CHAPTER 5: CASH FLOW STATEMENT PROBLEM SOLUTIONS

Assessing Your Recall

5.1 Because income recognition is done on an accrual basis the recognition of revenues and expenses either leads or lags cash inflows and outflows to some degree. Therefore, the income statement is not as useful in determining the cash situation of the company. Since cash is such an important commodity and the company cannot operate without an adequate supply of it, the cash flow statement provides useful information to the reader. The cash flow statement also reports on activities not covered (or partially covered) by the income statement (investment and financing activities).

5.2 Knowledge of the timing of the collection of receivables and the payment of payables as well as the level of inventories can help the reader of the financial statements understand the leads and lags between the recognition of income and the related cash flows. For instance, the more time the company gives its customers to pay (Accounts Receivable policy) the greater the lag will be between the recognition of the sale for income purposes and the recognition of the cash inflow. The higher the level of inventories required at the end of each period, the bigger the gap will be between the outflow of cash to pay for inventory and the recognition of those costs as expenses at the time of sale. The accounts payable policy also introduces a lag between the recognition of costs and the cash outflow.

5.3 The lead/lag relationship means that the cash flows of the company, for expenses and revenues, may either lead or lag the recognition of these expenses and revenues for income statement purposes. For this reason the cash flow statement provides different information from the income statement.

5.4 There are many reasons a company may have a cash flow problem. Listed below are some of the reasons and some potential solutions.a) Collection of Receivables (A/R Policy) – This problem involves the accounts receivable policy of the company. The longer the lag between the time of sale and the collection of the receivable the more of a problem cash flow can be. Possible solutions are to change the A/R policy so as to shorten it. This may have the negative side effect of turning customers away. Another alternative would be to offer a discount for prompt payment. Whether this solves the cash flow problem or not depends on how much the discount is and whether it is effective. The company gets the cash in sooner but it gets less. Another alternative would be to sell the accounts receivable. Again the benefit of receiving the cash sooner must be balanced with the fact that less cash is received.

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b) Inventory Policy – Inventory requires cash to make or buy and the longer

it remains unsold the bigger the lag between cash outflow and cash inflow from the sale. One possibility to reduce the cash outflow would be to reduce inventory levels. The cost of doing this, of course is that there is increased risk of stocking out of inventory and losing customers. This risk must be weighed against the cost of keeping too high a level of inventory. Many companies have attempted to implement different production/buying strategies that minimize inventories. The just-in-time strategies have the effect of reducing inventory levels, sometimes significantly so.c) Account Payable Policy – The longer the company can wait to pay its own bills the better off it will be from a cash flow perspective. This puts the cash outflows to acquire new inventory closer to the cash inflows from the sales of the goods available for sale. A company may try to negotiate better credit terms from its suppliers or find another supplier that is willing to give better terms.d) Expenses – The expenses of the company may be too high, regardless of the lead/lag relationships discussed above. Cost cutting measures can be implemented to reduce costs. Care must be exercised so as not to reduce the quality of the product.e) Revenues – The selling price of the good can be increased to

improve cash flows. Whether this works or not depends on whether the customers are willing to accept the price increase. This, of course, depends on the supply and demand characteristics of the marketplace.f) Cash Resources – Sometimes a cash flow problem is temporary and

will eventually turn around. In the meantime, however, the company may need to cover several periods of negative cash flows. The larger the balance in cash the easier this will be. Alternatives here are to either borrow more money (the company would then have to factor in the cash flows for the repayment of the loan) or to raise cash by issuing more equity.

5.5 The three major categories of cash flows are:Operating Activities – These cash flows are those associated with the daily operations of the company in selling goods and services to customers.Financing Activities - These cash flows are those associated with raising funds (cash) for the company to operate. These funds come from two major sources, debtholders, and shareholders. Repayments to the debtholders (principal repayments) and shareholders (repurchase of shares and dividends) are also shown in this section.

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Investing Activities – These cash flows are associated with the long-term investment of cash. The two major categories of items that fit in this section are the investment in property, plant, and equipment and the investment in other companies through acquisitions.

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5.6 The direct method for constructing the operating section of the cash flow statement determines and reports the actual gross cash collections from customers and cash payments to suppliers. The indirect method arrives at the same total cash flow from operations but reports the total as the net income for the period adjusted for all of the items that adjust net income to its cash flow equivalent.

5.7 Amortization is not a source of cash. Cash flows related to property, plant,

and equipment occur when the property, plant and equipment is purchased or when it is sold. During the time that it is held, its original cost is expensed periodically through the amortization entry, but there is no cash flow when this entry is recorded. Amortization does look like a source of cash in the indirect approach to preparing the cash flow statement. It is an addback to the net income in this section. Appearances are deceiving, however, since the reason for adding back the amortization is to correct for the fact that amortization, which is imbedded in the net income number, does not affect cash flows and must therefore be removed from net income in order to arrive at cash flow from operations.

5.8 a) Investing f) Financingb) Financing g) Operatingc) Operating h) Operatingd) Financing i) Gain/loss would be an adjustment in thee) Investing Operating section. There would also be an

entry in the investing section for the cashproceeds which include the gain/loss.

