Statement of Cash Flows

1. Statement of Cash Flows Revsine/Collins/Johnson: Chapter 17

2. Learning objectives • The major sources and uses of cash—operating, investing, and financing. • Why accrual net income and operating cash flows differ, and the factors that explain this difference. • The difference between the direct and indirect methods of determining cash flow from operations. • How to prepare a statement of cash flows from comparative balance sheet data, an income statement, and other information.

3. Learning objectivesConcluded • Why changes in balance sheet accounts over a year may not reconcile to the corresponding changes included in the statement of cash flows. • What “cash burn rates” are and how they can be used to evaluate the financial viability of start-up companies.

4. Why cash flows are important • Accrual earnings may not always provide a reliable measure of enterprise performance and health. • Accrual accounting relies on subjective judgments that may introduce measurement error and uncertainty into reported earnings. • One-time write-offs and restructuring charges can reduce the quality of reported earnings. • Management can readily manipulate accrual income. • For these reasons, analysts scrutinize a firm’s cash flows—not just its accrual earnings—to evaluate performance and creditworthiness.

5. Statement format Result from events or transactions that enter into the determination of net income; i.e., the cash-based revenues and expenses of a company. Operating cash flows Result from the purchase or sale of productive assets like plant and equipment, marketable securities, and from acquisitions and divestitures. Investing cash flows Result when a company sells its own stocks or bonds, pays dividends or buys back its own shares, or borrows money and repays the amounts borrowed. Financing cash flows Changes in cash

6. Statement format:Direct approach Measures the net cash-based revenues and expenses of a company

7. Statement format:Direct approach continued

8. Statement format:Cash flows and accruals at ABM Cash from operations $110.919 $65.796

9. Statement format:Reconciling cash flows and net income

10. Statement format:Indirect approach Accrual net income Items included in accrual net income but did not affect cash in the period Non-cash revenues and gains - + Non-cash expenses and losses Cash inflows received but not recognized as earned Items excluded from accrual net income but did affect operating cash in the period + - Cash outflows paid but not recognized for accrual purposes Operating cash flows

11. Statement format:Special disclosure rules • SFAS No. 95 allows a choice between the direct and indirect approach for the cash flow statement. • Firms using the direct approach are also required to provide a reconciliation between accrual earnings and operating cash flow, and to separately disclose income taxes paid. • Firms using the indirect approach are required to separately disclose interest paid and income taxes paid.

12. The purpose of the cash flow statement is to explain the underlying causes for the change in the cash balance. A three-step process: Identify the journal entry that led to the reported change in each non-cash balance sheet account. Determine the net cash flow effect of the journal entry. Compare the financial statement effect of the entry (Step 1) with its cash flow effect (Step 2) to determine what cash flow statement treatment is needed . Preparing the cash flow statement:Overview Operating Investing Financing Changes in cash

13. Preparing the cash flow statement:Burris Products Illustration

14. Preparing the cash flow statement:Burris Products solution The starting point for computing cash from operations Why the cash balance changed.

15. Preparing the cash flow statement:Burris Products—depreciation Step 1: The journal entry that generated the account change was: Step 2: Neither of these two accounts involve cash. Step 3: Because depreciation expense was included in the determination of net income but does not represent a cash outflow, the expense must be added back to net income.

16. Preparing the cash flow statement:Burris Products—gain on equipment sale Step 1: The journal entry was: Step 2: The sale resulted in a cash inflow of $57,000. Step 3: The recognized accrual gain ($17,000) does not correspond to the cash inflow ($57,000). The gain is removed from income, and the cash inflow is shown as an investing activity.

17. Preparing the cash flow statement:Burris Products—amortization of bond discount Step 1: The journal entry to record interest expense was: Step 2: The cash outflow as only $40,000. Step 3: Because interest expense ($44,000) exceeds the cash outflow ($40,000), the $4,000 difference is added back to net income.

18. Preparing the cash flow statement:Burris Products—deferred income taxes Step 1: The journal entry to record tax expense was: Step 2: The cash outflow for taxes was only $96,375. Step 3: Because the income statement expense is larger than the cash outflow, the $6,000 difference must be added in the operating activities section of the cash flow statement.

19. Preparing the cash flow statement:Burris Products—accounts receivable Step 1: The two journal entries associated with the account were: Step 2: The amount of cash collections ($3,039,000) exceeded the amount of accrual revenues included in income ($3,030,000). Step 3: The $9,000 excess of cash collections over accrual revenue is added back to net income to obtain cash from operations.

20. Preparing the cash flow statement:Burris Products—customer advance deposits Step 1: The journal entry for this account was: Step 2: There was no corresponding cash flow effect. Step 3: Because revenues exceed 2005 cash inflows by $11,000, this amount must be deducted in the operating section of cash flow statement.

