Chapter 7--Learning Objectives 4 1.Understand how the statement of cash flows assists users in evaluation of firm performance

Current operating cash flows a major user need Current operating cash flows (COCF) is cash available from normal operations

Current operating cash flows must be adequate for: 4 1.Permanent working capital 4 2.Seasonal working capital 4 3.Net fixed (and other long-term) assets 4 4.Repayment of debt principal & interest 4 5.Payment of dividends

Permanent working capital 4 a firm’s permanent investment in net operating asset 4 receivables and inventory less the amount of this investment financed by trade creditors through accounts payable

Seasonal working capital 4 increases in inventory levels required by seasonally increased demands for the firm’s product or service

Adequacy ratios 4 The following ratios help assess the adequacy of COCF to meet firm needs: 4 Capital acquisition ratio 4 Debt coverage ratio 4 Dividend coverage ratio 4 Cash flow adequacy ratio

Adequacy ratios (cont.) 4 Capital Financing 4 Reinvestment 4 Cash-Interest Coverage 4 Dividend Payout

Performance and quality ratios 4 Cash flow return on assets 4 Cash flow return on common equity 4 Quality of sales ratio 4 Quality of income ratio (2) 4 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 4 2.Interpret the format and content of the statement of cash flows

Statement of cash flows 4 The purpose of the cash flow statement is to show the sources and uses of cash 4 Where did the cash come from ? 4 Where did it go ?

Statement of cash flows 4 The statement has three principal sections: 4 1.Operating activities 4 2.Investing activities 4 3.Financing activities 4 And two ancillary sections 4 1.Noncash investing / financing 4 2.Reconciliation

Statement of cash flows 4 The statement can be prepared two ways 4 1.The indirect method 4 2.The direct method

Operating activities 4 Routine inflows and outflows from regular operations 4 Net income used as a starting point in indirect method 4 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 4 Items which affect income but not cash 4 -- Depreciation and amortization 4 Noncash items 4 -- Changes in current asset accounts 4 (except certain investments) 4 -- Changes in current liability accounts

Relationships to remember 4 An increase in another asset account results in a decrease in cash 4 ANOTHER ASSET UP -- CASH DOWN 4 ANOTHER ASSET DOWN -- CASH UP

Relationships to remember 4 Similarly, a decrease in a liability account results in a decrease in cash 4 LIABILITY DOWN -- CASH DOWN 4 LIABILITY UP -- CASH UP

Investing activities 4 Investments in our own business 4 Purchase of operational assets 4 Sale of operational assets 4 Investments in other businesses 4 Purchase of securities 4 Sale of securities 4 Making loans to other entities 4 Collecting such loans

Financing activities 4 Transactions involving owners 4 Sale of stock 4 Payment of dividends 4 Treasury stock transactions 4 Transactions involving creditors 4 Borrowing long-term 4 Repaying long-term debt

Some special cases 4 Purchase and sale of investments, whether short-term or long-term are INVESTING activities 4 Dividends and interest received from investments are considered to be OPERATING activities

More special cases 4 Interest paid to creditors is considered to be an OPERATING activity 4 Dividends paid to stockholders are considered to be a FINANCING activity

Noncash investing and financing activities 4 Transactions in which no cash is involved 4 Example: Purchase of equipment with no down payment by issuing a long-term note payable

The direct method 4 Starts with cash received from customers 4 Subtracts cash paid to 4 Suppliers 4 Employees 4 Creditors (interest payments) 4 Governments (taxes) 4 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 4 Begins with net income 4 Adjusts for items which affect income but not cash and for noncash items 4 Only the operating section is different between the indirect and direct methods 4 The investing and financing sections are identical

Chapter 7--Learning Objectives 4 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 4 We have to dig this information out for ourselves

What do we know ? 4 From the income statement, we know sales revenue 4 From the balance sheet, we know beginning and ending accounts receivable 4 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 4 (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 EqualsCash 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 4.Differentiate between the direct and indirect method of presentation

East-West Industries Statement 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 Industries Statement of Cash Flows - Direct Method (continued) Cash flows from investing activities Proceeds from sale of PP&E100,000 Proceeds from sale of land110,000 Proceeds from sale of patents70,000 Purchase of PP&E(200,000) Purchase of land( 50,000) Purchase of intangibles( 20,000) Cash flow from investing10,000

East-West Industries Statement of Cash Flows - Direct Method (continued) Cash flows from financing activities Sale of stock 30,000 Issuance of bonds100,000 Repurchase of stock(90,000) Retirement of debt(10,000) Payment of dividends (20,000) Cash flow from financing10,000 Net increase in cash50,000 Balance, June 30, ,000 Balance, June 30, ,000

Operating Section - Indirect Method Cash flows from operating activities Net income$97,000 Depreciation expense48,000 Amortization of patents4,000 Depletion of natural res.6,000 Deferred income taxes17,000 Noncash interest expense19,000 Gain on sale of land(47,000) Loss on sale of PP&E12,000 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. receivable9,000 Increase in AFBD3,000 Increase in inventory(60,000) Decrease in accts. payable(30,000) Decrease in wages payable(12,000) Increase in utilities payable4,000 Net cash flow from operations$30,000

Chapter 7--Learning Objectives 4 5.Prepare a statement of cash flows