157 28235 EA419 2012 4 2 1 CH 07

Chapter 07 - Cash Flow Analysis
Chapter 7
Cash Flow Analysis
REVIEW
Cash is the residual of cash inflows less cash outflows for all prior periods of a company.
Net cash flows, or simply cash flows, refer to the current periods cash inflows less cash
outflows. Cash flows are different from accrual measures of performance. Cash flow
measures reco!ni"e inflows when cash is recei#ed not necessarily earned, and outflows
when cash is paid not necessarily incurred. $he statement of cash flows reports cash
flow measures for three primary %usiness acti#ities& operatin!, in#estin!, and financin!.
'peratin! cash flows, or cash flows from operations, is the cash %asis counterpart to
accrual net income. Information on cash flows helps us assess a companys a%ility to
meet o%li!ations, pay di#idends, increase capacity, and raise financin!. It also helps us
assess the (uality of earnin!s and the dependence of income on estimates and
assumptions re!ardin! future cash flows. $his chapter descri%es cash flows and their
rele#ance to our analysis of financial statements. We descri%e current reportin!
re(uirements and their implications for our analysis of cash flows. We e)plain useful
analytical ad*ustments to cash flows usin! financial data to impro#e our analysis. We
direct special attention to transaction reconstruction, $+account, and con#ersion
analyses.
7-1
',$-INE
.tatement of Cash Flows
Rele#ance of Cash
Reportin! %y Acti#ities
Constructin! the Cash Flow .tatement
.pecial $opics
Reportin! Cash Flows from 'perations
Indirect /ethod
0irect /ethod
Con#ertin! from Indirect to 0irect /ethod
Ad*ustments to Cash Flow Components
Additional 0isclosures and Ad*ustments
Analysis Implications of Cash Flows
-imitations in Cash Flow Reportin!
Interpretin! Cash Flows and Net Income
Alternati#e Cash Flow /easures
Company and Economic Conditions
Free Cash Flow
Cash Flows as Validators
.peciali"ed Cash Flow Ratios
Cash Flow Ade(uacy Ratio
Cash Rein#estment Ratio
Appendi) 7A Analytical Cash Flow Wor1sheets
7-2
ANA-2.I. '34EC$IVE.
E)plain the rele#ance of cash flows in analy"in! %usiness acti#ities.
0escri%e reportin! of cash flows %y %usiness acti#ities.
0escri%e the preparation and analysis of the statement of cash flows.
Interpret cash flows from operatin! acti#ities.
Analy"e cash flows under alternati#e company and %usiness conditions.
0escri%e alternati#e measures of cash flows and their usefulness.
Illustrate an analytical tool in e#aluatin! cash flows 5Appendi) 7A6.
7-3
7,E.$I'N.
8. $he term cash flow was pro%a%ly first coined %y analysts. $hey reco!ni"ed that the
accrual system of income measurement permits the introduction of a #ariety of
alternati#e accountin! treatments and conse(uent distortions. $he crude concept of
cash flow9net income plus ma*or noncash e)penses 5such as depreciation69was
deri#ed to %ypass these distortions and %rin! income measurement closer to the
discipline of actual cash flows. $his cash flow measure, still a popular surro!ate for
cash from operations 5CF'6, is crude %ecause it falls short of relia%ly appro)imatin!
in most cases the correct measure of CF'.
Confusion with the term cash flow deri#es from se#eral sources. 'ne source of
confusion stems from the initial and incorrect computation of the crude measure of
cash flow as income plus ma*or noncash e)penses. $he fi!ure fails to reflect actual
cash flows. Another and more serious confusion arises from the assertion %y some,
and particularly %y mana!ers dissatisfied %y the le#el of their reported net income,
that cash flow is a measure of performance superior to or more #alid than net income.
$his assertion implicitly assumes that depreciation, and other noncash costs, are not
!enuine e)penses. E)perience shows that only net income is properly re!arded as a
measure of performance and can %e related to the e(uity in#estment as an indicator
of operatin! performance. If we add %ac1 depreciation to net income and compute
the resultin! return on in#estment, we are, in effect, confusin! the return on
in#estment with an element of return on in#estment in fi)ed assets.
:. While fra!mentary information on the sources and uses of cash can %e o%tained from
comparati#e %alance sheets and from income statements, a comprehensi#e picture of
this important area of acti#ity can %e !ained only from a statement of cash flows
5.CF6. $he .CF pro#ides information to help answer (uestions such as&
What amount of cash is !enerated %y operations;
What utili"ation is made of cash pro#ided %y operations;
What is the source of cash in#ested in new plant and e(uipment;
What use is made of cash from a new %ond issue or the issuance of common
stoc1;
<ow is it possi%le to continue the re!ular di#idend in the face of an operatin!
loss;
<ow is de%t repayment achie#ed;
What is the source of cash used to redeem the preferred stoc1;
<ow is the increase in in#estments financed;
Why, despite record profits, is the cash position lower than last year;
3. SFAS 95 re(uires that the statement of cash flows classify cash receipts and cash
payments %y operatin!, financin! and in#estin! acti#ities.
Operating activities encompass all the earnin!+related acti#ities of the enterprise.
$hey encompass, in addition to all the income and e)pense items found on the
income statement, all the net inflows and outflows of cash that operations impose on
the enterprise. .uch operations include acti#ities such as the e)tension of credit to
customers, in#estment in in#entories, and o%tainin! credit from suppliers. $his
means operatin! acti#ities relate to all items in the statement of income 5with minor
7-4
e)ceptions6 as well as to %alance sheet items that relate to operations mostly
wor1in! capital accounts such as accounts recei#a%le, in#entories, prepayments,
accounts paya%le, and
7-5
accruals. SFAS 95 also specifies that operatin! acti#ities include all transactions and
e#ents that are not of an in#estin! or financin! nature.
Financing activities include o%tainin! resources from owners and pro#idin! them
with a return of or a return on 5di#idends6 their in#estment. $hey also include
o%tainin! resources from creditors and repayin! the amounts %orrowed or otherwise
settlin! the o%li!ations.
Investing activities include ac(uirin! and sellin! or otherwise disposin! of %oth
securities that are not cash e(ui#alents and producti#e assets that are e)pected to
!enerate re#enues o#er the lon!+term. $hey also include lendin! money and
collectin! on such loans.
=. We can distin!uish amon! three cate!ories of ad*ustments that con#ert accrual %asis
net income to cash from operations& 5i6 E)penses, losses, re#enues, and !ains that
do not use or !enerate cash such as those in#ol#in! noncash accounts 5e)cept those
in ii6, 5ii6 Net chan!es in noncash accounts 5mostly in the operatin! wor1in! capital
!roup6 that relate to operations9these modify the accrual+%ased re#enue and
e)pense items included in income, 5iii6 >ains and losses 5such as on sales of assets6
that are transferred to other sections of the .CF so as to show the entire cash
proceeds of the sale.
?. $he two methods of reportin! cash flow from operations are&
Indirect Method& ,nder this method net income is ad*usted for noncash items
re(uired to con#ert it to CF'. $he ad#anta!e of this method is that it is a
reconciliation that discloses the differences %etween net income and CF'. .ome
analysts estimate future cash flows %y first estimatin! future income le#els and then
ad*ustin! these for leads and la!s %etween income and CF' 5that is, noncash
ad*ustments6.
Direct (or Inflow-Otflow! Method& $his method lists the !ross cash receipts and
dis%ursements related to operations. /ost respondents to the E)posure 0raft that
preceded SFAS 95 preferred this method %ecause this presentation discloses the
total amount of cash that flows into the enterprise and out of the enterprise due to
operations. $his !i#es analysts a %etter measure of the si"e of cash inflows and
outflows o#er which mana!ement has some de!ree of discretion. As the ris1s that
lenders are e)posed to relate more to fluctuations in CF' than to fluctuations in net
income, information on the amounts of operatin! cash receipts and payments is
important in assessin! the nature of those fluctuations.
@. $he function of the income statement is to measure the profita%ility of the enterprise
for a !i#en period. $his is done %y matchin! e)penses and losses with the re#enues
and !ains earned. While no other statement measures profita%ility as well as the
income statement, it does not show the timin! of cash flows and the effect of
operations on li(uidity and sol#ency. $he latter is reported on %y the .CF. Cash from
operations 5CF'6 reflects a %roader concept of operations relati#e to net income. It
encompasses all earnin!+related acti#ities of the enterprise. CF' is concerned not
only with e)penses and re#enues %ut also with the cash demands of these acti#ities,
such as in#estments in customer recei#a%les and in in#entories as well as the
financin! pro#ided %y suppliers of !oods and ser#ices. CF' focuses on the li(uidity
aspect of operations and is not a measure of profita%ility %ecause it does not include
important costs such as the use of lon!+li#ed assets in operations or important
7-6
re#enues such as the e(uity in the earnin!s of nonconsolidated su%sidiaries or
affiliates.
7-7
7. $he .CF sheds li!ht on 5i6 the effects of earnin! acti#ities on cash resources, 5ii6 what
assets are ac(uired, and 5iii6 how assets are financed. It also can hi!hli!ht more
clearly the distinction %etween net income and cash pro#ided %y operations. $he
a%ility of an enterprise to !enerate cash from operations on a consistent %asis is an
important indicator of financial health. No %usiness can sur#i#e o#er the lon! run
without !eneratin! cash from its operations. <owe#er, the interpretation of CF'
fi!ures and trends must %e made with care and with a full understandin! of all
surroundin! circumstances.
Arosperous as well as failin! entities can find themsel#es una%le to !enerate cash
from operations at any !i#en time, %ut for different reasons. $he entity cau!ht in the
Bprosperity s(uee"eB of ha#in! to in#est its cash in recei#a%les and in#entories to
meet e#er+increasin! customer demand will often find that its profita%ility will facilitate
financin! %y e(uity as well as %y de%t. $hat same profita%ility should ultimately turn
CF' into a positi#e fi!ure. $he unsuccessful firm, on the other hand, will find its cash
drained %y slowdowns in recei#a%le and in#entory turno#ers, %y operatin! losses, or
%y a com%ination of these factors. $hese conditions usually contain the seeds of
further losses and cash drains and also can lead to difficulties in o%tainin! trade
credit. In such cases, a lac1 of CF' has different implications. $he unsuccessful or
financially pressed firm can increase its CF' %y reducin! accounts recei#a%le and
in#entories, %ut usually this is done at the e)pense of ser#ices to customers that can
further depress future profita%ility. E#en if the unsuccessful firm mana!es to %orrow,
the costs of %orrowin! only ma!nify the ultimate drains of its cash. $hus, profita%ility
is a 1ey consideration, and while it does not insure CF' in the short run, it is
essential to a healthy financial condition in the lon! run.