5.9a) Financingb) Investingc) Operatingd) Financinge) Investingf) Financingg) Investingh) While the collection of an individual receivable would be excluded,

the change in total receivables would be included in the cash flow from operations under the indirect method

i) Does not appear on the cash flow statement because the declaration of dividends has no impact on the cash position of a company until the dividends are paid

j) Investing

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Applying Your Knowledge

5.10 Possible sources of cash are:1. Sale of tickets for performances2. Grants from the city or government3. Donations from patrons4. Borrowing of money

Possible uses of cash are:1. Construction of sets and costumes2. Payment of salaries of the employees3. Costs for the upkeep of the theatre4. Payments for advertising5. Purchase of equipment

5.11 A high sales growth rate can cause a company cash flow problems if there is a significant lead/lag relationship between the expenditure of costs and the receipt of revenues. The high growth rate causes the company to larger quantities of inventory which incurs a significant amount of cost. If there is a lag between purchase and sale and then sale and collection these costs do not get covered by corresponding revenues in the short run. The high growth rate exacerbates any lead/lag relationship that already exists. Depending on the characteristics of inventory purchase and the lead/lag relationship there is, in fact, a growth rate beyond which a company will perpetually be in need of infusions of cash. Most companies cannot sustain these high growth rates for long but during the early high growth years of many startup companies the demand for cash is great.

5.12 Cash outflows related to property, plant and equipment are typically at the date of purchase although if the purchase is financed then the cash flows for the purchase may be spread out over several years. During the use of the equipment the only cash outflows are for the normal maintenance and service of the equipment. The cash inflow for the property, plant and equipment comes at the date of sale or retirement. By way of contrast, the income statement shows the expense of using the property, plant and equipment over its useful life and not at the beginning or end of its life although it is possible that the company could show a gain or loss when the property, plant and equipment is sold.

5.13 Interest cash flows are classified as operating activities on the cash flow statement, because interest is deducted in the calculation of net income, and net income is used to derive cash flows from operations. Conceptually, this is not appropriate because interest represents payments to debt-holders, which is a financing activity.

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5.14 a) no effectb) no effectc) decreases cashd) increases cashe) decreases cashf) increases cashg) no effecth) decreases cashi) no effectj) decreases cashk) decreases cash

5.15a. Cash

Accumulated amortization Asset Gain on sale of asset

80,000

95,000 165,000 10,000

Increases cash: $80,000Operating activities: deduct gain of $10,000Investing activities: report cash inflow of $80,000

b. Asset Cash Notes payable

350,000 50,000

300,000

Decreases cash: $50,000Investing activities: report cash outflow of $50,000

c. Interest expense Cash

80,000 80,000

Decreases cash: $80,000(reflected in operating activities through net income)

d. Amortization expense Patent

16,000 16,000

No effect on cashOperating activities: add back the $16,000 because it has been deducted from net income

e. Income tax expense Cash Taxes payable

130,000 95,000 35,000

Decreases cash: $95,000Operating activities: if taxes payable increased from the prior year, add the

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difference

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5.16 a) and b)

Trans. No.

Cash Activity Other Current Assets

Noncurrent Assets

Current Liabilities

Noncurrent Liabilities

Shareholders’ Equity

1 +35,000 +35,0002 -32,000 Operating -32,0003 +60,000 +60,0004 -39,000 -39,0005 +58,000 operating -58,0006 +2,500 -2,5007 -2,000 operating -2,0008 -2,800 investing +2,8009 -1,200 -1,20010 +5,000 +5,00011 -350 operating -35012 +10,000 financing +10,00013 +700 investing -70014 +750 -75015 -600 financing -60016 -575 operating +57517 +10,000 financing +10,00018 +2,000 operating +2,00019 -1,325 operating -1,325

5.17 a) and b)

Trans. No.

Cash Activity Other Current Assets

Noncurrent Assets

Current Liabilities

Noncurrent Liabilities

Shareholders’ Equity

1 +100,000 financing +100,0002 -80,000 investing +120,000 +40,0003 +3,000 operating +3,0004 +25,000 operating +25,0005 +185,000 +185,0006 -25,000 -25,0007 +250,000 operating +100,000 +350,0008 -175,000 operating -175,0009 -10,000 -10,00010 -1,500 investing +1,50011 -360,000 investing +360,00012 -2,500 operating -2,50013 -10,000 operating -25,000 +15,00014 +100,000 financing +100,00015 +50,000 -40,000 +10,00016 -7,500 operating -7,50017 -15,000 -15,00018 -2,000 financing +5,000 -7,00019 -10,000 investing +10,00020 -25,000 operating -25,000

5.18 Cash Flow from OperationsI II III

Net Income (loss) 26,500 13,300 14,800Add:

Amortization expense

3,000 8,000 20,000

Decrease in inventories 10,000Decrease in accounts receivable

2,000

Decrease in prepaid expenses

500 1,000

Increase in salaries payable

2,000

Increase in interest payable

4,000

Increase in accounts payable

4,000 800

Less:Increase in inventories 5,000 15,000Increase in Accounts Receivable

3,500 1,000

Increase in prepaid expenses

1,800

Decrease in salaries payable

3,000 7,000

Decrease in interest payable

1,000 500

Decrease in accounts payable

9,000

Cash Flow from Operations

21,500 23,800 17,800

5.19 Cash Flow from OperationsI II III

Net Income (loss) 52,000 13,000 34,500Add:

Amortization expense 20,000 15,000 10,000Loss on sale 2,000Decrease in inventories

