Analyzing Cash flows - Papers Pool

C H4APT E R

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Flowsl

Joan and Joe: A Tale of Woe

Joe added up profits and went to see Joan, Assured of obtaining a much-needed loan.

When Joe arrived, he announced with good cheer: My firm has had an outstanding year,

And now I need a loan from your bank. Eyeing the statements, Joans heart sank Your profits are fine, Joan said to Joe

But where, oh where, is your companys cash flow? Im sorry to say: the answer is no.

L. FRASER

The statement of cash flows, required by Statement of Financial Accounting Standards No. 95, represents a major step forward in accounting measurement and disclosure because of its relevance to financial statement users. Ample evidence has been provided over the years by firms of every conceivable size, structure, and type of business operation that it is possible for a company to post a healthy net income but still not have the cash needed to pay its employees, suppliers, and bankers. The statement of cash flows, which replaced the statement of changes in financial position in 1988, provides information about cash inflows and outflows dur-ing an accounting period. On the statement, cash flows are segregated by operating activities, investing activities,and financing activities.1The mandated focus on cash inthis statement results in a more useful document than its predecessor. A positive net income figure on the income statement is ultimately insignificant unless a company can translate its earnings into cash, and the only source in financial statements for learning about cash generation is the statement of cash flows.

The objectives of this chapter are twofold: (1) to explain how the statement of cash flows is prepared and (2) to interpret the information presented in the

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1Financing and investing activities not involving cash receipts and paymentssuch as the exchange of debt for stock or the exchange of propertyare reported in a separate schedule on the statement of cash flows.

117

118 CHAPTER 4 Statement of Cash Flows

statement, including a discussion of the significance of cash flow from operations as an analytical tool in assessing financial performance. Readers may legitimately ask at this point why it is necessary to wade through the preparation of this statement in order to understand and use the information it contains. This chapter provides a more extensive treatment of the preparation of the statementits underpinningsthan the chapters on the balance sheet, income statement, and statement of stockholders equity. The reason for this approach is its extreme

EXHIBIT 4.1R.E.C. Inc. Consolidated Statements of Cash Flows for the Years EndedDecember 31, 2007, 2006, and 2005 (in Thousands)

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2007

2006

2005

Cash Flows from Operating ActivitiesIndirect Method

Net income

9,394

5,910

5,896

Adjustments to reconcile net income to cash provided (used)

by operating activities

Depreciation and amortization

3,998

2,984

2,501

Deferred income taxes

208

136

118

Cash provided (used) by current assets and liabilities

Accounts receivable

(610)

(3,339)

(448)

Inventories

(10,272)

(7,006)

(2,331)

Prepaid expenses

247

295

(82)

Accounts payable

6,703

(1,051)

902

Accrued liabilities

356

(1,696)

(927)

Net cash provided (used) by operating activities

10,024

3,767)

5,629

Cash Flows from Investing Activities

Additions to property, plant, and equipment

(14,100)

(4,773)

(3,982)

Other investing activities

295

Net cash provided (used) by investing activities

13,805)

4,773)

3,982)

Cash Flows from Financing Activities

Sales of common stock

256

183

124

Increase (decrease) in short-term borrowings

(includes current maturities of long-term debt)

(30)

1,854

1,326

Additions to long-term borrowings

5,600

7,882

629

Reductions of long-term borrowings

(1,516)

(1,593)

(127)

Dividends paid

(1,582)

(1,862)

(1,841)

Net cash provided (used) by financing activities

2,728

6,464

111

Increase (decrease) in cash and marketable securities

1,053)

2,076)

1,758

Cash and marketable securities, beginning of year

10,386

12,462

10,704

Cash and marketable securities, end of year

9,333

$10,386

$12,462

Supplemental cash flow information:

Cash paid for interest

2,585

2,277

1,274

Cash paid for taxes

7,478

4,321

4,706

The accompanying notes are an integral part of these statements.

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CHAPTER 4 Statement of Cash Flows 119

importance as an analytical tool. Understanding the statement is greatly enhanced by understanding how it is developed from the balance sheet and income state-ment; knowing the nuts and bolts helps the analyst utilize its disclosures to maxi-mum effectiveness.

The Consolidated Statements of Cash Flows for R.E.C. Inc., shown in Exhibit 4.1, will serve as the background for an explanation of how the statement is prepared and a discussion of its usefulness for financial analysis.

Preparing a Statement of Cash Flows

Preparing the statement of cash flows begins with a return to the balance sheet, cov-ered in Chapter 2. The statement of cash flows requires a reordering of the information presented on a balance sheet. The balance sheet shows account balances at the end of an accounting period, and the statement of cash flows shows changes in those same account balances between accounting periods (see Figure 4.1). The statement is called a statement of flows because it shows changes over time rather than the absolute dollar

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FIGURE 4.1 How Cash Flows During an Accounting Period

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Operating Activities

Inflows

Outflows

Revenue from sales of goods

Payments for purchase of inventory

Revenue from services

Payments for operating expenses (salaries,

Returns on equity securities (dividends)

rent, etc.)