Chan!es in operatin! wor1in! capital items must %e similarly interpreted in li!ht of
attendin! circumstances. An increase in recei#a%les can mean e)pandin! consumer
demand for enterprise products or it can mean an ina%ility to collect amounts due in a
timely fashion. .imilarly, an increase in in#entories 5and particularly of the raw
material component6 can imply preparations for an increase in production in
response to consumer demand. It also can imply 5particularly if the finished !oods
component of in#entories is increasin!6 an ina%ility to sell due to, say, when
anticipated demand did not materiali"e.
C. A #alua%le analytical deri#ati#e of the .CF is Bfree cash flow.B As with any other
analytical measure, analysts must pay careful attention to components of this
computation. <ere, as in the case of any cash flow measures, ulterior moti#es may
sometimes affect the #alidity of the computation. 'ne of the analytically most useful
computations of free cash flow is&
Cash from 'perations 5CF'6
+ Capital e)penditures re(uired to maintain producti#e capacity used in !eneratin!
income
+ 0i#idends 5on preferred stoc1 and maintenance of desired payout on common
stoc16
D Free Cash Flow 5FCF6
7-8
Aositi#e FCF implies that this is the amount a#aila%le for company purposes after
pro#isions for financin! outlays and e)penditures to maintain producti#e capacity at
current le#els. Internal !rowth and financial fle)i%ility depend on an ade(uate amount
of FCF. Note that the amount of capital e)penditures needed to maintain producti#e
capacity at current le#els is !enerally not disclosed %y companies. It is included in
total capital e)penditures, which also can include outlays for e)pansion of producti#e
capacity. 3rea1in! down capital e)penditures %etween these two components is
difficult. $he FA.3 considered this issue, %ut in SFAS 95 it decided not to re(uire
classification of in#estment e)penditures into maintenance and e)pansion
cate!ories.
E. For financial statement analysis, the .CF pro#ides clues to important matters such
as&
Feasi%ility of financin! capital e)penditures and possi%le sources of such
financin!.
.ources of cash to finance an e)pansion in the %usiness.
0ependence of the firm on e)ternal sources of financin! 5such as de%t or e(uity6.
Future di#idend policies.
A%ility to meet future de%t ser#ice re(uirements.
Financial fle)i%ility, that is, the firms a%ility to !enerate sufficient cash so as to
respond to unanticipated needs and opportunities.
Insi!ht into the financial ha%its of mana!ement and indications of future policies.
.i!nals re!ardin! the (uality of earnin!s.
7-9
EFERCI.E.
E)ercise 7+8 5:G minutes6
$he 2ear 88 CF' of Camp%ell is hi!her 5%y H=GI.7 million6 than its 2ear 88 net
income for two main reasons&
8. .ome items decreased net income %ut did not use cash9specifically&
a. 0epreciation and amorti"ation are e)penses not re(uirin! a cash outlay
5H:GC.@6.
%. 0eferred income ta)es are an e)pense that has no present cash payment
5HI?.?6.
c. .e#eral char!es and e)penses did not re(uire outlays of cash 5H@I.:6.
d. A decrease in in#entory implies that cost of sales are char!ed %y reducin!
in#entory le#els rather than %y ma1in! cash payments of H=C.7.
:. .ome items !enerated operatin! cash inflow did not enter into the
determination of net income9specifically&
a. $he decrease in accounts recei#a%le means that cash is collected %eyond
the amounts reco!ni"ed as sales re#enue in the income statement 5H87.86.
%. $here are se#eral other items that had a similar effect, amountin! to HIG.@.
E)ercise 7+: 5=G minutes6
a. SFAS 95 re(uires that the .CF classify cash receipts and payments %y
operatin!, financin!, and in#estin! acti#ities.
("! Operating activities encompass all the earnin!+related acti#ities of the
enterprise. $hey encompass, in addition to all the income and e)pense items
found on the income statement, all the net inflows and outflows of cash that
operations impose on the enterprise. .uch operations include acti#ities such
as the e)tension of credit to customers, in#estment in in#entories, and
o%tainin! credit from suppliers. $his means operatin! acti#ities relate to all
items in the statement of income 5with minor e)ceptions6 as well as to %alance
sheet items that relate to operations mostly wor1in! capital accounts such as
accounts recei#a%le, in#entories, prepayments, accounts paya%le, and
accruals. SFAS 95 also specifies that operatin! acti#ities include all
transactions and e#ents that are not of an in#estin! or financin! nature.
(#! Financing activities include o%tainin! resources from owners and
pro#idin! them with a return of or a return on 5di#idends6 their in#estment.
$hey also include o%tainin! resources from creditors and repayin! the
amounts %orrowed or otherwise settlin! the o%li!ations.
(3! Investing activities include ac(uirin! and sellin! or otherwise disposin! of
%oth securities that are not cash e(ui#alents and producti#e assets that are
e)pected to !enerate re#enues o#er the lon!+term. $hey also include lendin!
money and collectin! on such loans.
7-10
E)ercise 7+:9concluded
%. SFAS 95 re(uires that all si!nificant financin! and in#estin! acti#ities %e
disclosed. For e)ample, noncash transactions that include the con#ersion of
de%t to e(uity, the ac(uisition of assets throu!h the issuance of de%t, and
e)chan!es of assets or lia%ilities, should %e disclosed in a separate schedule
of noncash in#estin! and financin! acti#ities.
c. 586 Net income is the startin! point of the computation of CF'. SFAS 95 does
not re(uire the separate disclosure of e)traordinary items in the .CF.
5:6 0epreciation is added %ac1 as an e)pense not re(uirin! cash.
5I6 $he write+off of uncollecti%le recei#a%les does not affect cash. .imilarly,
the %ad de%t e)pense does not re(uire an outlay of cash. .ince this
corporation uses the indirect method for presentation of CF', no
additional ad*ustment is needed %eyond the ad*ustment for the chan!e in
the net accounts recei#a%le, which includes the credit to the allowance for
dou%tful accounts.
5=6 $he H8=G,GGG increase in accounts recei#a%le means that some sales ha#e
not %een collected in cash and, accordin!ly, net income is reduced %y
H8=G,GGG in arri#in! at CF'. $he H@G,GGG decline in in#entories means that
cost of !oods sold includes in#entories paid for in prior years, and did not
re(uire cash this year. As such, net income is increased %y H@G,GGG in
arri#in! at CF'.
5?6 $his HICG,GGG is an e)pense re(uirin! cash9no ad*ustment is called for.
$his amount also must %e disclosed as part of the supplemental
disclosures.
5@6 A reconstructed analytical entry would appear as&
Cash............................................... IG,GGG
Accumulated 0epreciation.......... ?G,GGG
AAE................................................ 7?,GGG
>ain on sale of machine.............. ?,GGG
$he HIG,GGG increase in cash is shown as a source from in#estin!
acti#ities. $he H?,GGG !ain is deducted from 5remo#ed from6 net income so
that the entire proceeds of the sale are shown as part of in#estment
acti#ities.
576 'nly the cash payment of H8GG,GGG is shown in the .CF as an in#estin!
acti#ity outflow. In a separate schedule, the purchase of %uildin!s and land
for noncash considerations is detailed.
5C6 $his is a noncash transaction that is disclosed in a separate schedule of
noncash in#estin! and financin! acti#ities.
5E6 $he declaration of a cash di#idend creates a current lia%ility. 0urin! 2ear C,
no cash outflow occurs and there is nothin! to report on the 2ear C .CF.
58G6$his e#ent has no effect on cash nor need it %e reported in con*unction
with the .CF.
7-11
E)ercise 7+I 5IG minutes6
a. Cash Flows from 'perations Computation&
Net income..................................................................... H8G,GGG
Add 5deduct6 items to con#ert to cash %asis&
0epreciation, depletion, and amorti"ation............ HC,GGG
0eferred income ta)es............................................. =GG
Amorti"ation of %ond discount............................... ?G
Increase in accounts paya%le.................................. 8,:GG
0ecrease in in#entories........................................... C?G 8G,?GG
H:G,?GG
,ndistri%uted earnin!s of unconsolidated
su%sidiaries and affiliates...................................... 5:GG6
Amorti"ation of premium on %onds paya%le......... 5@G6
Increase in accounts recei#a%le............................. 5EGG6 58,8@G6
Cash pro#ided %y operations ..................................... H8E,I=G
%. 586 $he issuance of treasury stoc1 for employee stoc1 plans 5as
compensation6 re(uires an add%ac1 to net income %ecause it is an
e)pense not usin! cash.
5:6 $he cash outflow for interest is not included in e)pense and must %e
included as cash outflow in in#estin! acti#ities 5as part of outlays for
property.6
5I6 If the difference %etween pension e)pense and actual fundin! is an
accrued lia%ility, the unpaid portion must %e added %ac1 to income as an
e)pense not re(uirin! cash. If the amount funded e)ceeds pension
e)pense, then net income must %e reduced %y that e)cess amount.
7-12
E)ercise 7+= 5IG minutes6
a. 3e!innin! %alance of accounts recei#a%le......... H IG?,GGG
Net sales............................................... 8,EI7,GGG
$otal potential receipts......................................... H:,:=:,GGG
Endin! %alance of accounts recei#a%le.............. + :E?,GGG
Cash collected from sales.................................... H8,E=7,GGG
%. Endin! %alance of in#entory................................. H ?=E,GGG
Cost of sales.......................................................... J8,8?G,GGG
$otal ...............................................H8,@EE,GGG
3e!innin! %alance of in#entory........................... + =I8,GGG
Aurchases............................................................... H8,:@C,GGG
3e!innin! %alance of accounts paya%le............. H ?@I,GGG
Aurchases 5from a%o#e6........................................ 8,:@C,GGG
$otal potential payments...................................... H8,CI8,GGG
Endin! %alance of accounts paya%le.................. + @G=,GGG
Cash payments for accounts paya%le................. H8,::7,GGG
c. Issuance of common stoc1................................... H C8,GGG
Issuance of treasury stoc1................................... 87,GGG
$otal nonoperatin! cash receipts........................ H EC,GGG
d. Increase in land...................................................... H 8?G,GGG
Increase in plant and e(uipment.......................... 8C,GGG
$otal payments for noncurrent assets................ H 8@C,GGG
E)ercise 7+? 5:G minutes6
Sorce $se Ad%st&ent 'ategor(
a. F F '
%. F F
c. F F
d. F I
e. F F
f. NCN
!. F I
h. NC.
i. F F
*. F F '
7-13
E)ercise 7+@ 5:G minutes6
Sorce $se Ad%st&ent 'ategor(
a. F F '
%. F F
c. NCN
d. F I
e. NC.
f. NCN
!. F I
h. NC.
i. NE
*. NE
E)ercise 7+7 5IG minutes6
)et 'ash fro& 'ash
Inco&e operations position
8. NE NE J
:. NE NE J
I. J J J
=a. + NE NE
=%. NE
586
J
5:6
J
5:6
=c. + J
5:6
J
5:6

?. NE J J
@. + J 5lon!+run +6 J 5lon!+run +6
7. + +
5?6
J
C. J NE NE
E. J
5I6
J
5=6
J
5=6
8G. NE J J
88. J J J
8:. NE NE J
8I. NE NE J
586
0eferred ta) accountin!.