10,000 5,000

Decrease in accounts receivable

4,000

Increase in interest payable

100

Increase in accounts payable

1,000 1,500

Less:Gain on sale 500Increase in inventories

15,000

Increase in Accounts Receivable

5,000 3,500

Decrease in interest payable

500 700

Decrease in accounts payable

2,000

Cash Flow from Operations

74,500 39,300 27,100

5.20Dennison CompanyCash Flow Statement

Year ended December 31, 2001

OperationsNet Income $13,500Add back amortization 23,500Add back loss on sale of equipment 5,000Decrease in accounts receivable 24,000Increase in inventories (20,000)Decrease in accounts payable (10,100)Decrease in salaries payable (12,000)

Cash flow from operations $23,900Investing

Acquisition of property, plant, and equipment (50,000)Proceeds from sale of property, plant, and equipment 25,000

Cash flow from investing (25,000)Financing

Repayment of bank loan (10,000)Dividends (10,000)

Cash flow from financing (20,000)Net Change in Cash ($21,100)

See the t-account analysis that follows.

A-Cash 25,500

Operations:Net income (1) 13,500 20,000 (4) Incr. In Inv.Amortization (2) 23,500 10,100 (5) Decr. In Acc. Pay.Decr. In Acc. Rec.(3) 24,000 12,000 (6) Decr. In Sal. Pay.Loss on Sale of Eq.(7) 5,000

Investing:Proceeds from saleof PP&E (7) 25,000 50,000 (8) Acq. of PP&E

Financing: 10,000 (10) Dividends10,000 (9) Repmt. of Loan

4,400

A-Accounts Receivable A-Inventories

59,000 30,000 24,000 (3) (4) 20,000

35,000 50,000

A-PP&E XA-Accumulated Amortization

165,000 61,900 (8) 50,000 35,000 (7) (7) 5,000 23,500 (2)

180,000 80,400

L-Accounts Payable L-Salaries Payable

38,600 24,000 (5) 10,100 (6) 12,000

28,500 12,000

L-Bank Loan SE-Common Shares

50,000 100,000 (9) 10,000

40,000 100,000

SE-Retained Earnings5,000

(10) 10,000 13,500 (1)

8,500

5.20 Matrix Incorporateda)

Matrix IncorporatedStatement of Income and Retained Earnings

For the year ended December 31, 2001

Sales Revenues $350,000Expenses:

Cost of Goods sold $275,500Amortization Expense 10,000Rent Expense 12,000Interest Expense 15,000Salary Expense 24,000

336,500Net Income 13,500Retained Earnings

December 31, 2000 2,500Retained Earnings

December 31, 2001 $16,000

b)Matrix Incorporated

Balance Sheet December 31, 2001

Assets:Cash $ 2,900Accounts receivable 12,500Prepaid rent 6,000Inventories 18,900Total current assets 40,300

Property, plant and equipment 160,000Accumulated amortization (45,500)

Net property, plant and equipment 114,500Total Assets $154,800Liabilities

Accounts payable $ 13,800Interest payable 9,000Salaries payable 6,000 Current liabilities 28,800Bonds payable 10,000

Total liabilities 38,800Shareholders’ Equity

Common shares 100,000Retained earnings 16,000 Total shareholders’ equity 116,000

Total liabilities and shareholders’ equity $154,800

c)Matix IncorporatedCash Flow Statement

For the year ended December 31, 2001

OperationsNet income $13,500Add back Amortization 10,000Increase in Accounts Receivable (2,500)Increase in Prepaid Rent (6,000)Decrease in Notes Receivable 5,0001

Decrease in Inventories 1,600Increase in Accounts Payable 8,800Increase in Interest Payable 9,000Decrease in Salaries Payable (12,000)

Cash flow from operations 27,400Investing Cash flow from investing 0Financing

Repayment of Bonds (40,000) Cash flow from financing (40,000)Net Change in Cash ($12,600)

1 This would have been classified as an investing activity if it had not arisen as a result of the sale of inventory.

A-Cash 15,500

Operations:Net income (1) 13,500 2,500 (3) Incr. In Acc. Rec.Amortization (2) 10,000 6,000 (6) Incr. In Prepd. Rt.Decr. In Inv. (4) 1,600 12,000 (8) Decr. In Sal. Pay.Decr. in Note Rec(5) 5,000Incr. In Acc. Pay (7) 8,800Incr. In Int. Pay. (9) 9,000

Financing: 40,000 (10) Repmt. of

Debt

2,900

A-Accounts Receivable A-Inventories 10,000 20,500(3) 2,500 1,600 (4)

12,500 18,900

A-Trade Notes Receivable A-Prepaid Rent 5,000 0

5,000 (5) (6) 6,000

0 6,000

A-PP&E XA-Accumulated Amortization 160,000 35,500

10,000 (2)

160,000 45,500

L-Accounts Payable L-Salaries Payable5,000 18,000

8,800 (7) (8) 12,000

13,800 6,000

L-Interest Payable L-Bonds Payable0 50,000

9,000 (9) (10) 40,000

9,000 10,000

SE-Retained Earnings SE-Common Shares2,500 100,000

13,500 (1)

16,000 100,000

5.22 a)Athabasca CompanyCash Flow Statement

Year Ended December 31, 2001

OperationsNet Income $61,000Add back amortization 40,000Decrease in accounts receivable 20,000Increase in wages payable 5,000Increase in inventory (60,000)Decrease in accounts payable (10,000) Cash flow from operations $56,000InvestingAcquisition of building / equipment

(90,000)

Cash flow from investing (90,000)FinancingIssue of shares 70,000Repayment of bonds (50,000)Dividends (35,000)Cash flow from financing (15,000)Net Change in Cash (49,000)

b) The working capital did not change by the same amount as cash generated by operations. It decreased $4,000 ($330,000 - $326,000). The cash balance in working capital is affected by more than just operating activities. Financing and investing activities also affect it.

