This week its Accounting Theory 1-1 Session 1 Session 2 Tuesday Financial Statements/Expenses/Revenues Accounting Cycle & Accounts Wednesday The Income

This week its Accounting Theory

1-1

Session 1 Session 2

Tuesday Financial Statements/Expenses/Revenues Accounting Cycle & Accounts

Wednesday The Income Statement The Balance Sheet

Thursday The Cash Flow Statement Tools & Techniques

Friday Presentations Presentations

Why Cash Flow is Important: An Example


The company reported rising amounts of net income.

The company failed to generate any cash from its operations.

These deficits were offset by borrowings.The company went bankrupt in 2008.


It is possible for a company to post a healthy net income but not have cash needed to pay its employees, suppliers, and bankers.

Positive net income on the income statement is ultimately insignificant unless a company can translate its earnings into cash.


The statement of cash flows:provides information about cash inflows and

outflows during an accounting period and over time and

is extremely important as an analytical tool.


Cash flows are segregated by:

operating activities,investing activities,

andfinancing activities.

Statement of Cash Flows: Basic Principle

The statement of cash flows is another way of presenting the balance sheet of the company.

The balance sheet shows amounts at the end of the accounting period.

The statement of cash flows shows changes in the balance sheet accounts between periods.


Change in cash between periods is explained by changes in all other balance sheet accounts.

Each balance sheet account is related either to an operating activity, an investing activity, or a financing activity.

Change in cash between periods is equal to cash flow from operating activities, investing activities, or financing activities.



Cash account increased by $1,299 million between November 30, 2006 and 2007. Operations used cash (net outflow) of $45,945 million. Investing activities used cash (net outflow) of $1,698

million. The company borrowed (net inflow) $48,592 million.

The company borrowed to cover the cash deficit in operations and capital expenditures.

Preparing a Statement of Cash Flows

Begins with a return to the balance sheetRequires reordering of the information

presented on a balance sheetShows changes over time rather than the

absolute dollar amount of the accounts at a point in time




Four parts of a statement of cash flowsCashOperating activitiesInvesting activitiesFinancing activities


Cash includes:cashhighly liquid short-term marketable

securities (cash equivalents)short-term investments


Operating activities include:delivering or producing goods for saleproviding servicescash effects of transactions and other events

that enter into the determination of income


Investing activities include:acquiring and selling or otherwise disposing

of: securities that are not cash equivalents productive assets that are expected to benefit the firm

for long periodslending money and collecting on loans


Financing activities include:borrowing from creditors and repaying

principalobtaining resources from owners and

providing them with a return on the investment


Prepared by:calculating changes in all of the balance

sheet accounts, including cash,listing the changes in all of the accounts

except cash as inflows or outflows, andcategorizing the flows by operating,

financing, or investing activities.The inflows less the outflows balance to and

explain the change in cash.



The next step is to transfer the account changes to the appropriate area of a statement of cash flows.

In doing so, a determination must be made of what constitutes an inflow and what constitutes an outflow.



Exhibit 4.2 (Inflows)Decrease in other assetsIncrease in long-term debtIncrease in common stock and additional

paid-in capital(Outflows)Increase in inventoriesDecrease in notes payable


Accumulated depreciationappears in the asset sectionis actually a contra-assetreduces the amount of total assetsshown in parentheses on the balance

sheethas the same effect as a liability account


Other complicationsTwo transactions in one accountMultiple transactions affecting other

accounts

Calculating Cash Flow from Operating Activities

Operating activities represent cash generated internally.

Investing and financing activities provide cash from external sources.


Firms may use one of two methods to calculate cash flow from operating activities: Direct Method Indirect Method

Direct and indirect methods yield identical figures for net cash flow from operating activities.


The direct method shows:cash collection from customersinterest and dividends collectedother operating cash receiptscash paid to suppliersinterest paidtaxes paidother operating cash payments


The indirect method starts with net income and adjusts for:

deferralsaccrualsnoncash itemsnonoperating items



Cash Flow from Investing Activities

Additions to property, plant, and equipment represent a cash outflow of $14.1 million.

Decrease in other assets represents a cash inflow of $295 thousand.

Cash Flow from Financing Activities

Sage Inc. issued new shares of stock during 2013.

The total cash generated from stock sales amounted to $256 thousand.


Short-term debt and current maturities of long-term debt jointly explain Sage Inc.’s net reduction in short-term borrowings:


Long-term borrowings should be segregated into two components Additions to long-term borrowings Reduction of long-term borrowings

Additions to long-term borrowings and reductions of long-term borrowings on the Sage Inc. statement of cash flows reconcile the change in the long-term debt account on the balance sheet.



Change in retained earnings results from net income recognition and the payment of cash dividends. Payment of cash dividends is financing

outflow. Declaration of a cash dividend would not

affect cash.This information is provided in the

Sage Inc. Statement of Stockholders’ Equity.


Change in Cash

In 2013, net cash provided by operating activities, less the net cash used by investing activities, plus the net cash provided by financing activities produced a net decrease in cash and cash equivalents for Sage Inc.:

Change in Cash

The cash flows provided (used) by operating, investing, and financing activities vary considerably depending on:

the company, its performance, its ability to generate cash, its financing and investing strategies, and its success in implementing financing and

investing strategies.

