Cash Flows CASH FLOW STATEMENT On the statement cash flows are segregated based on source - PDF document

Cash Flows - 1CASH FLOW STATEMENTOn the statement, cash flows are segregated based on source:Operating activities: involve the cash effects of transactions thatenter into the determination of net income.Investing activities:concern with buying (and selling) property, plants,and equipment (PPE); acquiring and disposing ofsecurities of other entities;Financing activities:include issuance and reacquisition of a firm's debtand capital stock, and dividend payments. Operating cash flows information indicates the business' ability togenerate sufficient cash from its continuing operations Investing cash flows information indicates how the business plans toexpandInformation about financing cash flows illustrates how the business plans tofinance its expansion/reward shareholders. Cash Flows - 2Cash from operations: The statement of cash flows typically arrives atcash from operations by adding to (or subtracting from) net income twotypes of adjustments:1. “Non-cash” expenses’2. Changes in operating (working capital)Net Income$30,000Non Cash Expenses:e.g. Depreciation 5,000 Change in operating accounts:Decrease in inventory 15,000 Cash from operations$50,000The format illustrated above follows the indirect method of presentation.For analytical purposes, (as we shall see), the method is more Cash Flows - 35.[Cash flow, transactional analysis; 1990 CFAadapted] The following financial statements are fromthe 19X2 Annual Report of the Niagara Company:Income Statement for Year Ended December 31, 19X2 Sales$1,000Cost of goods sold(650)Depreciation expense(100)Sales and general expense(100)Interest expense(50)Income tax expense(40) Net income$60Balance Sheets at December 31, 19X1 and 19X2 19X1 19X2 Cash$50$60Accounts receivable500520Inventory750770 Current assets$1,300$1,350Fixed assets (net)500550 Total assets$1,800$1,900Liabilities and equityNotes payable to banks$100$75Accounts payable590615Interest payable1020 Current liabilities$700$710Long-term debt300350Deferred income tax300310Capital stock400400Retained earnings100130 Total liabilities & equity$1,800$1,900Prepare a statement of cash flows for the year ended December 31, 19X2.Use the direct method.19X119X2 SalesA/R COGSInventory A/P Sales & General I InterestInt Payable N Tax ExpenseDef Tax I Depreciation VESTMENTPP&E PurchaseFixed Assets Debt PaymentNotes Payable LTD Stock IssueCapital Stock N Ret Earnings Net Income Cash Flows - 4Niagara CompanySales $1,000Cost of goods sold(650)Depreciation expense(100)SGA(100)Interest expense(50)Income tax expense(40) INDIRECT METHOD Cash from OperationsNet Income60Non Cash ItemsDepreciation100Deferred taxes10in operating accountsA/R(20)Inventory(20)Interest payable10A/P25 Cash for InvestmentCapital ExpendituresCash for FinancingST Debt repayment(25)LT Debt borrowing50Dividends(30) Change in Cash 10DIRECT METHOD Cash from OperationsCash collections980Cash for inputs(645)Cash SGA(100)Cash for InterestCash for Taxes( 30) Cash for InvestmentCapital ExpendituresCash for FinancingST Debt repayment(25)LT Debt borrowing50Dividends(30) Change in Cash 10 Cash Flows - P. 5Changes Included in Cash Flow from Operating Activities (CFO)Balance Sheet Account Cash Flow Description Accounts receivableCash received from customersInventoriesCash paid for inputs (materials)Prepaid expensesCash expensesAccounts payableCash paid for inputs/expensesAdvances from customersCash received from customersRent payableCash expensesInterest payableInterest paidIncome tax payableIncome taxes paidDeferred income taxesIncome taxes paidChanges Included in Cash Flow from Investing Activities (CFI)Balance Sheet Account Cash Flow Description Property, plant, and equipmentCapital expendituresProceeds from property salesInvestment in affiliatesCash paid for acquisitions andinvestmentsChanges Included in Cash Flow from Financing Activities (CFF)Balance Sheet Account Cash Flow Description Notes payableIncrease or decrease in debtShort-term debtIncrease or decrease in debtLong-term debtIncrease or decrease in debtBonds payableIncrease or decrease in debtCommon stockEquity financing or repurchaseRetained earningsDividends paidThe relationship between balance sheet changes and cash flows can besummarized as follows: Increases (decreases) in assets represent net cash outflows (inflows). If anasset increases, the firm must have paid cash in exchange. Increases (decreases) in liabilities represent net cash inflows (outflows).When a liability increases, the firm must have received cash in exchange. Cash Flows - P. 6Converting Indirect Method Cash Flows to Direct Method:Cash Flows =Income Statement +/-Balance Sheet Changes From CustomerSales Advances To SuppliersCOGS Inventory For ExpensesSG&A Accrued expense Prepaid Expense The Income Statement and the Cash Flow from Operations portion of the Statement ofCash Flows of the XYZ Company follow:Sales 90,000Net Income 30,000COGS20,000Add:Depreciation10,000Depreciation10,000Wages12,000 in A/R 3,000Rent 5,000 in A/P 2,000Interest 3,000Less:Taxes10,000 60,000 in Inventory (4,000) 30,000 in Rent Payable (3,000) in Tax Payable (2,000) 36,000Prepare the Cash Flow from Operations using the Direct Method: Cash Flows - P. 7Cash Flow Classification IssuesWhile the classification of