5.23Crescent Manufacturing Company

Cash Flow StatementYear ended December 31, 20x1

OperationsNet Income $50,00

0Add back amortization 50,00

0Increase in Accounts receivable (31,000)Decrease in Prepaid Insurance 6,

000Increase in Inventories (50,000)Increase in Accounts Payable 2,40

0Decrease in Interest PayableGain on sale of temp. invest.

(2,400)(25,000)

Cash flow from operations $ -0-

InvestingSale of temporary investments 125,000Purchase of Property, plant and equipment

(75,000)

Cash flow from investing 50,000

FinancingRepurchase of common shares (10,000)Dividends (20,000)Repayment of mortgage (25,000) Cash flow from Financing (55,000)

Net Change in cash (5,000)Cash position beginning of year 17,80

0Cash position end of year $12,

800

5.24Simcoe Company

Cash Flow StatementYear ended December 31, 20x1

OperationsNet Income $ 35,000Add back amortization 25,000Increase in accounts receivable (14,000)Decrease in inventories 10,000Increase in accounts payable 17,000Increase in wages payable 10,000 Cash flow from operations $83,000

InvestingPurchase of property, plant and equipment

(115,000)

Cash flow from investing (115,000)

FinancingIssue of bonds 25,000Issue of common shares 25,000 Cash flow from financing 50,000

Net Change in cash 18,000Cash position beginning of year

10,000Cash position end of year $28,000

5.25

Janxen Jeans CompanyCash Flow Statement

Year ended December 31, 20x2

OperationsNet Income $151,000Add back amortization 105,500Decrease in accounts

receivable 13,000

Increase in notes receivable (9,000)Increase in inventories (113,000)Decrease in accounts payable (13,000)Increase in interest payable 7,500Cash flow from operations $142,000

InvestingPurchase of land (25,000)Purchase of machinery (325,000)Sale of machinery 20,000 Cash flow from investing (330,000)

FinancingIssue of long-term debt 150,000Issue of common shares 100,000Dividends (50,000) Cash flow from financing 200,000

Net Change in cash 12,000Cash position beginning of

year 188,000Cash position end of year $ 200,000

5.26 a)Pharmex Pharmaceutical Company

Statement of Income and Retained EarningsYear ended December 31, 20x3

Sales $1,052,000Gain on sale of property, plant, and equipment 15,000

1,067,000Less: Cost of goods sold 878,000Amortization expense 75,000Interest expense 60,000Rent expense 85,000Total expenses 1,098,000Net income (Loss) (31,000)

Retained eEarnings December 31, 20x2 386,000Dividends (20,000)

Retained Earnings December 31, 20x3 $335,000

b)Pharmex Pharmaceutical Company

Cash Flow StatementYear ended December 31, 20x3

Operations:Net income (Loss) ($31,000)Add: Amortization 75,000Increase in accounts receivable(50,000)Increase in inventories (29,000)Decrease in accounts payable (15,000)Gain on sale of property, plant, And equipment (15,000)

Cash flow from Operations (65,000)Investing Activities:

Purchase of machinery (135,000)Sale of machinery 115,000

Cash flow from Investing (20,000)Financing Activities

Bonds Issued 25,000Shares Issued 50,000Dividends (20,000)

Cash flow from Financing 55,000Net change in cash (30,000)Beginning cash balance 80,000Ending cash balance $50,000

T-Account Worksheet

A-Cash 80,000

Operations:Amortization (2) 75,000 31,000 (1) Net Loss.

15,000 (3) Gain on sale of PP&E

50,000 (4) Inc. in A/R29,000 (5) Inc. in Inv.15,000 (7) Dec. in A/P

Investing:Proceeds from sale of machinery (3) 115,000 135,000 (6) Acquisition of

machinery

Financing:Proceeds from:Issuance of bonds(8) 25,000 20,000 (10) Dividends paidIssuance of stocks(9) 50,000

50,000

A-Inventory A-Accounts Receivable 296,000 185,000(5) 29,000 (4) 50,000

325,000 235,000

A-Machinery XA-Accumulated Amortization 545,000 122,500 (6) 135,000 125,000 (3) (3) 25,000 75,000 (2)

555,000 172,500

L-Accounts Payable L-Bonds Payable97,500 150,000

(7) 15,000 25,000 (8)

82,500 175,000

SE-Common Shares SE-Retained Earnings350,000 386,000

50,000 (9) (1) 31,000(2) 20,000

400,000 335,000

5.27a) $680,300 ($673,400 + $85,500 - $78,600) Lazard Company

collected last year’s accounts receivable plus a portion of this year’s sales; its current year sales of $673,400 plus amounts owed from the prior years’ sales that are reflected in the decrease in accounts receivable of $6,900.

b) $490,400 (Lazard company paid to suppliers the cost of its purchases for the current year of $501,600 ($490,000 - $121,000 [ending inventory] + $132,600 [ending inventory]) less the increase in accounts payable of $11,200 ($54,900 - $43,700). Note that the purchases can be computed from the beginning inventory, ending inventory, and cost of goods sold amounts.