Returns on interest-earning assets

Payments for purchases from suppliers

(interest)

other than inventory

Payments to lenders (interest)

Investing Activities

Payments for taxes

Inflows

Outflows

Revenue from sales of long-lived assets

Acquisitions of long-lived assets

Returns from loans (principal) to others

Loans (principal) to others

Revenue from sales of debt or equity

Purchases of debt or equity securities of

securities of other entities (except

other entities (except trading securities)

securities traded as cash equivalents)

Financing Activities

Inflows

Outflows

Proceeds from borrowing

Repayments of debt principal

Proceeds from issuing the firms own

Repurchase of a firms own shares

equity securities

Payment of dividends

Total Inflows less Total Outflows = Change in cash for the accounting period

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120 CHAPTER 4 Statement of Cash Flows

amount of the accounts at a point in time.Because a balance sheet balances, the changesin all of the balance sheet accounts balance, and the changes that reflect cash inflows less the changes that result from cash outflows will equal the changes in the cash account.

The statement of cash flows is prepared in exactly that way: by calculating the changes in all of the balance sheet accounts, including cash; then listing the changes in all of the accounts except cash as inflows or outflows; and categorizing the flows by operating, financing,or investingactivities. The inflows less the outflows balance to and explain the change in cash.

In order to classify the account changes on the balance sheet, it is first necessary to review the definitions of the four parts of a statement of cash flows:

Cash

Operating activities

Investing activities

Financing activities

Cash includes cash and highly liquid short-term marketable securities, also called cash equivalents.Marketable securities are included as cash for R.E.C. Inc., becausethey represent, as explained in Chapter 2, short-term highly liquid investments that can be readily converted into cash. They include U.S. Treasury bills, certificates, notes, and bonds; negotiable certificates of deposit at financial institutions; and commercial paper. Some companies will separate marketable securities into two accounts: (1) cash and cash equivalents and (2) short-term investments. When this occurs, the short-term investments are classified as investing activities.

Operating activitiesinclude delivering or producing goods for sale and providingservices and the cash effects of transactions and other events that enter into the deter-mination of income.

Investing activitiesinclude (1) acquiring and selling or otherwise disposing of

(a) securities that are not cash equivalents and (b) productive assets that are expected to benefit the firm for long periods of time and (2) lending money and collecting on loans.

Financing activitiesinclude borrowing from creditors and repaying the principaland obtaining resources from owners and providing them with a return on the investment.

With these definitions in mind, consider Exhibit 4.2, a worksheet for preparing the statement of cash flows that shows comparative 2007 and 2006 balance sheet accounts for R.E.C. Inc. Included in this exhibit is a column with the account balance changes and the category (or categories) that applies to each account. Explanations of how each account change is used in a statement of cash flow will be provided in subsequent sections of this chapter.

(1)(2) Cash and marketable securities are cash. The changes in these two accountsa net decrease of $1,053 thousand (decrease in marketable securi-ties of $2,732 thousand less increase in cash of $1,679 thousand)will be explained by the changes in all of the other accounts. This means that for the year ending 2007, the cash outflows have exceeded the cash inflows by $1,053 thousand.

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CHAPTER 4 Statement of Cash Flows 121

EXHIBIT 4.2 R.E.C. Inc. Worksheet for Preparing Statement of Cash Flows (in Thousands)

CHANGE

2007

2006

(20072006)

CATEGORY

Assets

(1)

Cash

$ 4,061

2,382

1,679

Cash

(2)

Marketable securities

5,272

8,004

(2,732)

Cash

(3) Accounts receivable (net)

8,960

8,350

610

Operating

(4)

Inventories

47,041

36,769

10,272

Operating

(5)

Prepaid expenses

512

759

(247)

Operating

(6)

Property, plant, and equipment

40,607

26,507

14,100

Investing

(7) Accumulated depreciation and amortization

(11,528)

(7,530)

(3,998)

Operating

(8)

Other assets

373

668

(295)

Investing

Liabilities and Stockholders Equity

Liabilities

(9) Accounts payable

14,294

7,591

6,703

Operating

(10)

Notes payablebanks

5,614

6,012

(398)

Financing

(11)

Current maturities of long-term debt

1,884

1,516

368

Financing

(12) Accrued liabilities

5,669

5,313

356

Operating

(13)

Deferred income taxes

843

635

208

Operating

(14)

Long-term borrowings

Additions to long-term borrowings

5,600

Reductions of long-term borrowings

(1,516)

Net change in long-term debt

21,059

16,975

4,084

Financing

Stockholders Equity

(15)

Common stock

4,803

4,594

209

Financing

(16) Additional paid-in capital

957

910

Financing

(17)

Retained earnings

(a)

Net income

9,394

Operating

(b) Dividends paid

(1,582)

Financing

Net change in retained earnings

$40,175

$32,363

7,812

(3)(4)(5) Accounts receivable, inventories, and prepaid expenses are all operating accounts relating to sales of goods, purchases of inventories, and payments for operating expenses.

