2 Previous Lecture Summary Statement of Cash FlowsFinancial Ratios and the Statement of Cash Flows,Practical Exercises
3 Today’s Lecture Topics Statement of Cash FlowsOperating Cash Flow/Current Maturities of Long-TermDebt and Current Notes Payable,Operating Cash Flow/Total Debt,Operating Cash Flow Per Share,Operating Cash Flow/Cash DividendsAlternative Cash Flow,Procedures for Development of the Statement of Cash FlowsPractical ExercisesToday’s Lecture Topics
4 Financial Ratios and the Statement of Cash Flows Statement of cash flows is relatively newRequired presentation began in 1987Cash flow financial ratios were slowly developedTraditional ratios relate balance sheet to income statement
5 Operating Cash Flow/Current Maturities of Long-Term Debt and Current Notes Payable Indicates a firm’s abilities to meet its current maturities of debtHigher ratio indicates better liquidity
6 Operating Cash Flow to Total Debt Indicates a firm’s ability to cover total debt with the yearly operating cash flowConservative approach is to include all possible balance sheet debt
7 Operating Cash Flow Per Share A better indication of a firm’s ability to make capital expenditure decisions and pay dividends than is earnings per shareDoes not reflect firm’s profitabilityFirms are prohibited from reporting this statistic in financial statements or in the notes thereto
8 Operating Cash Flow to Cash Dividends Indicates a firm’s ability to cover cash dividends with the yearly operating cash flow
9 Alternative Cash Flow No standard definition of cash flow A summary of the actual or anticipated incomings and outgoings of cash in a firm over an accounting period (month, quarter, year).No standard definition of cash flowAlternative definitionNet income plus depreciation expenseLess useful than the net cash flow from operating activities
10 Procedures to Develop the Statement of Cash Flows Analyze all balance sheet accounts other than cash and cash equivalents.IncreaseDecreaseCurrent assetsOperating outflowOperating inflowNoncurrent assetsInvesting outflowInvesting inflowCurrent liabilitiesLong-term liabilitiesFinancing inflowFinancing outflowStockholders’ equity
11 Procedures to Develop the Statement of Cash Flows (Cont’d) Determine change in cash and cash equivalentsCompute the change in all other balance sheet accountsClassify as operating, investing, and financing
12 Procedures to Develop Direct Operating Cash Flows Operating section describes income statement accounts as receipts or paymentsCash receiptsFrom customersFrom other operating sourcesCash paymentsFor merchandiseTo employeesFor other operating expenses
13 Procedures to Develop Indirect Operating Cash Flows Begin with net incomeEliminate gains and losses that relate to investing and financing activitiesAdd back or deduct adjustments to change accrual-based net income to cash basisCurrent noncash assetsCurrent liabilities
14 Practical Exercise Melvin Company Balance Sheet The following statements are presented for Melvin Company.Melvin CompanyBalance SheetDecember 31, 2010, and 2009Assets20102009Cash$ 625$ 499Marketable securities,260370Trade accounts receivable, less allowancesof 36 in 2010 and 18 in 20091,080820Inventories, FIFO930870Prepaid expenses 230220Total current assets$3,125$2,779Investments $ 820 $ 600
15 Practical Exercise (Cont’d) Property, plant, and equipment:Land$ 130$ 127Buildings and improvements760670Machinery and equipment2,100 1,400$2,990$2,197Less allowances for depreciation1,100 890$1,890$1,307Goodwill 500 550Total assets$6,335$5,236
16 Practical Exercise (Cont’d) Liabilities and Shareholders' EquityAccounts payable$1,200$ 900Accrued payroll10080Accrued taxes 300 200Total current liabilities$1,600$1,180Long-term debt900750Deferred income taxes300280Shareholders' equity:Common stock1,000Retained earnings2,5352,026Total liabilities and shareholders' equity$6,335$5,236
17 Practical Exercise (Cont’d) Melvin CompanyIncome StatementFor the Year Ended December 31, 2010Net sales$8,000Cost of goods sold3,900Gross profit$4,100Selling, administrative, and general expenses2,600Operating income$1,500Interest expense 100Income before income taxes$1,400Income taxes 400Net income$1,000Net income per share$ 2.00Note: 500 shares of common stock were outstanding.