Analyzing the Statement of Cash Flows

The statement of cash flows helps to determine a firm’s:

ability to generate cash flows in the future, capacity to meet cash obligations, future external financing needs, success in productively managing investing

activities, and effectiveness in implementing financing and

investing strategies.


Cash Flow from OperationsIt is possible for a firm to be highly

profitable and not be able to pay dividends not be able to invest in new equipment not be able to service debt go bankrupt


Cash Flow from OperationsOngoing operation depends on success in

generating cash from operations.Firms need cash to satisfy creditors and

investors.Temporary shortfalls of cash can be satisfied

by borrowing or other means, but ultimately a firm must generate cash.


Cash Flow from OperationsPeriods of high interest rates and inflation

contributed to the enhanced attention paid to cash flow by investors and creditors. When interest rates are high, the cost of

borrowing can be out of reach for many firms seeking to cover temporary cash shortages.

Periods of inflation distort the meaningfulness of net income.


Nocash CorporationNocash Corporation had sales of $50,000 in its

first year of operations.Nocash Corporation had sales of $100,000 in

its second year of operations.Nocash Corporation had expenses of $40,000

in its first year of operations.Nocash Corporation had expenses of $70,000

in its second year of operations.



Nocash CorporationThe income statement does not show

that: Nocash eased its credit policies and attracted

lower quality customers. Nocash purchased a new line of inventory near

the end of Year 1 and had to sell it below cost. Rumors regarding problems with accounts

receivable and inventory management prompted some suppliers to refuse the sale of goods on credit to Nocash.

The effects of these factors can be found on the balance sheet.



Nocash CorporationIf Nocash’s net income is recalculated

on a cash basis, the following adjustments would be made:


Nocash CorporationMore sales revenue was recognized

in computing net income than was collected in cash.

The increase in accounts receivable is subtracted.


Nocash CorporationThe increase in inventory is

deducted, reflecting the cash outflow for inventory purchases in excess of the expense recognized through cost of goods sold.


Nocash Corporation Cash payments to suppliers in Year 2 were

greater than the amount of expense recorded. The decrease in accounts payable is deducted.


Nocash CorporationAppearance of $10,000 note payable

indicates that borrowing has enabled Nocash to operate.

Unless Nocash can generate cash, its problems will compound.

Bankers refer to this problem as a company’s “selling itself out of business.”

Sage Inc.: Analysis of the Statement of Cash Flows

An analysis of the statement of cash flows should cover the following areas:

Analysis of cash flow from operating activitiesAnalysis of cash inflowsAnalysis of cash outflows


Cash Flow from Operating ActivitiesThe statement of cash flows provides the

“net cash flow from operating activities.”The analyst should be concerned with:

the success or failure of generating cash from operations

the underlying causes of operating cash flow the magnitude of operating cash flow fluctuations in cash flow from operations



Cash Flow from Operating Activities – Sage Inc.Negative cash flow from operations in 2012Positive net income in 2012Apparent cause was substantial growth in

accounts receivable and inventories.Positive cash flow in 2013It will be necessary to monitor cash flow

operations and the management of inventories.


Summary Analysis of the Statement of Cash FlowsProvides an approach to analyzing the

statement of cash flowsProvides comparative cash flow dataUnderlines the importance of internal cash

generation from operationsHighlights the implications for investing and

financing activities when cash is not generated from operations




Analysis of Cash Inflows – Sage Inc.Operations supplied 62% of needed cash in

2013 and 73% in 2011.The firm had to borrow heavily in 2012, with

debt accounting for 98% of cash inflows.Sage Inc. also borrowed in 2013 and 2011

to obtain needed cash not supplied by operations.


Analysis of Cash InflowsGenerating cash from operations is the

preferred method for obtaining cash.Using external sources to generate the

majority of cash year after year should be further investigated.


Analysis of Cash Outflows – Sage Inc.Purchases of property, plant, and equipment

decreased in 2012 compared to 2011.Capital expenditures increased in dollars from

2012 to 2011 but not in percentage due to negative cash flow from operations.

Dividends paid increased from 2011 to 2012 and decreased from 2012 to 2013, but percentages declined each year due to cash outflows.


Analysis of Cash Outflows – Sage Inc.Capital expenditures in 2011 were

covered by cash from operations.Capital expenditures in 2012 were

covered by borrowing.Capital expenditures in 2013 were

covered by both cash from operations and borrowing.


Analysis of Cash OutflowsWhen analyzing cash outflows, the analyst

should consider: the necessity of the outflow how the outflow was financed

Generally, it is best to finance: short-term assets with short-term debt long-term assets with long-term debt or issuance

of stock


Analysis of Cash OutflowsRepayment of debt is a necessary outflow.

Notes to the financial statements are useful in assessing how much cash will be needed in upcoming years to repay outstanding debt.

Firms should only pay dividends if the company has excess cash not needed for: expansion property, plant, or equipment repayment of debt

Qualitative Issues Relating to the Statement of Cash Flows

Recording operating expenses as capital expenditures

Management of current asset and liability accounts

Accounting for vendor financing transactionsRecording of purchases and sales of trading

securities for nonfinancial companies

Documents

This week its Accounting Theory 1-1 Session 1 Session 2 Tuesday Financial Statements/Expenses/Revenues Accounting Cycle & Accounts Wednesday The Income