1. Course Title:
Financial Statement Analysis
Course Code:
MGT-537
Course Instructor:
Dr. Hafiz Muhammad Ishaq
Total Lectures: 32

2. Previous Lecture Summary
Statement of Cash Flows
Financial Ratios and the Statement of Cash Flows,
Practical Exercises

3. Today’s Lecture Topics
Statement of Cash Flows
Operating Cash Flow/Current Maturities of Long-Term
Debt and Current Notes Payable,
Operating Cash Flow/Total Debt,
Operating Cash Flow Per Share,
Operating Cash Flow/Cash Dividends
Alternative Cash Flow,
Procedures for Development of the Statement of Cash Flows
Practical Exercises
Today’s Lecture Topics

4. Financial Ratios and the Statement of Cash Flows
Statement of cash flows is relatively new
Required presentation began in 1987
Cash flow financial ratios were slowly developed
Traditional 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 debt
Higher 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 flow
Conservative 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 share
Does not reflect firm’s profitability
Firms 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 flow
Alternative definition
Net income plus depreciation expense
Less 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.
Increase
Decrease
Current assets
Operating outflow
Operating inflow
Noncurrent assets
Investing outflow
Investing inflow
Current liabilities
Long-term liabilities
Financing inflow
Financing outflow
Stockholders’ equity

11. Procedures to Develop the Statement of Cash Flows (Cont’d)
Determine change in cash and cash equivalents
Compute the change in all other balance sheet accounts
Classify as operating, investing, and financing

12. Procedures to Develop Direct Operating Cash Flows
Operating section describes income statement accounts as receipts or payments
Cash receipts
From customers
From other operating sources
Cash payments
For merchandise
To employees
For other operating expenses

13. Procedures to Develop Indirect Operating Cash Flows
Begin with net income
Eliminate gains and losses that relate to investing and financing activities
Add back or deduct adjustments to change accrual-based net income to cash basis
Current noncash assets
Current liabilities

14. Practical Exercise Melvin Company Balance Sheet
The following statements are presented for Melvin Company.
Melvin Company
Balance Sheet
December 31, 2010, and 2009
Assets
2010
2009
Cash
$ 625
$ 499
Marketable securities,
260
370
Trade accounts receivable, less allowances
of 36 in 2010 and 18 in 2009
1,080
820
Inventories, FIFO
930
870
Prepaid expenses
  230
220
Total current assets
$3,125
$2,779
Investments
 $  820
 $  600

15. Practical Exercise (Cont’d)
Property, plant, and equipment:
Land
$ 130
$ 127
Buildings and improvements
760
670
Machinery and equipment
2,100
 1,400
$2,990
$2,197
Less allowances for depreciation
1,100
  890
$1,890
$1,307
Goodwill
  500
  550
Total assets
$6,335
$5,236

16. Practical Exercise (Cont’d)
Liabilities and Shareholders' Equity
Accounts payable
$1,200
$  900
Accrued payroll
100 80
Accrued taxes
  300
  200
Total current liabilities
$1,600
$1,180
Long-term debt
900
750
Deferred income taxes
300
280
Shareholders' equity:
Common stock
1,000
Retained earnings
2,535
2,026
Total liabilities and shareholders' equity
$6,335
$5,236

17. Practical Exercise (Cont’d)
Melvin Company
Income Statement
For the Year Ended December 31, 2010
Net sales
$8,000
Cost of goods sold
3,900
Gross profit
$4,100
Selling, administrative, and general expenses
2,600
Operating income
$1,500
Interest expense
  100
Income before income taxes
$1,400
Income taxes
  400
Net income
$1,000
Net income per share
$ 2.00
Note: 500 shares of common stock were outstanding.

18. Practical Exercise (Cont’d)
Melvin Company
Statement of Cash Flows
For the Year Ended December 31, 2010
Cash flows from operating activities:
Net income
$1,000 
Adjustments to reconcile net income to net cash provided by Operating
activities:
Depreciation
$210 
Amortization
50 
Increase in accounts receivable
(260)
Increase in inventories
(60)
Increase in prepaid expenses
(10)
Increase in accounts payable
300
Increase in accrued payroll 20
Increase in accrued taxes
100
  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 taxes
20 
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 capital 2.
current ratio 3.
acid-test ratio (conservative) 4.
operating cash flow/current maturities of long-term debt and current notes payable 5.
operating cash flow/total debt 6.
operating cash flow per share b.
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 presented
using 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 Exercise
Arrowbell 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 Company
Sales and Net Income
Year 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 Company
Balance Sheet
December 31, 2005 and 2004
Assets
Current assets:
Cash $ 250,480 $260,155
Accounts receivable (net) $760,950 $690,550
Inventories at lower of cost or market $725,318 $628,238
Prepaid expenses $ 18,555 $ 20,250
Total current assets $1,755,303 $1,599,193
Plant and equipment:
Land, building, machinery, and equipment $3,150,165 $2,646,070
Less Accumulated depreciation $ 650,180 $ 525,650
Net plant and equipment $2,499,985 $2,120,420
Other assets:
Cash surrender value of life insurance $ ,650 $ ,180
Other $ ,660 $ ,918
Total other assets $ ,310 $ ,098
Total assets $4,316,598 $3,776,711

27. Practical Exercise (Cont’d)
Liabilities and Stockholders’ Equity
Current liabilities:
Notes and mortgages payable, current portion $ 915,180 $ 550,155
Accounts payable and accrued liabilities $1,150,111 $ 851,080
Total current liabilities $ 2,075,291 $ 1,401,235
Long term notes and mortgages payable
Less current portion above $ 550,000 $ 775,659
Total liabilities $2,625,291 $2,176,894
Stockholders’ equity:
Capital stock, par value $1.00; authorized
800,000; issued and outstanding
600,000 (2005 and 2004) $600,000 $600,000
Paid in excess of par $890,000 $890,000
Retained earnings $201,307 $109,817
Total stockholders’ equity $1,691,307 $1,599,817
Total liabilities and stockholders’ equity $4,316,598 $3,776,711

28. Practical Exercise (Cont’d)
Arrowbell Company
Cash Flow statement
December 31, 2005 and 2004
Cash flows from operating activities
Net Income $151,490 $86,800
Noncash expenses revenues losses
And gains included in income:
Depreciation , ,180
Increase in accounts receivable (70,400) (10,180)
Increase in inventories (97,080) (15,349)
Decrease in prepaid expenses
In 2005, increase in ,695 (1,058)
Increase in accounts payable
And accrued liabilities , ,265
Net cash provided by operating activities 429, ,658

29. Practical Exercise (Cont’d)
Cash flows from investing activities:
Proceeds from retirement of
Property plant and equipment 10,115 3,865
Purchase of property plant
And equipment (524,435) (218,650)
Increase in cash surrender
Value 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, ,155
Cash dividends (60,000) (60,000)
Net cash provided by financing activities 79,366 49,155
Net 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 payables
If 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. Comment
The 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 Concern
Suppliers 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. Comments
The 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 Concern
A 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-Term
Debt and Current Notes Payable,
Operating Cash Flow/Total Debt,
Operating Cash Flow Per Share, Operating
Alternative Cash Flow
Procedures for Development of the Statement of Cash Flows
Practical Exercises
Lecture Summary