Chapter 7--Learning Objectives

1. Understand how the statement of cash flows assists users in evaluation of firm performance

Current operating cash flowsa major user need

Current operating cash flows

(COCF)

is cash available from

normal operations

Current operating cash flowsmust be adequate for: 1. Permanent working capital 2. Seasonal working capital 3. Net fixed (and other long-term) assets 4. Repayment of debt principal &

interest 5. Payment of dividends

Permanent working capital

a firm’s permanent investment in net operating asset

receivables and inventory less the amount of this investment financed by trade creditors through accounts payable

Seasonal working capital

increases in inventory levels required by seasonally increased demands for the firm’s product or service

Adequacy ratios

The following ratios help assess the adequacy of COCF to meet firm needs:

Capital acquisition ratio Debt coverage ratio Dividend coverage ratio Cash flow adequacy ratio

Adequacy ratios (cont.)

Capital Financing Reinvestment Cash-Interest Coverage Dividend Payout

Performance and quality ratios

Cash flow return on assets Cash flow return on common equity Quality of sales ratio Quality of income ratio (2) Cash flow per share

Cash flow return on assets

COCF before interest and taxes *

Average total assets

* inclusion of taxes varies in practice

Cash flow return on common equity

COCF - preferred dividends

Average common equity

Quality of sales ratio

Cash from sales

Sales

Quality of income ratio # 1

Current operating cash flows

Operating income

Quality of income ratio # 2

C O C F before interest and taxes

Income before interest, taxes & deprec.

Cash flow per share*

C O C F - preferred dividends

Average number of common shares

*explicitly prohibited from disclosure in annual report

Chapter 7--Learning Objectives

2. Interpret the format and content of the statement of cash flows

Statement of cash flows

The purpose of the cash flow statement is to show the sources and uses of cash

Where did the cash come from ?Where did it go ?

Statement of cash flows

The statement has three principal sections: 1. Operating activities 2. Investing activities 3. Financing activities And two ancillary sections 1. Noncash investing / financing 2. Reconciliation

Statement of cash flows

The statement can be prepared two ways 1. The indirect method 2. The direct method

Operating activities

Routine inflows and outflows from regular operations

Net income used as a starting point in indirect method

Net income must be adjusted for items which affect income but not cash and for noncash items

Adjustments to net income in the operating section Items which affect income but not cash -- Depreciation and amortization

Noncash items -- Changes in current asset accounts (except certain investments) -- Changes in current liability

accounts

Relationships to remember

An increase in another asset account

results in a decrease in cash

ANOTHER ASSET UP -- CASH DOWNANOTHER ASSET DOWN -- CASH UP

Relationships to remember

Similarly, a decrease in a liability account results in a decrease in cash

LIABILITY DOWN -- CASH DOWNLIABILITY UP -- CASH UP

Investing activities

Investments in our own business Purchase of operational assets Sale of operational assets Investments in other businesses Purchase of securities Sale of securities Making loans to other entities Collecting such loans

Financing activities

Transactions involving owners Sale of stock Payment of dividends Treasury stock transactions Transactions involving creditors Borrowing long-term Repaying long-term debt

Some special cases

Purchase and sale of investments, whether short-term or long-term are INVESTING activities

Dividends and interest received from investments are considered to be OPERATING activities

More special cases

Interest paid to creditors is considered to be an OPERATING activity

Dividends paid to stockholders are considered to be a FINANCING activity

Noncash investing and financing activities Transactions in which no cash is involved

Example: Purchase of equipment with no down payment by issuing a long-term note payable

The direct method

Starts with cash received from customers Subtracts cash paid to Suppliers Employees Creditors (interest payments) Governments (taxes) Others (for operations)

A separate reconciliation

from net income

to

net cash flow from operating activities

is required

when the direct method

is used

The indirect method

Begins with net income Adjusts for items which affect income but

not cash and for noncash items Only the operating section is different

between the indirect and direct methods The investing and financing sections are

identical

Chapter 7--Learning Objectives

3. Derive cash flow information analytically from accrual information

Accrual based financial statements do not reveal cash received from customers or cash paid to suppliers

We have to dig this information out for ourselves

What do we know ?

From the income statement, we know sales revenue

From the balance sheet, we know beginning and ending accounts receivable

These numbers can be used to work toward cash received from customers

Sales revenue

Plus: Beginning accts. receivable

Less: Ending accts. receivable

Less: Accts. receivable written off

Equals: Cash recd. from customers

(Now how do we get accounts written off?)

Cash received from customers

Account receivable write-offs

Beginning Allow. for Bad Debts

Plus: Bad Debt Expense

Less: Ending Allow. for Bad Debts

Equals: Accounts written off

What about cash paid to suppliers ?

Purchases

Plus: Beginning Accts. Payable

Less: Ending Accts. Payable

Equals Cash paid to suppliers

If necessary, Purchases is calculated

Cost of Goods Sold

Plus: Ending Inventory

Less: Beginning Inventory

Equals: Purchases

Chapter 7--Learning Objectives

4. Differentiate between the direct and indirect method of presentation

East-West IndustriesStatement of Cash Flows - Direct Method

For the year ended June 30, 1995

Cash flows from operating activities

Collections from customers $200,000

Payments to vendors (60,000)

Payments to employees (40,000)

Payments to creditors (20,000)

Payments to utilities (20,000)

Payments to governments (30,000)

Cash flow from operations $30,000

East-West IndustriesStatement of Cash Flows - Direct Method

(continued)

Cash flows from investing activities

Proceeds from sale of PP&E 100,000

Proceeds from sale of land 110,000

Proceeds from sale of patents 70,000

Purchase of PP&E (200,000)

Purchase of land ( 50,000)

Purchase of intangibles ( 20,000)

Cash flow from investing 10,000

East-West IndustriesStatement of Cash Flows - Direct Method(continued)Cash flows from financing activities

Sale of stock 30,000

Issuance of bonds 100,000

Repurchase of stock (90,000)

Retirement of debt (10,000)

Payment of dividends (20,000)

Cash flow from financing 10,000

Net increase in cash 50,000

Balance, June 30, 1994 120,000

Balance, June 30, 1995 170,000

Operating Section - Indirect Method

Cash flows from operating activities

Net income $97,000

Depreciation expense 48,000

Amortization of patents 4,000

Depletion of natural res. 6,000

Deferred income taxes 17,000

Noncash interest expense 19,000

Gain on sale of land (47,000)

Loss on sale of PP&E 12,000

Gain on debt retirement (40,000) 19,000

Operating Section - Indirect Method--continued

Cash flows from operating activities

Gain on debt retirement (40,000) 19,000

Decrease in accts. receivable 9,000

Increase in AFBD 3,000

Increase in inventory (60,000)

Decrease in accts. payable (30,000)

Decrease in wages payable (12,000)

Increase in utilities payable 4,000

Net cash flow from operations $30,000

Chapter 7--Learning Objectives

5. Prepare a statement of cash flows