(6) The net increase in property, plant, and equipment is an investing activity reflecting purchases of long-lived assets.

(7) The change in accumulated depreciation and amortization is classified as operating because it will be used as an adjustment to operating expenses or net income to determine cash flow from operating activities.

(8) Other assets are holdings of land held for resale, representing an investing activity.

(9) Accounts payable is an operating account because it arises from purchases of inventory.

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122 CHAPTER 4 Statement of Cash Flows

(10) (11) Notes payable and current maturities of long-term debt result from borrowing (debt principal), a financing activity.

(12) Accrued liabilities are operating because they result from the accrual of operating expenses such as wages, rent, salaries, and insurance.

(13) The change in deferred income taxes is categorized as operating because it is part of the adjustment of tax expense to calculate cash flow from operating activities.

(14) The change in long-term debt, principal on borrowings, is a financing activity.

(15)(16) Common stock and paid-in capital are also financing activities because the changes result from sales of the firms own equity shares.

(17) The change in retained earnings, as explained in Chapter 3, is the product of two activities: (a) net income for the period, which is operating; and (b) the payment of cash dividends, which is a financing activity.

The next step is to transfer the account changes to the appropriate area of a state-ment of cash flows.2 In doing so, a determination must also be made of what constitutes an inflow and what constitutes an outflow when analyzing the change in an account balance. The following table should help:

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Inflow

Outflow

_ Asset account

_ Liability account

_ Equity account

The table indicates that a decrease in an asset balance and an increase in liability and equity accounts are inflows.3 Examples from Exhibit 4.2 are the decrease in other assets (cash inflow from the sale of property not used in the business), the increase in long-term debt (cash inflow from borrowing), and the increase in common stock and additional paid-in capital (cash inflow from sales of equity securities). Outflows are represented by the increase in inventories (cash outflow to purchase inventory) and the decrease in notes payable (cash outflow to repay borrowings).

Note that accumulated depreciation appears in the asset section but actually is a contra-asset or credit balance account because it reduces the amount of total assets. Accumulated depreciation is shown in parentheses on the balance sheet and has the same effect as a liability account.

Another complication occurs from the impact of two transactions in one account. For example, the net increase in retained earnings has resulted from the combination of net income for the period, which increases the account, and the payment of dividends, which reduces the account. Multiple transactions can also affect other accounts, such as property, plant, and equipment if a firm both acquires and sells capital assets during the period, and debt accounts if the firm both borrows and repays principal.

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2Several alternative formats can be used for presenting the statement of cash flows, provided that the statement is reconciled to the change in cash and shows cash inflows and outflows from operating, financing, and investing activities.

3In accounting terminology, an inflow results from the decrease in a debit balance account or an increase in a credit balance account; an outflow results from the increase in a debit balance account or the decrease in a credit balance account.

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CHAPTER 4 Statement of Cash Flows 123

Calculating Cash Flow From Operating Activities

The R.E.C. Inc. Consolidated Statements of Cash Flows begins with cash flow from operating activities. This represents the cash generated internally. In contrast, invest-ing and financing activities provide cash from external sources. Firms may use one of two methods prescribed by the Financial Accounting Standards Board (FASB) for calculating and presenting cash flow from operating activities: the direct method and the indirect method. The direct method shows cash collections from customers, interest and dividends collected, other operating cash receipts, cash paid to suppliers and employees, interest paid, taxes paid, and other operating cash payments. The indirect methodstarts with net income and adjusts for deferrals; accruals; noncash items, such as depreciation and amortization; and nonoperating items, such as gains and losses on asset sales. The direct and indirect methods yield identical figures for net cash flow from operating activities because the underlying accounting concepts are the same. According to Accounting Trends and Techniques, 593 firms out of 600 used the indirect method in 2003.4 The indirect method is illustrated and explained for R.E.C. Inc. in the chapter and the direct method is illustrated in the appendix to this chapter.

Indirect Method

Exhibit 4.3 illustrates the steps necessary to convert net income to cash flow from operat-ing activities.The steps shown in Exhibit 4.3 will be used to explain the calculation of cash flow from operating activities for R.E.C. Inc. using the indirect method. Exhibit 4.3 includes some adjustments not present for R.E.C. Inc.