5:6
0epends on whether ta) sa#in!s are reali"ed in cash.
5I6
If profita%le.
5=6
If accounts recei#a%le collected.
5?6
0epends on whether interest is paid or accrued.
Further e)planations 5listed %y proposal num%er6&
8. .u%stitutin! payment in stoc1 for payment in cash for its di#idends will not affect income or
CF' %ut will increase cash position.
:. In the short run, postponement of capital e)penditures will sa#e cash %ut ha#e no effect on
income or CF'. In the lon! term, %oth income and CF' may suffer due to lower operatin!
efficiency.
7-14
E)ercise 7+79continued
I. Cash not spent on repair and maintenance will increase all three measures. <owe#er, the
s1impin! on necessary discretionary costs will ad#ersely impact future operatin! efficiency
and, hence, profita%ility.
=. /ana!ers ad#ocatin! an increase in depreciation may ha#e spo1en in the mista1en %elief that
depreciation is a source of cash and that conse(uently increasin! it would result in a hi!her
cash inflow. In fact, the le#el of depreciation e)pense has no effect on cash flow9the same
amount of depreciation deducted in arri#in! at net income is added %ac1 in arri#in! at CF'.
'n the other hand, increasin! depreciation for ta) purposes will in all cases result in at least
a short+term sa#in!s.
?. 7uic1er collections will not affect income %ut will increase CF' %ecause of lower accounts
recei#a%le. Cash will also increase %y the speedier con#ersion of recei#a%les into cash. In the
lon!er run this stiffenin! in the terms of sale to customers may result in sales lost to
competition.
@. Aayments stretched+out will lower income %ecause of lost discounts %ut does positi#ely
affect CF' %y increasin! the le#el of accounts paya%le. Cash conser#ation will result in a
hi!her cash position. Relations with suppliers may %e affected ad#ersely. Note& -on!+term
cash outflow will %e hi!her %ecause of the lost discount.
7. 3orrowin! will result in interest costs that will decrease income and CF'. Cash position will
increase.
C. $his chan!e in depreciation method will increase income in the early sta!es of an assets life.
$he opposite may hold true in the later sta!es of the assets life.
E. In the short term, hi!her sales to dealers will result in hi!her profits 5assumin! we sell a%o#e
costs6 and, if they pay promptly, %oth CF' and cash will increase. <owe#er, unless the
dealers are a%le to sell to consumers, such sales will %e made at the e)pense of future sales.
8G. $his will lead to less income from pension assets in the future which could cause future
pension e)pense to increase.
88. $he cost of fundin! in#entory will %e reduced in the future. In the current period net income
may also %e increased %y a -IF' li(uidation from reduced in#entory le#els.
8:. $he current period decline in the #alue of the tradin! securities has %een reflected in current
period income, as has the pre#ious !ain. Althou!h the sale will increase cash, it will ha#e no
effect on current period income. If the current period decline is deemed to %e temporary, the
company is sellin! a potentially profita%le security for a short+term cash !ain.
8I. Reissuance of treasury shares will increase cash, %ut will ha#e no effect on current period
income as any K!ainL or KlossL is reflected in additional paid in capital, not income. If the
stoc1 price is considered to %e temporarily depressed, the company is fore!oin! a future sale
at a !reater mar1et price and is, thus, sufferin! current dilution of shareholder #alue.
7-15
E)ercise 7+C 5:G minutes6
a. 0epreciation is neither a source nor a use of cash. Instead, depreciation is an
allocation of the cost of an asset o#er its useful life.
%. A ma*or cause of the %elief that depreciation is a source of cash is the Badd
%ac1B presentation in the .CF prepared usin! the indirect format. $his
presentation adds depreciation to net income and !i#es the erroneous
impression that it increases cash from operations.
c. $here is one sense in which depreciation is a source of cash, and for this
reason we must not overemphasi"e the idea that depreciation is not a source
of cash. Namely, when sellin! prices are sufficient to reco#er the depreciation
e)pense allocated to products sold, then re#enues do pro#ide mana!ement
with a discretionary, e#en if temporary, inflow of cash 5assumin! no si!nificant
chan!e in operatin! wor1in! capital6. Normally, mana!ement will ha#e to
in#est this cash in fi)ed assets replacements to continue in %usiness on a
lon!+term %asis. <owe#er, in the e#ent of a financial crisis or cash shortfall,
mana!ement has the option of di#ertin! such cash to uses that will a#ert a
li(uidity crisis. $his is the one e)ception that may allow one to re!ard
depreciation as a temporary Ksource of cash.L
7-16
E)ercise 7+E 5@G minutes6
a. Cash Collections Computation&
Accounts Recei#a%le 5Net6
3e! MaN ?@=.8
.ales M8IN @:G?.C @8=?.= Cash collections M%N
End MIIN @:=.?
Notes&
MaN 3alance at 7O:EO2ear 8G............................................ H@:=.? MIIN
-ess& increase in 2ear 8G........................................ 5@G .=6 M@8N
H?@=.8
M%N$his amount is o#erstated %y the pro#ision for dou%tful accounts e)pense that is included in
another e)pense cate!ory.
%. Cash 0i#idends Aaid Computation&
0i#idends Aaya%le
0i#idend paid M77N 8I7.? I:.I 3e! M=IN
8=:.: 0i#idend declared MaN MCEN
I7.G End M=IN
Note MaN& Item MCEN represents di#idends declared, not di#idends paid 5see also Item M77N6.
c. Cost of >oods and .er#ices Aroduced Computation&
In#entories
3e! MI=N C8E.C
Amount to %alance IEC:.=
=GE?.? Cost of products sold M8=N
End MI=N 7G@.7
d. $he entry for the income ta) pro#ision for 2ear 88 is&
Income ta) e)pense M:7N....................................... :@?.E
0eferred income ta) 5current6 plu!................. 8:.8
Income ta) paya%le.............................................. :IG.=
0eferred income ta) 5noncurrent6 MaN .............. :I.=
Notes&
586 $he entry increases current lia%ilities %y H8:.8 since deferred income ta) 5current6 is
credited %y this amount. It also increases current lia%ilities %y H:IG.= M8:=AN, the amount of
income ta)es paya%le.
5:6 $he MaN is the difference in the %alance of the noncurrent deferred income ta) item M87@N D
H:?C.? + H:I?.8 D H:I.=.
5I6 Also, H:I.= J H8:.8 D HI?.?, which is total deferred ta) M?EN or M8:7AN
7-17
E)ercise 7+E9continued
e. 0epreciation e)pense has no effect on cash from operations. $he credit, when
recordin! the depreciation e)pense, !oes to accumulated depreciation, a
noncash account.
f. $hese pro#isions are added %ac1 %ecause they affect only noncash accounts,
the char!e to earnin!s must %e remo#ed in con#ertin! it to the cash %asis.
!. $he KEffect of e)chan!e rate chan!es on cashL represents translation
ad*ustments 5differences6 arisin! from the translation of cash from forei!n
currencies to the ,... dollar.
h. Any !ain or loss is reported under Bother, netB9Item M@GN.
i. Free cash flows D
Cash flow from operations P Cash used for capital additions P 0i#idends
paid
2ear 88& HCG?.: P HI@8.8 P H8I7.? D HIG@.@
2ear 8G& H==C.= P HIC7.@ P H8:=.I D H5@I.?6
2ear E& HI?7.I P H:C=.8 P HC@.7 D H58I.?6
*. .tart+up companies usually ha#e !reater capital addition re(uirements and
lower cash inflows from operations. Also, start+ups rarely pay cash di#idends.
Free cash flow earned %y start+up companies is usually used to fund the
!rowth of the company, especially if successful.
1. 0urin! the launch of a new product line, the statement of cash flows can %e
affected in se#eral ways. First, cash flow from operations is lower %ecause
su%stantial ad#ertisin! and promotion is re(uired and sales !rowth has not
yet %een ma)imi"ed. .econd, su%stantial capital additions are usually
necessary to pro#ide the infrastructure for the new product line. $hird, cash
flow from financin! can %e affected if financin! is o%tained to launch this new
product line.
7-18
E)ercise 7+8G 58? minutes6
a. Re#enues are, in certain instances, reco!ni"ed %efore cash is recei#ed 5that is,
when earned6. E)penses are, in certain instances, reco!ni"ed after cash is
paid 5that is, matched with re#enues6. As a result, net income can %e positi#e
when operatin! cash flows are ne!ati#e. Consider some e)amples& 586 If
accounts recei#a%le increase su%stantially durin! the year, this implies that
re#enues outpaced cash collections. 5:6 If a company %uilds up its in#entory
le#els su%stantially, then cash is paid out %ut no e)pense is reco!ni"ed. 5I6 If
the company reduces its accounts paya%le %alances su%stantially durin! the
year, then cash flows can %e ne!ati#e when net income is positi#e.
%. 'peratin! cash flows can ser#e as one indicator of earnin!s (uality %ecause
o#er a num%er of years, cash flows should appro)imate earnin!s. If cash
flows from operations are consistently lower than earnin!s, it is possi%le that
the reported earnin!s are not of hi!h (uality. 5As with any %road !uideline, one
must loo1 for corro%oratin! e#idence.6
E)ercise 7+88 58? minutes6
a. 0urin! the !rowth sta!e, a company in#ests hea#ily in infrastructure !rowth
and into ad#ertisin! and promotion. As the company transitions into the
Kcash cowL sta!e, the company reduces the in#estment in %oth infrastructure
!rowth and ad#ertisin! and promotional acti#ities. $his transition would %e
manifested in the statement of cash flows %y increased operatin! cash flows
5less cash outflows for ad#ertisin! and promotion, hi!her mar!ins, so forth6
and decreased use of cash for in#estin! acti#ities.
%. $he decline of a Kcash cowL would %e reflected in the statement of cash flows
%y declinin! cash flows from operations. $he declinin! operatin! cash flows
will result from declinin! sales of the fadin! Kcash cowL products.
7-19
AR'3-E/.
Aro%lem 7+8 5@G minutes6
W'RQ.<EE$ $' C'/A,$E CA.< F-'W FR'/ 'AERA$I'N. 5IN /I--I'N.6
0IREC$ 5INF-'W+',$F-'W6 ARE.EN$A$I'N
CA/A3E-- .',A 9 2EAR EN0E0 4,-2 :C, 2EAR 88
Ref. Reported Ad*ust. Re#ised
Cash Receipts from 'perations
Net .ales.......................................................... 8I H@,:G=.8 H7.? H@,:88.@
'ther re#enue and income............................. 8E :@.G C :@.G
5I6 0 in current recei#a%les............................. @8 87.8 C 87.8
5I6 0 in noncurrent recei#a%les......................