5.28 a) Cash generated from operations:Net income $388,900Adjustments:

Amortization expense 67,000Amortization of patent 3,800Gain on sale of equipment (5,000)

Increase in accounts receivable (13,000)Decrease in inventory 7,000Increase in accounts payable 3,500Decrease in wages payable (1,300)Increase in income taxes payable 3,100Cash generated from operations $454,000

Supporting calculations:Amortization of patent: $3800 = $31,200 - $27,400Gain on sale of equipment: $5,000 = $22,000 - $17,000

b)Cash flow from investing activities:

Purchase of patent $(31,200)Purchase of equipment (516,000)Sale of equipment 22,000Cash used in investing $(525,200)

Supporting calculations:Purchase of equipment: $516,000 = $465,000 + $51,000

c)Cash flow from financing activities:

Cash dividends paid $(52,000)Purchase of common shares (44,000)Proceeds from sale of bonds 100,000Cash generated by financing $ 4,000

d)Downsview CompanyCash Flow Statement

Year ended December 31, 2000

OperationsNet Income $388,900Add: amortization Amortization of patent

67,0003,800

Gain on sale of equipment (5,000)Increase in taxes payable 3,100Increase in accounts

receivable (13,000)

Decrease in inventories 7,000Increase in accounts payable 3,500Decrease in wages payable (1,300)Cash Flow from operations $454,000

InvestingPurchase of patent (31,200)Purchase of plant and

equipment(516,000)

Sale of equipment 22,000 Cash flow from investing (525,200)

FinancingIssue of bonds 100,000Redemption of common

shares (44,000)

Dividends (52,000) Cash flow from financing 4,000

Net Change in cashBeginning cash balanceEnding cash balance

(67,200) 261,800

$194,600

5.29 a) The two items that seem to be continuing needs for cash are the acquisition of property, plant, and equipment and dividends. Both of

these items have increased over the last three years and are likely to require even larger expenditures in the future. While cash from operations has also grown over the last three year, this growth has not kept pace with the growth in expenditures for property, plant, and equipment and dividends. In 20x1 cash from operations was just barely sufficient to meet both of these needs. By 20x3 the cash from operation is significantly below the level of these two needs. More sporadically cash has been used over the last three years to retire long-term debt and to repurchase shares. During 20x1 and 20x2 these non-continuing uses of cash were financed by the issuance of long-term debt. In 20x3 the shortfall was covered through the issuance of shares. In terms of the future it would seem that the cash from operations is not keeping pace with the needs of the company and something will have to be done to solve this problem. The issuance of shares in 20x3 also means that in future years there could be a further increase in the amount of dividends paid out, which is not a good sign. Of course the company has the option not to pay dividends, but this may not be its policy.b) The changes in the inventories and accounts payable shown in the operating section do not seem significant and, therefore, do not seem to indicate a problem. The rather large increases in accounts receivable over the last two years are of some concern. These increases may indicate that the company is having a hard time managing the collection of its receivables. Part of the increase could be explained by the growth in income which suggests an increase in the level of sales. However, the increases seem out of line when compared to changes in the inventories and accounts payable which you would also expect to increase in a period of increased volume of activity.c) Since cash from operations was not sufficient to meet the needs of Sherman Brothers in 20x3 it issued shares.

Management Perspective Problems

5.30 The bank loan officer is very interested in determining the ability of the company to pay back its loan. If the loan is short-term then the bank must look for repayment of the loan from operating cash flows and secondarily from other sources of cash that the company might have. This information is best provided by the cash flow statement. The information on the income statement represents the company’s best estimate of the net cash proceeds that will ultimately result from the sale of goods and services during the current accounting period. However, there are many leads and lags in these numbers that prevent net income from being a short-run predictor of cash. If the loan being evaluated is a long-term one then the income statement

becomes much more important to the banker since the repayment of the loan will take place over a much longer period of time.

5.31 The stock analyst attempts to assess and value the productive capabilities of

a company. Those productive capabilities are played out over long periods of time and hence the income statement is likely to be a better source of information in trying to predict future results. The analyst cannot, however, ignore the cash flow statement as it provides useful information about the ability of the company to meet is cash flow and liquidity needs. If the company is unsuccessful in managing its cash position in the short run it may not make it to the long run to capture the value that is represented in its forecasted earnings. Yet, if you had to decide which statement would likely be more useful, you would conclude that the income statement is more useful to the analyst.

5.32 Management compensation plans are typically used to motivate mangers to

think about the long run health of the company. Therefore, the income statement would likely be a better performance measure to use than the cash flow from operations since it focuses on the longer run net effect on the wealth of the shareholder rather than the immediate cash picture. On the other hand, if cash flow management were a particular problem for your company you might be tempted to put in measures of both net income and cash flow to focus mangers on both the long-term picture as well as the shorter run cash flow issue.

5.33 In general, lenders should be quite satisfied with the classification of cash

flows into the three categories of operating activities, investing activities, and financing activities. These activities represent the sources (financing) and uses (investing) of cash, in addition to the cash generated as a result of investment in business activities (operating). However, the classification of interest as an operating activity is inappropriate in the sense that interest represents a return paid to lenders, and is thus related to financing rather than to the revenue-generating activities of the business.

