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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.
Why Cash Flow is Important: An Example
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.
Why Cash Flow is Important: An Example
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.
Why Cash Flow is Important: An Example
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.
Statement of Cash Flows: Basic Principle
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.
Statement of Cash Flows: Basic Principle
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
Preparing a Statement of Cash Flows
Four parts of a statement of cash flowsCashOperating activitiesInvesting activitiesFinancing activities
Preparing a Statement of Cash Flows
Cash includes:cashhighly liquid short-term marketable
securities (cash equivalents)short-term investments
Preparing a Statement of Cash Flows
Operating activities include:delivering or producing goods for saleproviding servicescash effects of transactions and other events
that enter into the determination of income
Preparing a Statement of Cash Flows
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
Preparing a Statement of Cash Flows
Financing activities include:borrowing from creditors and repaying
principalobtaining resources from owners and
providing them with a return on the investment
Preparing a Statement of Cash Flows
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.
Preparing a Statement of Cash Flows
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.
Preparing a Statement of Cash Flows
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
Preparing a Statement of Cash Flows
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
Preparing a Statement of Cash Flows
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.
Calculating Cash Flow from Operating Activities
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.
Calculating 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
Calculating Cash Flow from Operating Activities
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.
Cash Flow from Financing Activities
Short-term debt and current maturities of long-term debt jointly explain Sage Inc.’s net reduction in short-term borrowings:
Cash Flow from Financing Activities
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.
Cash Flow from Financing Activities
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.
Analyzing the Statement of Cash Flows
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
Analyzing the Statement of Cash Flows
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.
Analyzing the Statement of Cash Flows
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.
Analyzing the Statement of Cash Flows
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.
Analyzing the Statement of Cash Flows
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.
Analyzing the Statement of Cash Flows
Nocash CorporationIf Nocash’s net income is recalculated
on a cash basis, the following adjustments would be made:
Analyzing the Statement of Cash Flows
Nocash CorporationMore sales revenue was recognized
in computing net income than was collected in cash.
The increase in accounts receivable is subtracted.
Analyzing the Statement of Cash Flows
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.
Analyzing the Statement of Cash Flows
Nocash Corporation Cash payments to suppliers in Year 2 were
greater than the amount of expense recorded. The decrease in accounts payable is deducted.
Analyzing the Statement of Cash Flows
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
Sage Inc.: Analysis of the Statement of Cash Flows
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
Sage Inc.: Analysis of the Statement of Cash Flows
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.
Sage Inc.: Analysis of the Statement of Cash Flows
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
Sage Inc.: Analysis of the Statement of Cash Flows
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.
Sage Inc.: Analysis of the Statement of Cash Flows
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.
Sage Inc.: Analysis of the Statement of Cash Flows
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.
Sage Inc.: Analysis of the Statement of Cash Flows
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.
Sage Inc.: Analysis of the Statement of Cash Flows
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
Sage Inc.: Analysis of the Statement of Cash Flows
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