D CA.< C'--EC$I'N................................. H@,:=7.: H7.? H@,:?=.7
Cash 0is%ursements for 'perations
$otal e)penses 5include min. int. R ta)es6
a
H?,CI8.G H7.? H?,CIC.?
-ess& E)penses R losses not usin! cash&
+ 0epreciation and amorti"ation..................... ?7 5:GC.@6 5:GC.@6
+ Noncurrent deferred income ta)es............. ?E 5I?.?6 5I?.?6
+ 'ther, net....................................................... @G 5@I.:6 5@I.:6
Chan!e in Current Assets and -ia%ilities
related to 'perations
I 506 in in#entories......................................... @: H 5=C.76 H 5=C.76
I 506 in prepaid e)penses............................. I? 5:?.I6 5:?.I6
5I6 0 in accounts paya%le.............................. =8 =:.C =:.C
5I6 0 in ta)es paya%le.................................... == 5:8.I6 5:8.I6
5I6 0 in accruals, payrolls, etc.
%
................... 87? 5:@.C6 5:@.C6
I or 0 in noncurrent accounts
c
.................... ? .C G .G ? .C
D CA.< 0I.3,R.E/EN$.............................. H?,=?G.: H7.? H?,=?7.7
0i#idends Recei#ed
E(uity in income of
unconsolidated affiliates.............................. := :.= :.=
0istri%utions %eyond e(uity
in income of affiliates
c
................................. ? .C G .G ? .C
D 0i#idends from unconsol. affiliates............ 8@EA H C .: HG .G H C .:
CA.< F-'W FR'/ 'AERA$I'N. ................ H CG?.: HG.G H CG?.:
a
$otal costs and e)penses M::AN J $a)es on earnin!s M:7N J /inority interests M:?N J
Interest income M8EN D H?,?I8.E J H:@?.E J H7.: J H:@.G D H?,CI8
%
It is assumed that accruals, payrolls, etc., are part of item M87?N.
c
A reconcilin! amount to tie in with the HC.: di#idends from affiliates 5item 8@EA6 #ersus
e(uity in earnin!s of affiliates 5item :=6.
7-20
Aro%lem 7+: 57? minutes6
a.
W'RQ.<EE$ $' C'/A,$E CA.< F-'W FR'/ 'AERA$I'N. 5IN /I--I'N.6
0IREC$ 5INF-'W+',$F-'W6 ARE.EN$A$I'N
CA/A3E-- .',A 2EAR EN0E0 4,-2 :E, 2EAR 8G
Ref. Reported Ad*ust. Re#ised
Net .ales.......................................................... 8I H@,:G?.C H7.? H@,:8I.I
'ther re#enue and income&
5I6 0 in current recei#a%les............................. @8 5@G.=6 5@G.=6
5I6 0 in noncurrent recei#a%les
Effect of translation ad*ustments ............... G .G G .G G .G
D Cash Collections.......................................... H@,8=?.= H7.? H@,8?:.E
$otal e)penses 5include interest R
ta)es6 M::AN J M:7N J M:?N............................... H@,:8=.E H7.? H@,:::.=
-ess& E)penses R -osses not usin! cash
+ 0epreciation R amorti"ation........................ ?7 5:GG.E6 5:GG.E6
+ Noncurrent deferred income ta)es............. ?E 5I.E6 5I.E6
+ 'ther pro#ision for restructurin!
and writedowns............................................. ?C 5IIE.86 5IIE.86
+ 'ther S........................................................... @G 5:=.76 5:=.76
+ 'ther
Chan!es in Current Assets and -ia%ilities
related to operations
I 506 in in#entories......................................... @: 58G.76 58G.76
I 506 in prepaid e)pense...............................
5I6 0 in accounts paya%le..............................
5I6 0 in ta)es paya%le....................................
5I6 0 in accruals, payrolls, etc......................
5I6 0 in di#idends paya%le.............................
I or 0 other SS................................................. @I @C.C @C.C
I or 0 in noncurrent amounts....................... G .G G .G G .G
D Cash 0is%ursements............................ H?,7G=.= H7.? H?,788.E
0i#idends Recei#ed
E(uity in income of unconsolidated
affiliates......................................................... := 8I.? 8I.?
+ ,ndistri%uted e(uity in income of
affiliates......................................................... 8@EA 5@ .86 G.G 5@ .86
D 0i#idends from unconsol. affils.................. 7 .= 7 .=
Cash Flow From 'perations.......................... H ==C.= H ==C.=
S
'ther, net M@GN H8C.@ J M8@EAN H@.8 D H:=.7
SS
Camp%ell shows a com%ined fi!ure instead of details of operatin! assets and lia%ilities.
7-21
Aro%lem 7+I 57? minutes6
a.
Tett Company
For the 2ear Ended 0ecem%er I8, 2ear :
Cash flows from operatin! acti#ities
Net Income.............................................................. H7,GGG
Add 5deduct6 items to con#ert to cash %asis
0epreciation....................................................... ?,GGG
-oss on sale of fi)ed assets............................. 8,GGG
>ain on sale of in#estment............................... 5I,GGG6
0ecrease in in#entory........................................ :,GGG
Increase in recei#a%les..................................... 5?,GGG6
0ecrease in accounts paya%les....................... 57,GGG 6
Net cash pro#ided from operatin! acti#ities G
Cash flows from in#estin! acti#ities
.ale of fi)ed assets............................................... @,GGG
.ale of in#estments............................................... E,GGG
Aurchase of fi)ed assets...................................... 5=,GGG6
Net cash pro#ided from in#estin! acti#ities 88,GGG
Cash flows from financin! acti#ities
.ale of unissued common stoc1.......................... 8,GGG
Aurchase of treasury stoc1................................... 588,?GG6
Net cash used %y financin! acti#ities.................. 58G,?GG 6
Net Increase in cash.............................................. ?GG
Spple&ental disclosre of 'ash Flow infor&ation
Cash paid durin! the year for&
Interest................................................................................ =,GGG
Income ta)es...................................................................... @,GGG
Schedle of noncash investing and financing activities&
Ac(uisition of fi)ed assets %y issue of %onds..................... IG,GGG
Con#ersion of %onds into common stoc1............................ 8G,GGG
7-22
Aro%lem 7+I9continued
%.
Tett Company
Comparison of Accrual and Cash Reportin!
Inco&e State&ent 'ash fro& operations
.ales........................................... H7G,GGG H@?,GGG Collection from
customers
>ain on sale of in#estments.... I,GGG 5a6
H7I,GGG H@?,GGG
Aurchases.................................. 5=G,GGG6 5=7,GGG6 Aayments to
suppliers 5%6
0ecrease in in#entory............... 5:,GGG6 9
0epreciation............................... 5?,GGG6 5c6
E)penses paid........................... 58C,GGG6 58C,GGG6
-oss on sale of fi)ed assets.... 58,GGG 6 5d6
Net income................................. H 7,GGG
Cash from operations............... H G
Notes&
5a6 'mitted %ecause it is lin1ed with proceeds from sale of in#estments 5in#estin!
acti#ities6.
5%6 Aurchase of H=G,GGG J 0ecrease in accounts paya%le of H7,GGG.
5c6 No cash re(uired.
5d6 -in1ed with sales of fi)ed assets 5in#estin! acti#ities6.
c. $he income statement prepared on the accrual %asis is desi!ned to reflect
profita%ility. Cash from operations measures the effects on cash of operatin!
acti#ities, and is %est for li(uidity and sol#ency analyses.
7-23
Aro%lem 7+= 57? minutes6
a.
0a) Corporation
For the 2ear Ended 0ecem%er I8, 2ear :
5H thousands6
Cash pro#ided from 5used for6 operations
Net Income....................................................................... H8@G
Add 5deduct6 items to con#ert to cash %asis&
Amorti"ation............................................................... 8G
0epreciation............................................................... E?
Inc. in accounts paya%le........................................... IG
Inc. in deferred income ta)....................................... 8:
Inc. in other current lia%ilities................................... 7
Inc. in accounts recei#a%le....................................... 5I8G6
Inc. in in#entories....................................................... 58=?6
Inc. in prepaid e)penses........................................... 5:?6
Net cash used for operations......................................... H58@@6
Cash pro#ided from 5used for6 in#estin! acti#ities
Aurchase of patents........................................................ 58=G6
Addition to plant and e(uipment................................... 57GG6
Addition to other assets................................................. 5:?6
Net cash used for in#estin! acti#ities........................... 5C@?6
Cash pro#ided from 5used for6 financin! acti#ities
Addition to lon!+term de%t............................................. CGG
Issuance of common stoc1............................................ :GG
0i#idends paid ................................................................ 58GE6
Net cash pro#ided from financin! acti#ities................ CE8
Net decrease in cash....................................................... H58=G6
Spple&ental disclosre of cash flow infor&ation
Cash paid durin! year for&
Interest................................................. H:C,GGG
Income ta)es....................................... H7G,GGG
7-24
Aro%lem 7+=9continued
%. $he ma*or reasons for the difference %etween net income of H8@G and cash
outflow for operations of H8@@ are the hea#y in#estments in in#entories of
H8=? and the increased le#el of financin! of customers e#idenced %y a HI8G
hi!her recei#a%les %alance. Compared to these hea#y in#estments in
operatin! assets, accounts paya%le ha#e increased #ery modestly. With risin!
sales and profits, the company is e)periencin! a prosperity s(uee"e.
c. $his situation must %e addressed %efore the li(uidity pro%lem %ecomes more
serious. $he followin! actions are reasona%le recommendations&
8. $he lar!er #olume of purchases *ustifies increased trade credit. $he
resultin! e)pansion of accounts paya%le would increase cash from
operations.
:. $he company needs a lar!er e(uity capital %ase. With increasin! profits
and with the company %ein! in a !rowth industry this may %e a !ood time
to sell stoc1 without dilutin! earnin!s per share.
I. Issuance of e(uity will form a !ood %ase for further %orrowin! should
%usiness continue to e)pand rapidly.
=. After additional e(uity capital has %een o%tained the company should
consider lowerin! the di#idend payout. For a fast !rowin! and profita%le
company such as 0a), a di#idend payout ratio of @CU 5H8GEOH8@G6 is (uite
hi!h. >i#en its current profit opportunities, more earnin!s should %e
retained in the %usiness.
7-25
Aro%lem 7+? 5=G minutes6
Nia!ara Company
For 2ear Ended 0ecem%er I8, 2ear E
Cash receipts from operations
.ales MaN..................................................................... HECG
Cash payments for operations
Aurchases of in#entory M%N...................................... 5@=?6
.ellin! and !eneral e)penses ................................ 58GG6
Interest e)pense McN.................................................. 5=G6
Income ta) e)pense MdN............................................ 5IG6
Cash flows from operations......................................... H8@?