5.34 a) Accumulating large amounts of cash and other current assets is not necessarily a sign of good management. Cash and those securities which are readily convertible into cash usually earn no return or a very low return. In addition, increases in accounts receivable and inventory may be beneficial. However these assets, although classified as current, are not as liquid as cash. We do not know the type of activities in which Titalussa Company is involved. The primary source of profit for many companies is through investment in production facilities and the production and sale of goods or through providing services to others. While holding sufficient cash to meet the company’s cash flow needs is necessary, having larger balances is not good utilization of the company’s resources.

b) There is little wrong with having modest amounts of debt if the company is in a mature or declining industry and has limited investment alternatives. If, however, there are opportunities for expansion into new product lines, new territories, or further refinement of existing products, an unwillingness to incur debt in order to take advantage of the opportunities may mean the company is headed for difficult times in the not distant future. At present, the company is earning an 18 percent return on equity. That appears to be a relatively good return. Management obviously is doing some things right.c) We do not know all the details of operating costs and revenues

which may have an impact on the amount of cash flows during the period. However, we are told that revenues are increasing by 10 percent and receivables and inventories are increasing at 20 percent annually. A buildup in accounts receivable and inventory reduces cash available. When the accumulation of inventories exceeds the increase in sales for a period of time, the possibilities of holding obsolete or unsalable inventory increases. The company should carefully evaluate its current inventory levels to be sure they do not have unrecognized inventory losses. Accounts receivables also are increasing faster than sales. The immediate question is whether all of the receivables will be collected. Has an adequate allowances for uncollectibles been made? Has the company loosened its credit standards in order to increase sales and, as a result, had more slow paying customers or ones which will not pay at all? A careful analysis of all accounts receivable appears to be in order as well.d) Titalussa is earning 18 percent on equity. We do not know what

the company is earning on the excess cash which it has on hand. Perhaps if it distributed nearly all of the cash to the shareholders, the same amount of total income would still be earned and the shareholders would get an additional return by investing the funds received. If Titalussa is able to earn a return on theses funds that is greater than that which the shareholders can earn, it should invest the funds. On the other hand, if the investors can earn a 20 percent return on their own and Titalussa is earning only at 18 percent return, the shareholders would be better off receiving the funds and investing them.

5.35a) Sources of cash flow for Green Company:

Dollar Amount % of Total

Operating activities $ 720,000 33.96%Sales of operating assets

$ 400,000 18.87%

Issuance of common shares

$1,000,000 47.17%

Total $2,120,000 100.00%

b) Uses of cash flow for Green Company:

Dollar Amount % of Total

Purchase of operating assets

$1,200,000 43.64%

Retirement of bonds $1,300,000 47.27%Dividends paid $ 250,000 9.09% Total $2,750,000 100.00%

c) One of the reconciling items between net income and cash provided by operations is a deduction of $120,000 for the change in current assets other than cash. Because the amount is deducted it means that current assets increased. An increase in current assets would be consistent with an increase in sales. As sales increase, so would accounts receivable (if sales are made on credit) and inventory levels. Green company appears to have reduced its financial risk during 2000. A total of $1,300,000 of bonds were retired and $1,000,000 of additional shares were issued.

d) The case does not provide information on the total asset base so we do not know how large an investment in capital assets already exists; however, $1,200,000 of new operating assets were purchased and $400,000 was sold, resulting in a net investment of $800,000. This net investment is substantially more than the $230,000 of amortization expense charged on existing assets in 2000. By examining total investment in capital assets, and accumulated amortization, a clearer picture of the rate of expansion that occurred in 2000 can be obtained. It would also be appropriate to examine the footnotes to see if some portion of the assets acquired had previously been leased. If the assets previously had been leased, a cost savings may be

realized through ownership, but there may have been no change in total productive capacity.

Green reduced its net financing by $300,000, and experienced an overall decrease in cash of $630,000. This indicates that additional financing is required if Green expects to continue expanding and to continue dividend payments of $250,000.

5.36a) Accounts receivable have increased by $160,000 this year. b) A total of $5,000 was added to net income for prepaid

expenses in computing cash provided by operations. When this occurs, the total for prepaid expenses at the end of the period is less than the balance at the start of the period. Thus, Johann has reduced the level of prepaid expenses. The cash position is lowered when the prepayments are made and a cash savings occurs in subsequent periods as the benefits are received from the prepayments. c) Inventory has increased $20,000 during 2000. An increase in inventory must be paid for with cash or by increasing accounts payable. d) Accounts payable have increased by $95,000. While we do not know the amount of the total purchases from suppliers for the year, it is probable that this represents a substantial increase in the reliance on credit financing. e) There does not appear to be sufficient information to know whether amortization expense has increased or decreased from the prior year. The cash flow statement indicates only the current year amortization expense. f) Johann has an increase in accounts receivable of $160,000 and an increase in accounts payable of $95,000. A creditor would want to know the total dollar amounts of receivables and payables and the proportion of receivables that Johann is likely to collect. Suppliers have a greater likelihood of being paid if the increase in receivables was due to an increase in sales rather than to problems in collecting accounts receivable. g) The cash balance at December 31, 2000 is close to

$1,000,000 and Johann generated $824,000 from operations in 2000. If it generates a similar amount in 2001, it might come close to

being able to make a payment of $2,000,000 on January 12, 2002. However, it is unlikely that all of the cash can be used for the payment of bonds. Johann has other current liabilities to pay and perhaps the need to invest in other assets. Johann very likely will have to borrow at least some portion of the $2,000,000 or find additional cash through other means.

