1. ENGG 401 X2 Fundamentals of Engineering Management Spring 2008 Chapter 3: Statement of Cash Flow Dave Ludwick Dept. of Mechanical Engineering University of Alberta http://members.shaw.ca/dave_ludwick/

2. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 2 ENGG 401 X2 – Fundamentals of Engineering Management Sources and Uses of Funds Logical questions in understanding any business. –How much funds did we get? –Where did we get them from? –What did we use them for? Like the income statement, these questions only make sense over a period of time. –The period must be reasonable. Year over year or month over month changes in a balance sheet can tell us where funds came from, and where they go to.

3. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 3 ENGG 401 X2 – Fundamentals of Engineering Management Sources and Uses of Funds (3) Comparing two successive balance sheets shows us where a company’s funds came from and where they went over a period of time. Reflect on the sources of funds and how they’re used. –Of the funds used, how much comes from debt versus operating activities? Assets Liabilities and EquityAssets from one period to another should always equal Liabilities and Equity over the same time period. –If not, there’s been a mistake made in the balance sheet or in the analysis (check for a sign error i.e., application to a wrong column).

4. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 4 ENGG 401 X2 – Fundamentals of Engineering Management Sources and Uses of Funds (2) Assets measure real things of value. use –An increase in an asset account is a use of funds (you had to have funds to get the extra assets). source –A decrease in an asset account is a source of funds. Liabilities measure real obligations to pay someone else. source –An increase in a liability is a source of funds (you are borrowing more from someone else). use –A decrease in a liability is a use of funds. From a cash flow point of view, there are other sources of funds as well: source –An increase in equity or retained earnings is a source of funds. source –Depreciation is a source of funds, since it is a non-cash expense.

5. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 5 ENGG 401 X2 – Fundamentals of Engineering Management Example: Goodco versus Badco Goodco and Badco have the same income statement for a one year period. –This means that the operational side of their businesses (i.e., its ability to create value) is identical. Goodco and Badco have the same balance sheet last year, which means they start from the same position. –They own the same things and drew the money from the same sources. Goodco and Badco have very different balance sheets this year. –Management decisions about the business were fundamentally different.

6. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 6 ENGG 401 X2 – Fundamentals of Engineering Management Example: Goodco versus Badco (2)

7. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 7 ENGG 401 X2 – Fundamentals of Engineering Management Revisiting Working Capital Deficiency Working capital deficiency is the major cause of business failure and is an “above the line” problem. Questions: –What can Badco do to get back onside? How effective is reducing receivables and inventory? …stretching payables? …borrowing more LT debt? …raising more equity? Acting above the line reduces short term borrowing but does not change the level of working capital. –Working capital deficiencies require correction below the line, by long-term debt, grant, or an increase in shareholder equity.

8. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 8 ENGG 401 X2 – Fundamentals of Engineering Management Purpose of the Cash Flow Statement Cash Flow StatementA Cash Flow Statement documents the changes in a company’s cash position over an accounting period. –Makes the reflection on the sources and uses of funds easier to see. Purpose: to report detailed info about the major cash receipts and cash payments during the period Generally there are 3 types of activities that generate or consume cash –Operating –Investing –Financing Although one of the more complex statements, this Cash Flow Statement, or the Statement of Changes in Financial Position (SCFP), is one of the most important statements

9. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 9 ENGG 401 X2 – Fundamentals of Engineering Management Why is cash important? Cash is the grease that allows the company to move and articulate its resources to achieve goals Cash is needed to –Pay debts –Meet unexpected obligations –Pursue unexpected opportunities –Plan day-to-day operating activities –Make long-term investment decisions The Statement of Changes in Financial Position (SCFP) can help answer: –How does the company obtain cash –How does it spend cash –What is the change in the cash balance

10. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 10 ENGG 401 X2 – Fundamentals of Engineering Management Cash and Cash Equivalents Lets also remember that this statement needs to cover both cash and cash equivalents: Cash Equivalents: –Assets that are readily convertible to a known amount of cash –Significantly close to maturity (within roughly 3 months) that its eventual cash value is determinable

11. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 11 ENGG 401 X2 – Fundamentals of Engineering Management 3 Types of Activities: Operating Operating: the principal revenue generating activities of the business Examples: –Production of goods and services for sale –Purchase of raw materials and labour –Admin expenses, taxes –Collection of loan principal Generally, the Operating activities involve the top of the balance sheet (Current Assets and Current Liabilities)

12. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 12 ENGG 401 X2 – Fundamentals of Engineering Management 3 Types of Activities: Investing Investing: these are activities that generally affect long-term assets Investing activities typically involve –Purchase or sale of capital assets –Purchase or sale of investments, other than cash equivalents –Lending and collecting on loans (long-term notes receivables that were created for activities other than operating activities) Generally the Investing activities involve the lower left side of the balance sheet (Capital or Fixed Assets)

13. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 13 ENGG 401 X2 – Fundamentals of Engineering Management 3 Types of Activities: Financing Financing: these are activities that affect a company's owners and creditors Financing activities include –Obtaining/disbursing cash as a result of debt incurred/debt paid off –Obtaining cash from or distributing cash to owners Note: –Interest expense usually incurred to support the company’s ability to generate revenue. Therefore it is deducted from revenue to get Net Income on the Income Statement. This is considered an Operating activity –Accounts payable are also incurred to purchase raw materials Therefore, paying AP is considered Operating activities Generally the Financing activities involve the lower right side of the balance sheet (LT Debt and Equity)

14. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 14 ENGG 401 X2 – Fundamentals of Engineering Management A sample Cash Flow Statement Statement of Changes in Financial Position Cash flows from Operating Activities Cash received from customers50000 Cash paid for inventory(15000) Cash paid for wages and benefits(20000)15000 Cash flows from Investing Activities Cash paid for equipment(5000) Cash flows from Financing Activities Cash paid for dividends(5000) Net cash increase5000 Cash balance at beginning of period10000 Cash balance at end of period15000

15. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 15 ENGG 401 X2 – Fundamentals of Engineering Management A sample Balance Sheet Balance Sheet Current Assets Cash10000 Current Liabilities Accounts Payable5000 Accounts Receivable20000 Wages Payable25000 Notes Receivable15000 Utilities Payable2000 Marketable Securities25000Long-Term Debt Inventory120000 Notes Payable20000 Capital Assets Bonds Payable600000 Equipment250000Owner’s Equity Buildings500000 Common Stock300000 Goodwill60000 Retained Earnings48000 Total Assets100000 0 Total Liabilities + OE1000000 Investing Financing Operating

16. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 16 ENGG 401 X2 – Fundamentals of Engineering Management Cash Flow Statements To complete a cash flow statement, two balance sheets (start of period and end of period) and the income statement for the intervening time period must be used. –The sources and uses of funds are balanced to cash (including short term debt) where did our money come from, and where did it goThe cash flow statement answers the question “where did our money come from, and where did it go?”

17. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 17 ENGG 401 X2 – Fundamentals of Engineering Management What Do We Look for in Cash Flow Statements? Profitable? Steady profits? How much cash is coming from operations? Non cash WC growing? Justified by sales (IS)? Dividend? Steady? What fraction of income? Investment relative to depreciation: –Larger (hence growing) –~Same (stable) –Smaller (blowdown of assets) Financing –Locking in or paying back long term debt? –Issuing or buying back shares? Common or preferred?

18. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 18 ENGG 401 X2 – Fundamentals of Engineering Management Operational vs. Financial Management All businesses require that management address two areas: –Operational health: does our underlying business activity create value independent of how we finance the business? –Financial health: have we raised money in a way that can sustain the business? The income statement is the primary source of evidence of operational health. –Contribution margin is a critical measure. The balance sheet is the primary source of evidence of financial health. –Working capital is important here The statement of cash flow links income statements and balance sheets.

19. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 19 ENGG 401 X2 – Fundamentals of Engineering Management Sample Problem Nissen Corp’s Comparative Balance Sheet Assets Cash 2007 75425 2006 107275 Accounts Receivable9100069475 Inventory Prepaid Expenses 383250 7525 353500 8750 Equipment223300154000 Accumulated Depr(48475)(61600) Total Assets732025631400 Liabilities and Owner’s Equity Accounts Payable123375163275 ST Notes Payable140008750 LT Notes Payable13125075250 Common Shares281750218750 Retained Earnings181650165375 Total Liabilities and OE732025631400

20. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 20 ENGG 401 X2 – Fundamentals of Engineering Management Sample Problem Nissen Income Statement For Year Ended Dec 31, 2007 Sales694750 COGS350000 Gross Profit344750 Operating Expenses Amortization Expense26250 Other Expenses191100 Total Operating Expenses217350 Loss on Sale of Equipment(7175) Income from Operations120225 Income Taxes(16975) Net Income103250

21. Dave Ludwick, Dept. of Mech. Eng. Statement of Cash Flow Summer 2008 21 ENGG 401 X2 – Fundamentals of Engineering Management Sample Problem Other information regarding Nissen –All sales are credit sales –Purchases to merchandise are on credit –All debits to accounts payable result from payments to merchandise –The only decrease to income taxes payable is for a tax payment –The other expenses are paid in advance and are initially debited to Prepaid Expenses –Equipment costing 65625 with accumulated depreciation of 39375 is sold for 19075 –Equipment costing 134925 is purchased by paying cash of 35000 and signing a long-term note payable for the balance –Borrowed 5250 by signing a Short-Term Note Payable –Paid 43925 to reduce Long-Term Note Payable –Issued 3500 common shares for $18 cash each –Declared and paid cash dividends of 86975