cash flows into the three main categories isimportant, we must recognize thatclassification guidelines can be arbitrary.Although total cash flow is not subject to manipulationCFO (and CFF and CFI) is affected by reporting methods that alter theclassification of cash flows among operating, investing, and financing1. Cash flows involving Property Plant and Equipment2. Differences due to some accounting methods3. Interest and dividends received4. Interest paid5. Noncash transactionsDrawbacks of cash from operations (analyst point of view). Cash from operations does not include charges for the use of long-livedassets; depreciation is added back into income in arriving at cash fromoperations. Cash from operations does not include cash outlays for replacing oldequipment (required to ensure uninterrupted operating activities). Identical firms that make different accounting choices may report differentcash from operations.1. Leasing firms report lower cash from operations than purchasing firms aslease rentals reduce cash from operations whereas payments forpurchasing reduce cash from investing activities.2. Capitalizing expenditures-firms report higher cash from operations thanexpensing-firms. Cash Flows - P. 8Example:Assumptions:Project -3 year lifeCash disbursements measure progress.Year123TotalCash Receipts1,0001,0001,0003,000Disbursements900600 300 1,800 cash1004007001,200 cash cumul1005001,200INCOME & CASH FLOWCompleted ContractYear123Total Revenues003,0003,000 Expenses 0 1,800 1,800 Income001,2001,200 Inventory(900)(600)1,500 Advances 1,000 (2,000) 1004007001,200 Percentage of Completion123Total 1,5001,0005003,000 Expenses 600 300 1,800 Income600400200 ! A/R(500) 500 CFO1004007001,200 BALANCE SHEETCompleted ContractYear Cash1005001,200 Inventory 1,500 0 Current Assets1,0002,0001,200 Advances (CL)1,0002,0000 Retained Earnings 0 1,200 Liability & Equity1,0002,0001,200 Percentage of CompletionYear Cash1005001,200 Accounts Receivable 500 0 Current Assets6001,0001,200 Advances (CL) Retained Earnings 1,000 1,200 Liability & Equity6001,0001,200 May be called Inventory: Work inProcess at Contract Price and may bereported at times net of advances Cash Flows - P. 9Example:Assumptions:Project -3 year lifeUp front item (UFI) cost of $1,500 may be capitalized orexpensed immediately.Year 1 2 3TotalCash / Income Pre2,0002,0002,0006,000"Up front item"1,5000 0 1,500 cash5002,0002,0004,500 cash cumul5002,5004,500INCOME & CASH FLOWYear123Total Revenues2,0002,0002,0006,000 Expenses 0 0 1,500 Income5002,0002,0004,500 5002,0002,0004,500 Capitalize / Amortize123Total 2,0002,0002,0006,000 Expenses 500 500 1,500 Income1,5001,5001,5004,500 Add Deprec 500 500 1,500 CFO2,0002,0002,0006,000 (1,500) 0 (1,500) Cash5002,0002,0004,500 BALANCE SHEETYear Cash5002,5004,500 0 0 Assets5002,5004,500 Retained Earnings 2,500 4,500 Liability & Equity5002,5004,500 Capitalize / AmortizeYear Cash5002,5004,500 500 0 Assets1,5003,0004,500 Retained Earnings 3,000 4,500 Liability & Equity1,5003,0004,500 Cash Flows - P. 10FREE CASH FLOWSTo overcome these problems, analysts typically use free cashflowsas an alternative measure for cash from operations defined as:CFO less net cash outlays for the replacement of operating capacity.Although the definition implies that only net investment in replacing oldequipment is subtracted from cash from operations, in practice totalinvestment appearing in the cash used by investing activity section of thestatement of cash flows is used. This may overstate (understate) the netinvestment in replacing equipment because some of the investmentreported under cash used by investing activities may represent expansion(downsizing). Thus, the free cash flow may overstate or understate truecash from operations.Free cash flows still shares two drawbacks of cash from operations Interest and dividends received, which are classified as operating cashflows, should be reclassified (using the after-tax numbers) as investingcash flows. This has the advantages of reporting operating cash flowsthat reflect only operating activities of the firm's core business Interest payments, which are classified as operating cash flows, shouldbe reclassified (using the after-tax numbers) as cash used by financingactivities. This has the advantage of reporting identical cash fromoperations by two firms with different capital structure but otherwiseidentical. Significant Noncash transactions Cash Flows - P. 11Alternatively CFO provides information as toLiquidityThe cash flow statement provides information about the firm's liquidityand its ability to finance its growth from internally generated funds.The Effect of Accounting PoliciesThe cash flow statement allows the analyst to distinguish between theactual events that have occurred and the accounting assumptions thathave been used to report these events.The (Validity) of the Going Concern Assumptionthe statement of cash flows serves as a “check” on the assumptionsinherent in the income statement.Analysis of Cash Flow TrendsThe data contained in the statement of cash flows can be used to1. Review individual cash flow items for analytic significance2. Examine the trend of different cash flow components over time and theirrelationship to related income statement items.3. Consider the interrelationship between cash flow components over time Cash Flows - P. 12