Reading and Interpreting Published Financial Statements

5.37 a) Sources of cashDollar Amount % of Total

Issuance of shares $1,111,570 19.6Loans receivable 20,000 .3Net obligations incurred for capital leases 23,907 .4Long term debt 4,465,107 78.7Disposition of property, plant and equipment 54,076 1.0

$5,674,660 100.0

b) Uses of cashDollar Amount % of Total

Operations $1,969,370 26.0Payment to Liard Resources 47,455 .6Purchase of property, plant and equipment 5,558,331 73.4

$7,575,156 100.0

c) Accounts receivable decreased $1,231,649; prepaid expenses, deposits and inventories increased $44,643; accounts payable and accrued liabilities decreased $5,099,780; corporate taxes payable increased $57,121.

d) The cash position of Purcell Energy Ltd. decreased dramatically in 1998. This is the result of several factors: a net loss of $2,545,249; a decrease in accounts payable and accrued liabilities of $5,099,780 (the company completely reversed its activity from 1997 where its accounts payable increased by $5,538,039); and an investment in property, plant, and equipment (this investment is less than half the size of the previous year’s investment in property, plant, and equipment). These uses of cash were financed by debt, $4,465,107, and the issuance of shares, $1,111,570.

5.38 a) Sources of cashDollar Amount % of Total

Operations $104,987 22.4Proceeds from long term debt 162,194 34.5Issuance of shares 61,076 13,0Proceeds from disposition of capital assets 15,436 3.3Translation adjustment 1,442 .3Change in non cash investment working capital 124,392 26.5

$469,527 100.0

b) Uses of cashDollar Amount % of Total

Retirement of debt $ 2,131 .8Payment of dividend 10,259 3.9Purchase of capital assets 85,468 32.3Business acquisition 154,005 58.1Other investments 12,906 4.9

$264,769 100.0

c) The cash position of CCL increased by $204,758. This is largely the result of operations, $104,987, proceeds from debt, $162,194, and changes in non cash investment working capital, $124,392. The major uses of cash during the year were to purchase capital assets, $85,468, and to purchase an investment in another company, $154,005.

The major changes from the previous year were an increase in financing from issuing shares ($23,927 to $61,076); a decrease in the amount spent to acquire other companies ($306,252 to $154,005); a decrease in the proceeds earned from disposals ($111,579 to $15,436); and an increase in cash from non cash investment working capital (a negative $106,694 in 1997 to a positive $124,392 in 1998).

5.39 a) Bema Gold has been operating at a loss in each of the three years with 1998 representing the largest loss of $46,127 thousand. Although the company operated at a loss, it generated a positive cash flow from operations in two of the three years. Several of the items that contributed to the losses did not affect cash. The largest of these items in 1998 was the write-down of properties of $32,738 thousand.

There were dramatic changes in its accounts receivable, inventories and accounts payable in 1998. The accounts receivable decreased $1,685 thousand generating more cash for the company. The inventories decreased $446 thousand when in the previous two years they had been increasing. The company is either managing its inventories more efficiently or its sales are stabilizing. The accounts payable decreased $7,423 thousand which means the company used cash to pay off more of its accounts payable.

In each of the three years, Bema Gold has been generating extra cash by issuing shares rather than debt. Its repayment of debt has exceeded its generation of cash through the issuance of new debt.

In each of the three years, Bema Gold has been using cash to invest in other companies and to explore and development new mines. Both of these activities are essential to its long term profitability.

b) The additional information you would want would be the following: the current and expected future state of the mining industry; when the company expects to make a profit; how many shares have been issued; and the current level of debt. Other answers are possible.

5.40 a) Over the last two years, Algoma Central Corporation has generated approximately $32 million in cash annually. In 1997, this was sufficient to cover its cash needs for the year. In 1998, the company used approximately $90 million to buy new capital assets. The amount generated from operations was not sufficient to cover this. The large expenditure for capital assets does appear to be continuing. In 1997, the company purchased $32 million in capital assets and sold capital assets for $61 million.

You would need more information before you could determine whether an expenditure of $90 million or $32 million was typical of this company.

b) The items that would require more investigation or further explanation would be: the decline in net income; the changes in the non-cash operating working capital; the company’s future needs for capital assets; the company’s current debt load; the company’s ratio of debt to equity; why the company chooses to issue new debt rather than issue shares. Other answers are possible.

c) In 1998, the net income declined to $15,963 thousand from the previous year’s $75,950 thousand. However the cash from operations remained virtually the same, $31,155 thousand in 1998 and $33,091 thousand in 1997. The reasons for this are the following: first, the amortization increased approximately $10,000 thousand from the previous year. This is a non-cash expense and the reason for the increase is probably due to the additional capital assets that were acquired. Second, in 1997 there was a gain on the sale of forest lands, $61,299 thousand, that was deducted from the net income amount. The cash proceeds, including the gain, were included under the investing activities. There was no gain in 1998. Third, the change in the non-cash operating working capital in 1998 resulted in an additional deduction of approximately $14,500 thousand larger than the previous year. These major items were the main contributors to the even cash flow from operations in the two years.