Aurchase of fi)ed assets......................................... 58?G6
Repayment of notes paya%le................................... 5:?6
Issuance of lon!+term de%t..................................... ?G
Cash di#idends paid................................................. 5IG 6
Cash flows used in financin!....................................... 5?6
Net increase in cash...................................................... H 8G
3e!innin! cash %alance................................................ ?G
Endin! cash %alance..................................................... H @G
Notes&
MaN .ales................................................................................ H8,GGG
-ess increase in recei#a%les......................................... 5:G6
Cash collections............................................................ HECG
M%N Cost of !oods sold......................................................... H 5@?G6
Add increase in in#entories........................................... 5:G6
-ess increase in paya%les............................................. :?
5@=?6
McN Interest e)pense............................................................. H 5?G6
-ess increase in interest paya%le................................. 8G
5=G6
MdN Income ta) e)pense....................................................... H 5=G6
-ess increase in deferred income ta)......................... 8G
5IG6
Note& Aurchase of fi)ed assets is computed from depreciation e)pense plus chan!e in fi)ed
assets 5H8GGJH?G6. 0i#idends paid is computed from net income and chan!e in retained
earnin!s 5H@G+HIG6.
Spporting schedle for 'FO&
Net income..................................................................................................... H @G
Add depreciation........................................................................................... 8GG
Increase in deferred ta)................................................................................ 8G
Increase in recei#a%les................................................................................. 5:G6
Increase in in#entory.................................................................................... 5:G6
Increase in accounts paya%le...................................................................... :?
Increase in interest paya%le......................................................................... 8G
Cash flows from operations......................................................................... H8@?
7-26
Aro%lem 7+@ 5I? minutes6
Effects Analytical Entries 5'ptional6
a. M+2, 88,GGGN 3ad 0e%t E)pense.......................... 88,GGG
MCC, 88,GGGN Allowance for 3ad 0e%t.......... 88,GGG
%. M+2, 8@,GGGN 0epreciation................................... 8@,GGG
M2A, 8@,GGGN Accumulated 0epreciation..... 8@,GGG
c. MNAA, 8GG,GGGN 3uildin!........................................... 8GG,GGG
MN0E, 8GG,GGGN -on!+$erm Note Aaya%le......... 8GG,GGG
d. None
e. None
f. MJC, 8G,GGGN Cash................................................. 8G,GGG
M+2, :,GGGN -oss................................................. :,GGG
MCC, 8:,GGGN In#entory................................... 8:,GGG
!. MJC, I?,GGGN Cash................................................. I?,GGG
M0C, ?,GGGN Accounts Recei#a%le..................... ?,GGG
MCC, :?,GGGN In#entory................................... :?,GGG
MJ2, 8?,GGGN >ain........................................... 8?,GGG
h. MCC, I,GGGN Allowance........................................ ?,GGG
M+2, I,GGGN 3ad 0e%t E)pense.......................... I,GGG
Accounts Recei#a%le............... C,GGG
i. MAA, 8GG,GGGN Assets.............................................. 8GG,GGG
M+C, 8GG,GGGN Cash.......................................... 8GG,GGG
M+2, :G,GGGN 0epreciation e)pense.................... :G,GGG
M2A, :G,GGGN Accumulated 0epreciation..... :G,GGG
*. MJC, C,GGGN Cash................................................. C,GGG
MA0, C,GGGN -oss on .ale................................... 8,GGG
M2A, 8,GGGN /achinery 5net6......................... E,GGG
M+2, 8,GGGN
7-27
Aro%lem 7+7 5@G minutes6
Aart I.
a. M0-, 8GG,GGGN Current Aortion of -+$ 0e%t.......... 8GG,GGG
%. MJC, =,GGGN Cash................................................. =,GGG
MA0, =,GGGN -oss................................................. 8,GGG
M2A, 8,GGGN E(uipment................................. ?,GGG
M+2, 8,GGGN
c. M+2, 7?,GGGN -oss................................................. 7?,GGG
MCC, 7?,GGGN In#entory................................... 7?,GGG
d. MJC, :C,GGGN Cash................................................. :C,GGG
M0E, :C,GGGN Aaid+In Capital................................ :,GGG
$reasury stoc1.......................... IG,GGG
e. MNAA, IGG,GGGN Alant Assets.................................... IGG,GGG
MN0E, IGG,GGGN /ort!a!e Aaya%le.................... :?G,GGG
/ort!a!e Aaya%le9Current. . . ?G,GGG
f. MJC, @,GGGN In#estment....................................... IG,GGG
MJ2, IG,GGGN E(uity in NI of .u%sidiary....... IG,GGG
M2., :=,GGGN Cash................................................. @,GGG
In#estment @,GGG
!. MJC, 8G,GGGN Cash................................................. 8G,GGG
MJ2, =G,GGGN Accounts Recei#a%le, current....... 8G,GGG
M0C, 8G,GGGN Accounts Recei#a%le, noncurrent :G,GGG
MNC, :G,GGGN .ales.......................................... =G,GGG
h. M0C, E,GGGN In#entory......................................... E,GGG
MJ2, E,GGGN Cost of >oods .old................. E,GGG
i. M0C, :@G,GGGN Current Assets................................ :@G,GGG
MCC, 8@G,GGGN Alant and E(uipment..................... @7G,GGG
M0E, =8G,GGGN Current -ia%ilities.................... 8@G,GGG
M+C, I@G,GGGN -on!+$erm 0e%t....................... =8G,GGG
Cash 5H=GG+H=G6....................... I@G,GGG
*. M+2, @G,GGGN E)pense........................................... @G,GGG
MCC, @G,GGGN Allowance for dou%tful accounts @G,GGG
7-28
Aro%lem 7+79continued
Aart II.
a. MAA, 8:G,GGGN In#estment....................................... 8:G,GGG
M+C, 8:G,GGGN Cash.......................................... 8:G,GGG
%. M2., 7,?GGN In#estment....................................... 7,?GG
MJ2, 7,?GGN E(uity in Earnin!s.................... 7,?GG
c. MJC, I,GGGN In#estment....................................... E,GGG
MJ2, E,GGGN E(uity in Earnin!sVVVVV.. E,GGG
M2., @,GGGN Cash................................................. I,GGG
In#estment................................ I,GGG
d. MJC, =,GGGN Cash................................................. =,GGG
MA0, =,GGGN E(uipment 5net6........................ I,GGG
M2., 8,GGGN >ain on .ale ............................ 8,GGG
MJ2, 8,GGGN
e. MJC, @G,GGGN Cash................................................. @G,GGG
MI-, @G,GGGN Note Aaya%le 5current6............ @G,GGG
f. MN0R, E,GGGN 3onds Aaya%le............................... E,GGG
MN0E, E,GGGN Common stoc1......................... :,GGG
Aaid+In Capital.......................... 7,GGG
!. MJC, @,GGGN Cash................................................. @,GGG
M0E, @,GGGN $reasury stoc1.......................... =,GGG
Aaid+In Capital.......................... :,GGG
h8.MAA, :GG,GGGN In#estment....................................... :GG,GGG
M0E, 8GG,GGGN Common stoc1......................... 8GG,GGG
h:.M0C, CG,GGGN Current Assets 5H8:G+H=G6............. CG,GGG
MAA, 8CG,GGGN Alant and E(uipment..................... 8CG,GGG
M0E, 8=G,GGGN Current -ia%ilities.................... @G,GGG
M+C, @G,GGGN -on!+$erm 0e%t....................... =G,GGG
Common stoc1......................... 8GG,GGG
Cash 5H8GG+H=G6....................... @G,GGG
i. M+2, =,GGGN /inority Interest E)pense............. =,GGG
M2A, =,GGGN /inority Interest....................... =,GGG
7-29
Aart II.
*. M+2, ?G,GGGN In#entory -oss................................ ?G,GGG
MCC, ?G,GGGN In#entory................................... ?G,GGG
1. None Allow. for dou%tful accounts......... 8,:GG
Accounts recei#a%le 8,:GG
l. MNAA, 8:G,GGGN -eased E(uipment......................... 8:G,GGG
MN0E, 8:G,GGGN -on!+$erm de%t........................ 8:G,GGG
m. None Retained Earnin!s.......................... 8CG,GGG
Common stoc1 ........................ 8:G,GGG
Aaid+in Capital......................... @G,GGG
n. M+2, :7,GGGN 3ad 0e%ts E)pense....................... :7,GGG
MCC, :7,GGGN Allow for 0ou%tful Accounts. . :7,GGG
7-30
Aro%lem 7+C 5=? minutes6
3IR0 C'RA'RA$I'N
3alance .heet
As of 4anuary 8, 2ear 8
Assets
Cash.............................................................................. H ?G,GGG
Accounts recei#a%le................................................... EG,GGG
In#entory....................................................................... 88G,GGG
Current assets............................................................. H:?G,GGG
Aroperty, plant, and e(uipment................................. H=@?,GGG
-ess& Accumulated depreciation............................... :I?,GGG :IG,GGG
'ther noncurrent in#estments................................... :=?,GGG
$otal assets.................................................................. H7:?,GGG
-ia%ilities and E(uity
Accounts paya%le........................................................ H @G,GGG
Current portion of lon!+term de%t............................. 88G,GGG
Current lia%ilities......................................................... H87G,GGG
-on!+term de%t............................................................ 8C?,GGG
Common stoc1............................................................ :EG,GGG
Retained earnin!s....................................................... CG,GGG
$otal lia%ilities and e(uity.......................................... H7:?,GGG
)ote* +-Acconts for ,econstrction of -alance Sheet (Optional!
Cash
3e! 5H8GG,GGG Endin! + H?G,GGG Incr.6 ?G,GGG
'perations
Net income 586 8?G,GGG
0epreciation e)pense 5:6 C?,GGG
-oss on sale of e(uip 5I6 ?,GGG
Increase in accounts paya%le 5=6 =G,GGG
?G,GGG 5?6 >ain on sale of in#estments
IG,GGG 5@6 Increase in accounts recei#a%le
:G,GGG 576 Increase in in#entory
In#estin!
.ale of e(uipment 5C6 8G,GGG
.ale of in#estments 5E6 E?,GGG
8?G,GGG 58G6 Additions to property and e(uip.
Financin!
Issuance of common stoc1 5886 8G,GGG
Additions to lon!+term de%t 58:6 8?,GGG

Endin! 8GG,GGG
CG,GGG 58I6 Cash di#idends
IG,GGG 58=6 0ecrease in current portion
of lon!+term de%t
7-31
Aro%lem 7+C9continued
Retained Earnin!s Aroperty, Alant, and E(uipment
58I6 CG,GGG CG,GGG 3e!