R.E.C. Inc. Indirect Method

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Net income

$ 9,394

Adjustments to reconcile net income to cash provided by operating activities:

_ Depreciation and amortization expense

3,998

_ Increase in deferred tax liability

208

Cash provided (used) by current assets, liabilities

_ Increase in accounts receivables

(610)

_ Increase in inventory

(10,272)

_ Decrease in prepaid expenses

247

_ Increase in accounts payable

6,703

_ Increase in accrued liabilities

356

Net cash flow from operating activities

$10,024

Depreciation and amortizationare added back to net income because theyreflect the recognition of a noncash expense. Remember that depreciation repre-sents a cost allocation, not an outflow of cash. The acquisition of the capital asset was recognized as an investing cash outflow (unless it was exchanged for debt or stock) in

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4Accounting Trends and Techniques,American Institute of Certified Public Accountants, 2004.

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124 CHAPTER 4 Statement of Cash Flows

EXHIBIT 4.3 Net Cash Flow from Operating

ActivitiesIndirect Method

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Net income*

Noncash/Nonoperating revenue and expense included in income:

Depreciation, amortization, depletion expense for period

Increase in deferred tax liability

_ Decrease in deferred tax liability

_ Decrease in deferred tax asset

Increase in deferred tax asset

Increase in investment account from equity income**

_ Decrease in investment account from equity income***

_ Gain on sale of assets

_ Loss on sale of assets

Cash provided (used) by current assets and liabilities

_ Decrease in accounts receivable

_ Increase in accounts receivable

_ Decrease in inventory

_ Increase in inventory

_ Decrease in prepaid expenses

_ Increase in prepaid expenses

_ Decrease in interest receivable

_ Increase in interest receivable

_ Increase in accounts payable

_ Decrease in accounts payable

_ Increase in accrued liabilities

_ Decrease in accrued liabilities

_ Increase in deferred revenue

_ Decrease in deferred revenue

Net cash flow from operating activities

*Before extraordinary items, accounting changes, discontinued operations. **Amount by which equity income exceeds cash dividends received.

***Amount by which cash dividends received exceed equity income recognized.

the statement of cash flows for the period in which the asset was acquired. So depre-ciation itself does not require any outflow of cash in the year it is recognized. Deducting depreciation expense in the current years statement of cash flows would be double counting. Amortization is similar to depreciationan expense that enters into the determination of net income but that does not require an outflow of cash. Depletion would be handled in the same manner as depreciation and amortization.

The depreciation and amortization expense for R.E.C. Inc. in 2007 is equal to the change in the balance sheet accumulated depreciation and amortization account.

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CHAPTER 4 Statement of Cash Flows 125

If the firm had dispositions of capital assets during the accounting period, however, the balance sheet change would not equal the expense recognition for the period because some of the account change would have resulted from the elimination of accumulated depreciation for the asset that was removed. The appropriate figure to subtract would be depreciation and amortization expense from the earnings statement.

The deferred tax liability account, as discussed in Chapter 2, reconciles the difference between tax expense recognized in the calculation of net income and the tax expense actually paid. The increase in the liability account for R.E.C. Inc. is added back to net income because more tax expense was recognized in the calculation of net income than was actually paid for taxes.

The increase in accounts receivable is deducted because more sales revenue has been included in net income than has been collected in cash from customers.

The increase in inventory is subtracted because R.E.C. Inc. has purchased more inventory than has been included in cost of goods sold. Cost of goods sold used in calcu-lating net income includes only the inventory actually sold.

The decrease in prepaid expenses is added back because the firm has recognized an expense in the current period for which cash was paid in an earlier period, on a net basis.

The increase in accounts payable is added because less has been paid to suppliers for purchases of inventory than was included in cost of goods sold.

The increase in accrued liabilities is an addition to net income because it reflects the recognition of expense, on a net basis, prior to the payment of cash.

There are other potential adjustments, not required for R.E.C. Inc., that enter into the net income adjustment for noncash expense and revenues. One such item is the recognition of investment income from unconsolidated subsidiaries by the equity method of accounting, discussed in Chapter 3. When a company uses the equity method, earnings can be recognized in the income statement in excess of cash actually received from dividends, or the reverse can occur, for example, in the case of a loss recorded by an investee. For a firm using the equity method, there would be a deduc-tion from net income for the amount by which investment income recognized exceeded cash received. Other potential adjustment items include changes relating to deferred income, deferred expense, the amortization of bond discounts and premi-ums, extraordinary items, and gains or losses on sales of long-lived assets.

Although gains and losses from asset sales are included in the calculation of net income, they are not considered an operating activity. A gain should be deducted from net income, and a loss should be added to net income to determine cash flow from operating activities. The entire proceeds from sales of long-lived assets are included as cash inflows from investing.

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