18 Practical Exercise (Cont’d) Melvin CompanyStatement of Cash FlowsFor the Year Ended December 31, 2010Cash flows from operating activities:Net income$1,000 Adjustments to reconcile net income to net cash provided by Operatingactivities:Depreciation$210 Amortization50 Increase in accounts receivable(260)Increase in inventories(60)Increase in prepaid expenses(10)Increase in accounts payable300Increase in accrued payroll20Increase in accrued taxes100 350 Net cash provided by operating activities$1,350
19 Practical Exercise (Cont’d) Cash flows from investing activities:Outflow for investments$(220)Outflow for property, plant, and equipment(793)Net cash outflow for investing activities(1,013)Cash flows from financing activities:Inflow from issuance of bonds$ 150 Inflow from deferred taxes20 Dividends paid(491)(321)Net increase in cash and cash equivalents$ 16
20 Practical Exercise (Cont’d) a. Compute the following for 2010:1.working capital2.current ratio3.acid-test ratio (conservative)4.operating cash flow/current maturities of long-term debt and current notes payable5.operating cash flow/total debt6.operating cash flow per shareb.1. Review the statement of cash flows and comment on significant items.2. Comment on cash dividends in relation to net income and net cash provided by operating activities.c.1.Which items appearing on the cash flow statement do not directly represent cash flow?2.Why are these items disclosed on the cash flow statement?
23 B. (1)Net cash provided by operating activities was $1,350, cash outflow for investing was $1,013, and net cash outflow for financing activities was $321.Cash outflow for property, plant, and equipment was significant in relation to cash provided by operations.B. (2)Cash dividends represent 49% of net income and 36% of cash provided by operating activities.
24 C. (1)Depreciation; Amortization.C. (2)The cash flows from operating activities is presentedusing the indirect approach.This approach starts with net income and adjusts to net cash provided by operating activities.Since the noncash items of depreciation and amortization have been considered to be expenses on the income statement, they need to be added back.
25 Practical ExerciseArrowbell Company is a growing company. Two years ago it decided to expand in order to increase its production capacity. The company anticipates that the expansion program can be completed in another two years. Financial information for Arrowbell Company follows:Arrowbell CompanySales and Net IncomeYear Sales Net Income$2,568,660 $145,800$2,660,455 $101,600$2,550,180 $ 52,650$2,625,280 $ 86,800$3,680,650 $151,490
26 Practical Exercise (Cont’d) Arrowbell CompanyBalance SheetDecember 31, 2005 and 2004AssetsCurrent assets:Cash $ 250,480 $260,155Accounts receivable (net) $760,950 $690,550Inventories at lower of cost or market $725,318 $628,238Prepaid expenses $ 18,555 $ 20,250Total current assets $1,755,303 $1,599,193Plant and equipment:Land, building, machinery, and equipment $3,150,165 $2,646,070Less Accumulated depreciation $ 650,180 $ 525,650Net plant and equipment $2,499,985 $2,120,420Other assets:Cash surrender value of life insurance $ ,650 $ ,180Other $ ,660 $ ,918Total other assets $ ,310 $ ,098Total assets $4,316,598 $3,776,711
27 Practical Exercise (Cont’d) Liabilities and Stockholders’ EquityCurrent liabilities:Notes and mortgages payable, current portion $ 915,180 $ 550,155Accounts payable and accrued liabilities $1,150,111 $ 851,080Total current liabilities $ 2,075,291 $ 1,401,235Long term notes and mortgages payableLess current portion above $ 550,000 $ 775,659Total liabilities $2,625,291 $2,176,894Stockholders’ equity:Capital stock, par value $1.00; authorized800,000; issued and outstanding600,000 (2005 and 2004) $600,000 $600,000Paid in excess of par $890,000 $890,000Retained earnings $201,307 $109,817Total stockholders’ equity $1,691,307 $1,599,817Total liabilities and stockholders’ equity $4,316,598 $3,776,711
28 Practical Exercise (Cont’d) Arrowbell CompanyCash Flow statementDecember 31, 2005 and 2004Cash flows from operating activitiesNet Income $151,490 $86,800Noncash expenses revenues lossesAnd gains included in income:Depreciation , ,180Increase in accounts receivable (70,400) (10,180)Increase in inventories (97,080) (15,349)Decrease in prepaid expensesIn 2005, increase in ,695 (1,058)Increase in accounts payableAnd accrued liabilities , ,265Net cash provided by operating activities 429, ,658