8?G,GGG 586
3e! =@?,GGG
58G6 8?G,GGG @?,GGG 5I6,5C6 R 5a6
8?G,GGG End End ??G,GGG
'ther Noncurrent In#estments Accumulated 0epreciation
3e! :=?,GGG =?,GGG 5?6,5E6 5a6 ?G,GGG :I?,GGG 3e!
C?,GGG 5:6
End :GG,GGG :7G,GGG End
-on!+term 0e%t Common .toc1
8C?,GGG 3e!
8?,GGG 58:6
:EG,GGG 3e!
8G,GGG 5886
:GG,GGG End IGG,GGG End
Accounts Recei#a%le In#entory
3e! EG,GGG
5@6 IG,GGG
3e! 88G,GGG
576 :G,GGG
End 8:G,GGG End 8IG,GGG
Accounts Aaya%le Current Aortion of -on!+$erm 0e%t
@G,GGG 3e!
=G,GGG 5=6
58=6 IG,GGG 88G,GGG 3e!
8GG,GGG End CG,GGG End
7-32
Aro%lem 7+E 5IG minutes6
Current Wor1in! Capital Cash from 'perations Analytical Entries 5'ptional6
Ratio Effect Amount Effect Amount 0r. Cr.
a. J NE HG + H8,GGG Wa!es Aaya%le Cash
%. + NE G NE G Aurchases Acct.
Aay.
c. + + 7G,GGG NE G -oss Acct.
Aay.
d. NE NE G J C,GGG Cash Acct.
Rec.
e. + + 8GG,GGG NE G -and Cash
f. J NE G NE G Note Aaya%le Cash
!. J J 8?,GGG NE G Note Recei#a%le -and
h.J J EG,GGG NE G Cash Aaid+in Cap
i. + + :G,GGG NE G /achine Cash
.+$
-ia%.
-+$
-ia%.
*. + + ?G,GGG NE G 3ond Aaya%le Cash
Aremium on 3. Aay. >ain
1. + + 8G,GGG NE G Retained Earnin!s 0i#.
Aay.
l. J NE G NE G 0i#idend Aaya%le Cash
m. NE NE G NE G Retained Earnin!s .t1 0i#
Aay
n.NE NE G NE G .toc1 0i#idend Aay. Aaid+in Cap
Capital
.t1
o. NE NE G NE G No entry
p. + NE G NE G Cash Notes
Aay.
(. J NE G + :G,GGG Accounts Aaya%le Cash
r. + + :G,GGG NE G Aatent Cash
s. + + 8?,GGG + 8?,GGG -oss /1t%le
.ec
t. NE NE G NE G -oss 'r!.
E)p.
u.NE NE G NES G 0epreciation E)p. Accum 0ep
#. J J :C,GGG NE G Accounts Recei#a%le .ales
w. J J EG,GGG NES G Cash
3uildin!
>ain
7-33
). J J ?,GGG NE G Cash
/achine
Notes Recei#a%le
y. + + =G,GGG NE G Income $a) E)pense Inc $a)
Aay
0ef $a)
5-$6
S$ransaction does not effect cash from operations. <owe#er, the co&ptation of cash from
operations is effected if it is calculated usin! the indirect method.
7-34
Aro%lem 7+8G 5=? minutes6
a. $he two measures are summary performance metrics from two different
statements 5or portions of statements6 that deal with operations9the income
statement and the cash from operations 5CF'6 section of the statement of cash
flows. $here is considera%le confusion amon! users of financial statements a%out
%oth the concept of BoperationsB and a%out the different aspects of operations
that these two measures are desi!ned to portray.
$he function of the inco&e state&ent is to measure the profita.ilit( of the
enterprise for a !i#en period. $his is done %y reco!ni"in! re#enue when earned,
and then matchin! e)penses with those re#enues. /oreo#er, costs incurred
durin! a period that do not create future %enefits must %e char!ed to e)pense
re!ardless of the a#aila%ility of related re#enues a!ainst which they can %e
matched. While no other statement measures profita%ility as well as the income
statement, it does not show the timin! of cash flows and the effect of operations
on li(uidity and sol#ency. Conse(uently, other speciali"ed statements are needed
to focus on the latter factors, which are different dimensions of earnin!+related
acti#ities.
'ash fro& operations ('FO! encompasses the %roader concept of
operations compared with net income. It encompasses all earnin!+related
acti#ities of the entity and it is concerned not only with re#enues and e)penses
%ut also with the cash demands of these acti#ities such as in#estments in
customer recei#a%les and in in#entories as well as the financin! pro#ided %y
suppliers of !oods and ser#ices. We can arri#e at operatin! cash receipts and
dis%ursements %y ad*ustin! net income for items needed to con#ert it to the cash
%asis 5indirect format6. We must remem%er that CF' focuses on li(uidity and is
not a measure of profita%ility as it e)cludes important costs such as the use of
lon!+li#ed assets in operations, nor important re#enues such as e(uity in the
earnin!s of nonconsolidated su%sidiaries or affiliates.
%. Analysis of $ransactions
Net Income Cash from 'perations
8. J NE
:. J NE
I. NE NE
=. NE NE
?. NE J
@. + NE
7. NE NE
C. + NE
E. NE +
8G. + NE
88. NE NE
8:. + NE
8I. + NE
8=. + NE
8?. NE NE
8@. J NE
87. + NE
8C. NE NE
8E. + NE
:G. + NE
:8. NE NE
::. NE +
7-35
Aro%lem 7+88 57? minutes6
a. As an initial step, the effect of the Qraft ac(uisition must first %e remo#ed from
the Ahilip /orris 5A/6 accounts. $he resultin! %alance sheet chan!es are
Ahilip /orris ,nad*usted A/ Ad*.
2ear 7 2ear C Chan!e Qraft Chan!e
Accts. Rec%le. H:,G@? H :,::: H 8?7 H 7?C H 5@G86
In#entories .... =,8?= ?,IC= 8,:IG 8,:I: 5:6
AARE ............. @,?C: C,@=C :,G@@ 8,7=G I:@
>oodwill ........ =,G?: 8?,G78 88,G8E 8G,I@8 @?C
.+$ 0e%t........ 8,==G 8,:?E 58C86 7GG 5CC86
Accts. Aay. .... 7E8 8,777 EC@ ?7C =GC
Accrued lia%.. :,:77 I,C=C 8,?78 ?IG 8,G=8
-+$ 0e%t......... @,:EI 87,8:: 8G,C:E EGG E,E:E
7-36
$his permits one to deri#e the statement of cash flows9indirect format
A<I-IA /'RRI. C'/AANIE., INC.
For the 2ear Ended 0ecem%er I8, 2ear C
Net income...................................................................... H :,II7
Add 5deduct6 ad*ustments to cash %asis
0epreciation e)pense.............................................. @?=
Amorti"ation of !oodwill......................................... 8:?
0ecrease in accounts recei#a%le............................ @G8
0ecrease in in#entories........................................... :
0ecrease in deferred ta)es...................................... 5I:?6
Increase in accounts paya%le.................................. =GC
Increase in accrued lia%ilities................................. 8,G=8
Increase in income ta)es paya%le.......................... I@:
Net cash flow from operatin! acti#ities..................... H ?,:G?
Increase in property, plant R e(uipment
5%efore depreciation6.................................................. 5ECG6
Increase in !oodwill 5%efore amorti"ation6................ 57CI6
0ecrease in in#estments.............................................. =G?
Ac(uisition of su%sidiary9Qraft S.............................. 588,ICI6
Net cash used %y in#estin! acti#ities......................... 58:,7=86
0ecrease in short+term de%t........................................ 5CC86
Increase in lon!+term de%t........................................... E,E:E
0ecrease in e(uity 5repurchase6 SS........................... 5?=G6
0i#idends declared....................................................... 5E=86
Increase in di#idends paya%le..................................... =7
Net cash pro#ided %y financin! acti#ities................. 7,@8=
Net increase in cash..................................................... H 7C
Spple&ental disclosre of cash flow infor&ation
Interest paid durin! year ......................................................................... H @7G
Income ta)es paid durin! the year.......................................................... H8,I?I
Notes&
S $otal of Qraft assets and lia%ilities remo#ed from year to year chan!es and shown as cash
outlay for in#estin! acti#ity.
SS $he net issuance or repurchase of e(uity is computed %y reconcilin! the stoc1holders e(uity
account as follows&
8:OI8O2ear 7 %alance............................................................................................. H@,C:I
2ear C net income................................................................................................. :,II7
0i#idend declared................................................................................................. 5E=86
$otal........................................................................................................................ C,:8E
8:OI8O2ear C %alance............................................................................................. 57,@7E6
0ecrease in e(uity 5repurchase6.......................................................................... H ?=G
7-37
%. Note& For the complete statement of cash flows, the followin! presentation 5direct
format6 of the cash flows from operatin! acti#ities section should replace the cash
flows from operatin! acti#ities section 5usin! the indirect format6 for the statement of
cash flows in part a.
A<I-IA /'RRI. C'/AANIE., INC.
Cash Flow From 'perations
For 2ear Ended 0ecem%er I8, 2ear C 5H /illions6
Cash receipts from operations
.ales MaN..................................................................... HI:,I=I
Cash payments for operations
Aurchases of in#entory M%N...................................... 588,7=@6
.ellin! and administrati#e e)penses McN................ 58I,I@E6
Interest e)pense MdN.................................................. 5@7G6
Income ta) e)pense MeN............................................ 58,I?I6
Cash flows from operations......................................... H?,:G?
Notes
MaN& .ales................................................................................... HI8,7=:
0ecrease in accounts recei#a%le..................................... @G8
Cash collections................................................................ HI:,I=I
M%N& Cost of !oods sold............................................................ 58:,8?@6
0ecrease in in#entories.................................................... :
Increase in accounts paya%le........................................... =GC 588,7=@6
McN& .ellin! and administrati#e e)pense................................. 58=,=8G6
Increase in accrued lia%ilities........................................... 8,G=8 58I,I@E6
MdN& Interest e)pense 5as !i#en6............................................... 5@7G6
MeN& Income ta) e)pense........................................................... 58,IEG6
Increase in income ta)es paya%le.................................... I@:
0ecrease in deferred income ta)es.................................. 5I:?6 58,I?I6
7-38
Aro%lem 7+889concluded
c. Free cash flow can %e defined in #arious ways. $he startin! point is cash flow
from operatin! acti#ities of H?,:G? million. .tudents may want to remo#e
interest e)pense from operatin! cash flowW if they do so, it should %e on an
after+ta) %asis. From operatin! cash flow, capital e)penditures should %e
deducted. It would %e proper to differentiate capital e)penditures re(uired to
maintain e)istin! %usiness from those that !enerate !rowth. $he simplest
calculation would %e operatin! cash flow less capital e)penditures&
H?,:G?+HECG D H=,::? million. 'ther #ariations are possi%le. .tudents should
also su%tract di#idends paid of HCE=. $his yields a free cash flow of HI,II8.