5.41 a) In 1997, AT Plastics had a shortfall of cash for the year of $14,815 thousand. In 1998, there was a slight increase in cash of $3,881 thousand. In 1997, the company generated a positive cash flow from operations of $23,638 thousand. However, in the same year, it spent almost $100,000 thousand in new assets. It met its cash needs for the year by increasing its net debt position by approximately $63,000 thousand dollars and by using an additional $14,815 thousand from its cash balance.

In 1998, the company generated $39,129 thousand from operations. In this year, the company purchased approximately $150,000 thousand in new assets. Besides operations, additional cash was generated from issuing $25,000 thousand in new shares and taking on an additional $100,000 thousand in new debt. The combination of these three items enabled the

company to end the year with an increase in cash of $3,881 thousand.

b) The items that would require more investigation or further explanation would be: the change in the non-cash working capital and other liabilities that changed from a negative $3,412 thousand in 1997 to a positive $11,145 thousand in 1998; the company’s future needs for capital assets; the company’s current debt load; and the company’s ratio of debt to equity. Other answers are possible.

c) Although the net incomes in 1997 and 1998 are very similar, the final cash position was different: in 1997 the cash decreased $14,815 thousand and in 1998 , it increased $3,881 thousand. The reason for the decline in cash in 1997 was that the company purchased approximately $100,000 thousand in new assets and only borrowed an additional $70,000 thousand to help cover the cash outlay for assets. The company used approximately $6,000 thousand to repay debt during the year. The combination of the cash from operations and new borrowing and the use of cash for new assets and debt repayment resulted in a decrease in cash of $14,815 thousand.

5.42 The main differences in this cash flow statement appear to be in the financing and investing sections. Financing activities includes increase (decrease) in customer deposits. These customer deposits would be long-term liabilities that result from customers paying money to Mackenzie to manage for them (similar to bank deposits). The investing section includes payment of selling commissions. As Mackenzie is involved in investment and fund management, these selling commissions appear to be long-term liabilities that Mackenzie owes to brokers and other agents who sell Mackenzie products. Also under investing there is a decrease (increase) in loans. On the cash flow statements illustrated in the chapter, loans would normally be included under financing activities. The loans referred to here are not loans that Mackenzie owes to outside lenders. Rather these are loans that customers owe to them. They are assets and therefore are classified correctly as investing activities.

5.43 a) The company is able to meet its need for cash over the last three years

through positive cash flows from operations. This cash has been used to invest in property, plant, and equipment, to buy share investments and to pay dividends. In addition, Volvo obtained

cash through increasing long-term loans in the amount of 3,404 krona in 1997. Non-continuing items include the redemption of shares in the amount of $5,807 that occurred in 1997. b) To understand the financial health of Volvo Group Inc., further explanation or explanation should be obtained for the nature of the share investments that Volvo has made in each of the last three years, and the reason for the increase in debt financing and decrease in equity financing that occurred during 1997. c) The ability of Volvo to generate cash from operations over the last three years is evident from the positive operating cash flows that occurred each year. These cash inflows resulted mainly from stable net income for each of the three years. Except for 1996, the cash from operations exceeded the original net income amount. d) The main differences between this cash flow statement from Sweden and a typical cash flow statement from Canada include the term liquid funds rather than cash or cash position, the fact that each amount on the statement is denoted as being positive or negative, and the use of multiple columns in the presentation of each year. The type of items appearing under each of the three categories, operating, financing and investing, are similar.

Beyond the Book

5.44 Answers to this question will depend on the company selected.

CASE

5.45 Atlantic Service CompanyAlthough Atlantic’s net income increased from 2000 to 2001, it is in a very poor cash position, with accounts receivable, inventory and accounts payable increasing and a very large negative cash position. The cash problem appears to come from two areas, the increase in current assets (accounts receivable and inventories) and the very large purchases of equipment.To overcome this cash difficulty, Atlantic can attempt to increase its cash flow by trying to collect the accounts receivable and reducing the level of inventories. It might also consider discontinuing dividend payment and reassessing the need for such large investments in equipment. However, it is likely that Atlantic should increase its long-term financing by issuing more shares or by arranging for a long-term loan, perhaps secured by a mortgage on its equipment.In general, the cash generated by operations is not that unhealthy. It would have been sufficient to put Atlantic into a positive cash flow if it had not purchased equipment. A recommendation would be to finance large purchases of equipment by long-term debt.

Critical Thinking

5.46 Many countries have issued standards requiring cash flow statements and the IASC has issued a standard requiring a cash flow statement very similar to the one required in Canada. The authors’ major argument is that the definitions provided in these standards tend to conflict, as do the objectives of the related statements of cash flows. Among the dimensions on which the definitions differ include (see Table 1 in the paper): treatment of cash and cash equivalents, treatment of equity securities as cash equivalents, specific guidelines on maturity periods for cash equivalents, and cash flow statement disclosures (presentations of items). For example, the definition of cash in both the U.S. and Canada excludes an investment that matures in more than three months from the time of purchase even though it will mature in less than three months from the balance sheet date. In addition, the definition of cash tends to be a function of the intended users of financial statements. In the U.S., primary financial statements users are investors and creditors, thus the definition of cash tends to be more simplistic than in countries such as Canada, which define cash as cash and certain equivalents that are managed as cash. Whereas short-term borrowings would not be included in the former definition, the later “treasure’s” perspective would subtract such borrowings to arrive at a net cash position.