29 Practical Exercise (Cont’d) Cash flows from investing activities:Proceeds from retirement ofProperty plant and equipment 10,115 3,865Purchase of property plantAnd equipment (524,435) (218,650)Increase in cash surrenderValue of life insurance (2,470) (1,845)Other (1,742) (1630)Net cash used for investing activities (518,532) (218,263)Cash flows from financing activities:Retirement of long term debt (225,659) (50,000)Increase in notes and mortgages payable 365, ,155Cash dividends (60,000) (60,000)Net cash provided by financing activities 79,366 49,155Net increase (decrease) in cash $(9,675) $8,550
30 Practical Exercise (Cont’d) Required:Comment on the short term debt position, including computations of current ratio, acid test ratio, cash ratio and operating cash flow /current maturities of long term debt and current notes payablesIf you were a supplier to this company what would you be concerned about?Comment on the long term debt position including computations of the debt ratio, debt/equity, and debt to tangible net worth and operating cash flow/total debt. Review the statement of operating cash flows.If you were a banker, what would you be concerned about if this company approached you for a long term loan to continue its expansion program?What should management consider doing at this point in regard to the company’s expansion program?
33 A. CommentThe usual guideline for the current ratio is two to one.Arrowbell Company had a 1.14 to 1 ratio in 2004 and a .85 to 1 ratio in 2005.The usual guideline for the acid-test ratio is one to one. Arrowbell Company had a .68 to 1 ratio in 2004 and a .49 to 1 ratio in 2005.The cash ratio dropped from .19 in 2004 to .12 in The working capital in 2004 was $197,958, and in 2005 it had declined to a negative $319,988.The short-term debt position appears to be very poor.
34 B. Supplier ConcernSuppliers will be concerned that Arrowbell Company will not be able to pay its creditors and, if payment is made, it will be later than the credit terms.The short-term creditors are financing the expansion program.
37 C. CommentsThe debt ratio has increased in 2005 to .61 from .58 in 2004.The debt/equity ratio has increased in 2005 to 1.55 from 1.36 in (A similar increase in the debt to tangible net worth as the increase in the debt/equity ratio.)There was an improvement in the operating cash flow/total debt, but this ratio remains very low.This indicates that a substantial amount of funds are coming from creditors. In general the dependence on creditors worsened in 2005.
38 Comments (Cont’d)Not enough information is available to compute the times interest earned, but we can estimate this to be between 2 and 3, based on the earnings and the debt. We would like to see the times interest earned to be higher than this amount.The review of the Statement of Cash Flows indicates that long-term creditors are going to be concerned by the use of debt to expand property, plant, and equipment.They also are going to be concerned by the payment of a dividend while the working capital is in poor condition
39 D. Banker ConcernA banker would be especially concerned about the short-term debt situation.This could lead to bankruptcy, even though the firm is profitable.A banker would be particularly concerned why management had used short-term credit to finance long-term expansion.
40 E. Management Consideration Management should consider the following or a combination of the following:Discontinue the expansion program at this time and get the short-term debt situation in order. Tighten control of accounts receivable and inventory, along with using funds from operations to reduce short-term debt.Issue additional stock to improve the short-term liquidity problem and the long-term debt situation. Because of the poor record on profitability and the way that management has financed past expansion, additional stock will probably not be well-accepted in the market place at this time.
41 Lecture Summary Statement of Cash Flows Operating Cash Flow/Current Maturities of Long-TermDebt and Current Notes Payable,Operating Cash Flow/Total Debt,Operating Cash Flow Per Share, OperatingAlternative Cash FlowProcedures for Development of the Statement of Cash FlowsPractical ExercisesLecture Summary