$he implications of free cash flow for a companyXs future earnin!s and
financial condition can include the&
8. Repayment of de%t resultin! in lower interest cost and hi!her earnin!s.
$his would also reduce de%t ratios and impro#es interest co#era!e,
possi%ly leadin! to hi!her de%t ratin!s.
:. Repurchase of e(uity. $his may raise earnin!s per share and 5if
repurchased %elow stated %oo1 #alue per share6 would increase this %oo1
#alue.
I. Increased a%ility to ma1e ac(uisitions 5such as Qraft6, which can pro#ide
future !rowth, %etter di#ersification, and lower ris1.
=. Increased fundin! of internal !rowth throu!h capital spendin!, research
and de#elopment, new product introduction costs, and so forth.
?. Increase in di#idends, pro#idin! lar!er payout of earnin!s to e(uity
in#estors.
@. Increased li(uidity 5financial fle)i%ility6, allowin! the firm to respond to
une)pected needs and opportunities.
7-39
Aro%lem 7+8: 5@G minutes6
a.
TE$A C'RA'RA$I'N
W'RQ.<EE$ $' C'/A,$E CA.< F-'W FR'/ 'AERA$I'N.
0IREC$ ARE.EN$A$I'N 5IN HGGG.6
/ear 0 /ear 5
'peratin! Cash Receipts and 0is%ursements
Net sales MaN 58C@,GGG J 8C,GGG6
58??,GGG J :I,GGG6 MAN.................................................. 8S H:G=,GGG H87C,GGG
'ther re#enue and income........................................... :S
5I6 0 in current recei#a%les........................................... I 5I,GGG6 5:,=GG6
5I6 0 in non+current recei#a%les M%N.............................. =
'ther ad*ustments McN................................................... ?
D CA.< C'--EC$I'N.................................................. @ :G8,GGG 87?,@GG
$otal e)penses MaN M3N................................................... 7S 8E@,GGG 87G,GGG
-ess& E)penses and losses not usin! cash
+ 0epreciation and amorti"ation................................... C 5@,GGG6 5=,GGG6
+ Noncurrent deferred income ta)es............................ E 58,@GG6 58,GGG6
+ 'ther minority interest................................................ 8G 5:GG6
+ 'ther loss on discontinued operations..................... 88 57GG6
+ 'ther............................................................................ 8:
Chan!es in Current Assets and -ia%ilities
related to 'perations
I 506 in in#entories......................................................... 8I 8?,EGG @,GGG
I 506 in prepaid e)pense................................................ 8= :GG
5I6 0 in accounts paya%le and accruals....................... 8? 5:,?GG6 5:,GGG6
5I6 0 in ta)es paya%le..................................................... 8@ 5?,7GG6 58,GGG6
5I6 0 in accruals.............................................................. 87
I or 0 other..................................................................... 8C
I or 0 other..................................................................... 8E
I or 0 in noncurrent accounts M%N................................. :G
D CA.< 0I.3,R.E/EN$............................................ :8 8E?,:GG 8@C,:GG
0i#idends Recei#ed
E(uity in income of unconsolidated affiliates............ ::S :,GGG 58,GGG6
+ ,ndistri%uted e(uity in income of affiliate............... :I 58,=GG6 8,IGG
D 0IVI0EN0. FR'/ ,NC'N.'- AFFI-IA$E............ := @GG IGG
'ther Cash Receipts 50is%ursements6....................... :?S
CA.< F-'W FR'/ 'AERA$I'N. MdN........................ :@ H @,=GG H 7,7GG
7-40
Aro%lem 7+8:9continued
Notes&
5S6 $hese fi#e lines must e(ual reported net income per income statement M2ear @ #erification&
H:G=,GGG +H8E@,GGG J H:,GGG D H8G,GGGN.
5a6 Includin! ad*ustments 5!rossin!+up6 of re#enue and e)pense of discontinued operations
reported in note.
5%6 0etermined to relate to operations 5descri%ed in footnotes6.
5c6 .uch as remo#al of !ains included a%o#e 5descri%ed in footnotes6.
5d6 Reconcile to amount reported %y company. If not reported, reconcile to chan!e in cash for
period.
5A6 .ales from discontinued operations 5see Note =6
2ear @ 2ear ?
536 E)penses per income statement................................................... 8@7,GGG 8IC,GGG
Income ta)es................................................................................... 8G,GGG 7,CGG
/inority interest.............................................................................. :GG
0iscontinued operations............................................................... 8,8GG 8,:GG
-oss on disposal............................................................................ 7GG
Cumulati#e effect of accountin! chan!e..................................... 58,GGG6 +
87C,GGG 8=7,GGG
E)penses of discontinued operations......................................... 8E,8GG :=,:GG
-oss on discontinued operations................................................. 58,8GG6S 58,:GG6SS
8E@,GGG 87G,GGG
S Replaced %y sales of H8C,GGG 5Note =6 + e)penses H8E,8GG.
SS Replaced %y sales of H:I,GGG 5Note =6 + e)penses H:=,:GG.
MNote& 0ue to the ac(uisition of $R' Company in 2ear @, the operatin! wor1in! capital
accounts include amounts so ac(uired and may distort cash inflows and outflows from
operations.N
%.
/ear 0 /ear 51
Income ta) e)pense...............................................................H8G,GGG H7,CGG
$a)es in K%elow lineL items&
J $a) on cumulati#e effect.................................................... 8,GGG ++
P $a) on discontinued operations........................................ 58,8GG6 58,:GG6
P $a) on loss with disposal 57GG6 ++
E,:GG
@,@GG
Increase in deferred income ta)........................................... 58,@GG6 58,GGG6
Increase in ta)es paya%le...................................................... 5?,GGG6 58,GGG6
Income ta)es paid..................................................................H :,@GG H=,@GG
S 0ata for 2ear ? not pro#ided in financial statements.
7-41
Aro%lem 7+8:9continued
c.
Chan!e in %alances of KAccounts Aaya%le and
AccrualsL9per %alance sheet.......................................
H@,GGG
-ess& Ad*ustment due to disposal MaN............................ H IGG
-ess& Ad*ustment due to $R' ac(uisition M%N............... I,:GG I,?GG
Ad*ustment to net income to arri#e at CF'................... H:,?GG
E)planations&
MaN Note = descri%es the loss on disposal9summari"ed as follows&
-oss on disposal..................................................................... 8,=GG
Aroperty, plant R e(uipment .............................................. 8,GGG
In#entories S ........................................................................ 8GG
Accounts paya%le R accruals S.......................................... IGG
and
$a) paya%le S ........................................................................... 7GG
-oss on disposal................................................................. 7GG
No cash is in#ol#ed in this loss. <owe#er, if the operatin! wor1in! capital items
5mar1ed %y S6 in#ol#ed in this entry are not ad*usted, the operatin! cash flows will %e
distorted. $hus, the effect of this entry on these accounts must %e eliminated. $he
%alance sheet year+to+year chan!e in the BAccounts Aaya%le and AccrualsB account
shows an increase of H@,GGG. <owe#er, the chan!e related to cash effects of
operations is HIGG less %ecause a HIGG credit to the account represents a noncash
entry. $hus, the ad*ustment in the .CF is H?,7GG. $he total ad*ustment from loss on
disposal in the .CF can %e summari"ed as&
In#entories 5increase6.............................................................. 8GG
Accounts paya%le and accruals 5decrease6 ......................... IGG
Aroperty, plant and e(uipment 5increase6............................. 8,GGG S
-oss on discontinued oper. 5add%ac1 to income6............ 7GG
$a)es paya%le 5increase6.................................................... 7GG
S $he amount of H@,?GG shown as additions to AARE reflects this ad*ustment.
M%N Note I descri%es the ac(uisition of $R' Company. Teta assumed accounts
paya%les and accruals of HI,:GG. $hese must %e remo#ed from the determination of
CF' to not distort this fi!ure. $he HI,:GG is shown as part of the amount determinin!
the ac(uisition price of $R'.
7-42
CA.E.
Case 7P8 5=? minutes6
a. 8. 0epreciation e)pense represents the allocation of the cost of fi)ed assets
o#er the useful life of the asset. Amorti"ation e)pense represents the
allocation of the cost of intan!i%le assets o#er the useful life of the asset.
In each of these cases, the in#estin! cash outflow occurs when the asset is
ac(uired 5and not when its cost is su%se(uently allocated to e)pense6.
:. Chan!es in deferred ta)es impact reported ta) e)pense, %ut not ta)es paid.
Conse(uently, the statement of cash flows %e!ins with net income 5usin!
reported ta) e)pense6 and ad*usts for chan!es in deferred ta)es in order to
deri#e cash ta)es paid.
I. 0ecreases in recei#a%les cause operatin! cash flows to %e !reater than net
income %ecause cash has %een collected relatin! to re#enues recorded in a
pre#ious period.
=. 0ecreases in in#entory cause operatin! cash flows to %e !reater than net
income %ecause cash was !enerated as in#entories are sold and not
replenished.
%. Net income is much less than operatin! cash flows in :GG? primarily %ecause
of the add+%ac1 of depreciation and amorti"ation, cash inflows arisin! from
the ta) %enefits relatin! to employee stoc1 options, and the reduction of
operatin! wor1in! capital.
c. Free cash flows D Cash flow from operations P Capital additions P 0i#idends
:GG?& H?,I8G P H?:? P HG D H=,7C?
:GG=& HI,@7G P HI:E P HG D HI,I=8
:GGI& HI,?IC P HIG? P HG D HI,:II
d. 0ell has used free cash flows primarily to repurchase shares of its stoc1. $he
e)cess has %een in#ested in mar1eta%le securities.
e. 0ell can return cash to shareholders #ia di#idend payments and stoc1
repurchases. Cash paid for di#idends is "ero, %ut stoc1 repurchases ha#e
amounted to HC,?GE million 5H=,:8EJH:,GGGJH:,:EG6 o#er the past I years.
7-43
Case 7P: 5=G minutes6
a. Analysis of the statement of cash flows su!!ests that this strate!y was
implemented durin! 2ear C. .pecifically, durin! that year the cash flows of
-andsX End to %uildup its in#entory to implement its new policy are #ery hi!h
9 H8G=.?=? million cash outflow to ac(uire additional in#entory.
%. 8. 0epreciation e)pense represents the allocation of the cost of fi)ed assets
o#er the useful life of the asset. Amorti"ation e)pense represents the
allocation of the cost of intan!i%le assets o#er the useful life of the asset.