21. Preparing the cash flow statement:Burris Products—inventories Step 1: The journal entries associated with this account were: Step 2: The cost-of-goods-sold deduction from net income ($4,526,625) is $12,000 lower than the cash outflow to buy inventory. Step 3: Because net income understates cash flow to buy inventory, $12,000 must be deducted in the computation of operating cash flow.

22. Preparing the cash flow statement:Burris Products—accounts payable Step 1: The inventory adjustment was computed under the assumption that all inventory was purchased for cash. We now relax that assumption, and note that accounts payable increased by $3,000 during the year. Step 2: This accounts payable increase means that $3,000 of the $12,000 inventory increase was not paid for in cash. Step 3: Therefore, $3,000 is added to net income in the cash flow statement.

23. Preparing the cash flow statement:Operating cash flow summary

24. Preparing the cash flow statement:Burris Products—land Step 1: The journal entry to reflect the increase in land was: Step 2: This transaction represents an $86,000 cash outflow. Step 3: The cash outflow is categorized as an investment outflow.

25. Preparing the cash flow statement:Burris Products—Buildings and equipment Step 1: The changes in this account are summarized by : Step 2: The transaction represents a $261,000 cash outflow. Step 3: The outflow is again categorized as an investment outflow.

26. Preparing the cash flow statement:Burris Products—stock sale and dividend paid Step 1: The journal entries were: Step 2: The cash effects involve a $50,000 inflow and a $90,000 dividend outflow. Step 3: Both the cash inflow and cash outflow are shown as financing activities.

27. Reconciling between statements:Some complexities

28. Reconciling between statements:Source of complexities • There are at least four reasons why changes in working capital accounts (like inventory) and fixed assets don’t correspond to the changes shown on the cash flow statement: • Asset write-offs due to impairment, restructuring or retirement. • Translation adjustments on assets and liabilities held by foreign subsidiaries. • Acquisition and divestitures of other companies. • Simultaneous investing and financing activities not directly affecting cash.

29. Reconciling between statements:Inventories—write-offs due to restructuring

30. Reconciling between statements:Inventories—other complexities • Translation adjustments • Acquisitions and divestitures Balance sheet inventory change • Computed using BOP and EOP foreign exchange rates. • Computed by comparing purchases with cost of goods sold. • Translated amounts are used for foreign subsidiaries. Cash flows inventory change Balance sheet inventory change • Includes the effects of acquisitions and divestitures. Cash flows inventory change • Includes cash flows from business segments owned at both the start and end of period.

31. Reconciling between statements:Plant and equipment—retirements • The journal entry to record a retirement is: • It is often not possible for statement readers to determine the exact dollar amount of retirements.

32. Reconciling between statements:Plant and equipment—other complexities • Foreign currency translation adjustments: • Changes in the balance sheet accounts that are due to foreign currency exchange rate fluctuations are not reflected in the cash flow statement. • Acquisitions and divestitures: • Changes in the balance sheet accounts that arise from acquisitions are often shown on a line separate from “Capital expenditures”.

33. Reconciling between statements:Simultaneous non-cash investing & financing • Some investing and financing activities occur simultaneously as part of a single transaction: • Buy a building and borrow the full amount as a mortgage. • Acquire an asset by entering into a capital lease. • Issue stock for non-cash assets as part of a business combination. • SFAS No. 95 requires firms to disclose these non-cash simultaneous investing and financing activities.

34. Reconciling between statements:Simultaneous non-cash investing & financing

35. Cash burn rate • The ability to generate positive operating cash flow is critical to the survival and success of any company. • This is particularly true for start-up companies: • Cash is essential for establishing the business and for growth. • Investment outlays are often large. • Operating cash flows are negative. • Cash burn rate is a popular metric for assessing how quickly a start-up firm will consume its cash reserves: Cash used for operations Cash used for capital expenditures or acquisitions + Cash burn rate = # of months covered by cash flow statement

36. Cash burn rate:Amazon.com illustration • Cash burn rate: • Months to burnout: = - ($119.782 + $50.321 +$6.198)/12 months = -$14.692 per month = $996.585/14.692 = 67.8 months

37. Cash burn rate:Selected companies

38. Summary • The statement of cash flows helps readers gauge the firm’s ability to generate sufficient cash to pay for operating expenses, capital improvements, and currently maturing obligations. • Firms that generate consistently strong positive cash flows from operations are considered better credit risks and benefit from a lower cost of capital. • The two alternative methods for presenting the operating section of a cash flow statement are the direct approach and the indirect approach. • Most firms use the indirect approach.

39. Summary concluded • Changes in non-cash balance sheet accounts may not correspond to the adjustments shown on the cash flow statement because of: • Asset write-offs due to impairment, restructuring, or retirement • Translation adjustments on assets and liabilities held by foreign subsidiaries. • Acquisitions and divestitures of other companies. • Simultaneous investing and financing activities. • Cash burn rates can be helpful in evaluating the financial viability of start-up companies.