of cash flows: Operating Activities Financing Activities Investing Activities 24 John Wiley & Sons Canada, Ltd. ©2011

Cash Flow Statement  Operating activities Sale of goods and services to customers Changes to current assets and current liabilities All other transactions not covered by financing or investing activities LINDT & SPRÜNGLI CASH FLOW STMT. 25 John Wiley & Sons Canada, Ltd. ©2011

Cash Flow Statement  Financing activities Obtaining and repaying resources from shareholders and lenders Examples: shares, bonds, mortgages, notes, dividends  Investing activities Investment, sale, or disposal of long-term assets Examples: property, plant, equipment, long-term marketable securities 26 John Wiley & Sons Canada, Ltd. ©2011

Cash Flow Statement - Presentation  May differ only in format and content of the Operating Activities section Direct approach Theoretically informative Rarely used Indirect approach Normally used in published statements  Investing Activities and Financing Activities sections are the same PREPARE A STATEMENT OF CASH FLOWS 27 John Wiley & Sons Canada, Ltd. ©2011

Interpretation of Cash Flow Information  Which cash flows are likely to continue?  Is there sufficient cash from continuing operations to pay for continuing investing and financing activities? 28 John Wiley & Sons Canada, Ltd. ©2011 NON-RECURRING CASH FLOWS

Interpretation of Cash Flow Information  Different users require different information: Bank loan officer Ability to pay interest and repay loan Stock analyst Ability to generate long-term cash flows for investors 29 John Wiley & Sons Canada, Ltd. ©2011

Interpretation of Cash Flow Information  The use of equity and debt to generate cash is limited  Operating cash flows must be sufficient to support investing and financing activities over the long term Purchase of property, plant and equipment Repayment of debt and interest Payment of dividends to shareholders  Key is to identify continuing cash sources and needs 30 John Wiley & Sons Canada, Ltd. ©2011

Discussion Question Comment on the change in cash position and sources and uses of cash during the period for Le Chateau stores. What can you infer about Le Chateau’s performance from the cash flow statement? If nonrecurring items are excluded, what would be the company’s sustainable cash flows? 31 John Wiley & Sons Canada, Ltd. ©2011 LE CHATEAU STATEMENT OF CASH FLOWS

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