In each of these cases, the in#estin! cash outflow occurs when the asset is
ac(uired 5and not when its cost is su%se(uently allocated to e)pense6.
:. Increases in recei#a%les cause operatin! cash flows to %e less than net
income %ecause re#enues 5reflectin! recei#a%les6 are included in net
income, %ut the related cash may not yet %e recei#ed. Con#ersely,
decreases in recei#a%les cause operatin! cash flows to %e !reater than net
income %ecause cash is recei#ed for re#enues reco!ni"ed in prior periods.
I. 0ecreases in in#entory cause net income to %e hi!her than operatin! cash
flows %ecause sales re#enue is reco!ni"ed when earned %ut the in#entory
sold can %e paid for in earlier periods. Increases in in#entory cause
operatin! cash flows to %e less than net income %ecause cash was used to
increase in#entory le#els. When these in#entories are su%se(uently sold,
re#enues will %e earned and net income will %e increased. <owe#er, this
in#entory will %e e)pensed on the income statement in the period that it is
sold.
=. Each year, -andsX End esta%lishes a reser#e for sales returns. As a result,
a reconcilin! item is created %etween net income and operatin! cash flows
%ecause the cash outflow to co#er the reser#e will occur in the ne)t period
when a portion of the sold items is actually returned.
c. Free cash flows D Cash flow from operations P Capital additions P 0i#idends
2ear ended 2ear E& H 7=,:@G P H=@,7?G P HG D H :7,?8G
2ear ended 2ear C& H 5:@,EI:6 P H=7,@?E P HG D H57=,?E86
2ear ended 2ear 7& H8:8,7E? P H8C,=C8 P HG D H8GI,I8=
d. -andsX End appears to ha#e recently used its free cash flow to repurchase
shares. Assumin! that mana!ement doesnXt ha#e any positi#e net present
#alue pro*ects for e)pansion a#aila%le, this is a reasona%le use of free cash
flow as it returns cash to shareholders. $hese shareholders can then in#est
these funds accordin! to their ris1 and return preferences.
7-44
Case 7+I 5IG minutes6
a. 2ahoo issued stoc1 5common and preferred6 to !enerate the necessary cash
flows to finance its %usiness acti#ities and !rowth opportunities.
%. Net income 5re#enues and e)penses6 appears to %e dri#in! operatin! cash
flows for 2ahoo. As net income increases 5decreases6, operatin! cash flow
increases 5decreases6.
c. 2ahoo has su%stantial cash reser#es !enerated #ia e(uity issuances. $his
e(uity capital is necessary to finance pro*ected !rowth in the upcomin! years.
,ntil the company re(uires the cash, it is %ein! in#ested in mar1eta%le
securities in a desire to earn a hi!her than KnormalL rate of return.
d. $his amount represents cash recei#ed %efore re#enue is reco!ni"ed 5that is,
the ser#iceOproduct is not yet deli#ered6. /ost of this deferred re#enue li1ely is
related to prepaid ad#ertisin! re#enue recei#ed in ad#ance.
7-45
Case 7+= 5@G minutes6
a.
W2A$$ C'RA'RA$I'N
For the 2ear Ended 0ecem%er I8, 2ear 8G
Net income S.......................................................................... H8C@,GGG
Add 5deduct6 ad*ustments to cash %asis
0epreciation e)pense..................................................... :=@,GGG
>ain on sale of e(uipment SS......................................... 5=,GGG6
Increase in accounts recei#a%le.................................... 5888,GGG6
Increase in in#entories................................................... 5:8C,GGG6
Increase in accounts paya%le........................................ 8GI,GGG
0ecrease in income ta)es paya%le................................ 5:?,GGG6
Increase in other paya%les............................................. E:,GGG
Net cash flow from operatin! acti#ities............................. H:@E,GGG
Aroceeds from sale of e(uipment....................................... I=,GGG
Additions to plant and e(uipment....................................... 5:8:,GGG6
Net cash used %y in#estin! acti#ities................................ 587C,GGG6
Issuance of stoc1.................................................................. 87,GGG
0i#idends............................................................................... 57=,GGG6
Reduction of de%t................................................................. 587,GGG6
Net cash pro#ided %y financin! acti#ities......................... 57=,GGG6
Net increase in cash........................................................... H 87,GGG
Cash %alance, 0ecem%er I8, 2ear E.................................. 87?,GGG
Cash %alance, 0ecem%er I8, 2ear 8G................................ H8E:,GGG
Notes&
S 0etermination of 2ear 8G net income&
Retained earnin!s, 8:OI8O2ear 8G........................................... H8,@IC,GGG
Retained earnin!s, 8:OI8O2ear E............................................. 58,?:@,GGG6
88:,GGG
Alus& 0i#idends paid................................................................ 7=,GGG
2ear 8G net income................................................................... H 8C@,GGG
SS0eri#ation of !ain on sale of e(uipment&
Accumulated depreciation, 8:OI8O2ear E................................ H E8@,GGG
0epreciation e)pense.............................................................. :=@,GGG
H8,8@:,GGG
Accumulated depreciation, 8:OI8O2ear 8G.............................. 58,8I8,GGG6
Accumulated depreciation on e(uipment sold..................... H I8,GGG
'ri!inal Cost............................................................................ H @8,GGG
Accumulated depreciation on e(uipment sold..................... 5I8,GGG6
3asis of e(uipment.................................................................. H IG,GGG
Aroceeds from sale.................................................................. I=,GGG
>ain on sale.............................................................................. H =,GGG
7-46
Case 7+=9continued
%. In 2ear 8G, Wyatt Corporation !enerated cash from operations of H:@E,GGG
after considerin! operatin! wor1in! capital needs. .u%tractin! pro*ected de%t
ser#ice of HIGG,GGG per year and estimated capital spendin! of HI:?,GGG per
year from that fi!ure lea#es a decidedly ne!ati#e num%er. $hat is, there is not
sufficient cash to fund %oth the de%t ser#ice and the e)pansion pro*ect for any
e)tended period of time. $herefore, the le#era!ed %uyout and the capital
spendin! plan are mutually not compati%le !oals9at least not as currently
proposed. Wyatt cannot do %oth. /oreo#er, it pro%a%ly should not do either
one if it wishes to maintain a reasona%le mar!in of safety.
7-47
Case 7+? 57? minutes6
0'VER C'RA.
For the 2ear Ended 0ecem%er I8, 2ear C
Net income.................................................................................... HIG?,GGG
Ad*ustments to reconcile net income to net cash
pro#ided %y operatin! acti#ities&
0epreciation.................................................................................. C:,GGG
Amorti"ation of patent................................................................. E,GGG
-oss on sale of e(uipment.......................................................... 8G,GGG
E(uity in income of $op Corp...................................................... 5IG,GGG6
>ain on sale of mar1eta%le e(uity securities............................ 58E,GGG6
0ecrease in allowance to reduce mar1eta%le
e(uity securities to mar1et........................................................ 58?,GGG6
Increase in accounts recei#a%le................................................. 5I?,GGG6
0ecrease in in#entories............................................................... CG,GGG
0ecrease in accounts paya%le and accrued lia%ilities ............. 588?,GGG6
Net cash pro#ided %y operatin! acti#ities ................................ H:7:,GGG
.ale of mar1eta%le e(uity securities.......................................... 88E,GGG
.ale of e(uipment ........................................................................ 8C,GGG
Aurchase of e(uipment................................................................ 58:G,GGG6
Net cash pro#ided %y in#estin! acti#ities ................................. 87,GGG
Issuance of common stoc1......................................................... :@G,GGG
Cash di#idend paid....................................................................... 5C?,GGG6
Aayment on note paya%le............................................................ 5IGG,GGG6
Net cash used in financin! acti#ities.......................................... 58:?,GGG6
Net increase in cash..................................................................... H8@=,GGG
Cash at %e!innin! of year ........................................................... IG7,GGG
Cash at end of year...................................................................... H=78,GGG
7-48
Case 7+?9continued
Feasi%ility Analysis of /ana!ementXs Aroposal
Cash from operations, 2ear C.................................................. H :7:,GGG
Additional interest cost............................................................ 5:GG,GGG6
Annual e(uipment in#estments............................................... 58CG,GGG6
-ess 2ear C outlay..................................................................... 8:G,GGG
Annual in#entory %uildup......................................................... 5@G,GGG6
Aro*ected cash shortfall........................................................... H 5=C,GGG6
Other considerations in Assessing Manage&ent2s 3roposal*
Non+CF' cash flows in 2ear C are H58GC,GGG6 9 a cash outflow. <owe#er, di#idend
payments can pro%a%ly %e reduced. A ultimate (uestion is whether the
in#estment in e(uipment will yield positi#e additions to CF'. $he current analysis
raises serious dou%ts a%out the feasi%ility of this proposal.
)O+4* .upportin! computations for the .CF draw on these $+accounts 5HGGGs6
Cash
3e!innin! IG7
'peratin!
586 -oss on sale of e(uipment 8G
5=6 Net income IG?
5%6 0ecrease in In#entory CG
5e6 Amorti"ation of patents E
5f6 0epreciation C:
I= 5:6 >ain on sale of securities
I=
IG 5c6 E(uity in $op Corp.
IG
I? 5a6 Increase in accounts recei#a%le
I?
88? 5!6 0ecrease in accounts paya%le
88?
In#estin!
586 Aroceeds from sale of
e(uipment 8C
5:6 Aroceeds from sale of
securities 88E
8:G 5d6 Additions to AARE
8:G
Financin!
5I6 Issue of common stoc1 :@G

Endin! =78
IGG 5h6 Increase in note paya%le
C? 5?6 0i#idends
7-49
Case 7+?9continued
/ar1eta%le .ecurities, at cost Allow. to Reduce /ar1eta%le .ec. to /ar1et
3e! :?G 8GG 5:6
8GG
5:6 8? :? 3e!
End 8?G 8G End
Accounts Recei#a%le In#entories
3e! ?8?
5a6 I?
3e! CEG CG 5%6
End ??G End C8G
In#estment in $op Corp. 5at e(uity6 AARE
3e! IEG
5c6 IG
3e! 8,G7G
5d6 8:G
=? 586
End =:G End 8,8=?
Aatent Accum. 0epreciation
3e! 88C E 5e6 586 87 :CG 3e!
C: 5f6
End 8GE I=? End
-on!+$erm Note Aaya%le Accounts Aaya%le and Accrued -ia%ilities
5h6 IGG EGG 3e! 5!6 88? E@G 3e!
@GG End C=? End
Common .toc1 0eferred Income $a)es
@?G 3e!
:GG 5I6
8EG 3e!
C?G End 8EG End
Retained Earnin!s Additional Aaid+In Capital
5?6 C? I@? 3e!
IG? 5=6
87G 3e!
@G 5I6
?C? End :IG End
7-50

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Chapter 07 - Cash Flow Analysis

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