CHAPTER 11 THE STATEMENT OF CASH FLOWS ‘Changes from Eleventh Edition Updated from the Eleventh Edition, Approach This is a topic that has always been difficult for students. The indirect method of developing, the amount of cash flow from operating activities is particularly difficult. The hearings prior to FASB 95 indicated that the investment analyst community would press companies to continue using the indirect (reconciliation) method; the primary supporters of the direct method were bankers. Thus, it appeats that students will not be well served in this subject area unless they gain an understanding of the indirect method. Since students were introduced to the difference between cash flows and accrual accounting’s revenues and expenses way back in Chapter 3, this should be reinforcement at this point, but it usually seems to be anew revelation to at Ieast a subsct of the class. For those who never succeed in fully understanding the rationale for the adjustments, Illustration 11-4 now gives them rote approach to which they can rever. Cases Medieval Adventures Company is an armchair case intended to dramatize the difference between operating cash flow and income. Amerbran Company (A) illustrates preparation of the cash flow statement from the other two statements and supplemental information. Great Valu Variety Stores illustrates the potential drawback of defining funds as working capital, and the importance of considering eash flows in conjunction with income statements. The origins of the ease, the W.T. Grant bankruptcy apparently influenced the FASB in changing the required definition of funds from ‘working capital to cash, Problems Problem 11-1 2003 sales. $8,743,000. Less: Change in accounts receivable... snnrnmnns nnn L000). Cash generated from sales during 2003. snr BETR ONO Problem 11-2 a, Issuance of a 12-month note in return for $2 million cash is a financing source of cash. Use of $2 nillion cash to purchase equipment is an investment use of cash: b. Cash proceeds from the issuance of common stock is a financing source of cash. The use of cash to retire mortgage bonds is a financing use of cash c. No cash effect, d._ No cash effect, ce. Cash proceeds from the sale of machinery is an investment source of cash,Accounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant The above responses assume the direct method is used to present its cash flow of statement. Problem 11-3 Problem 11-4 Problem 11-5 Kids’n Caboodle Statement of Cash Flows Cash received from customets....n sn -S155,000. Cash used in operations (146,900) ‘Cash from operation $8,100... Exquipment rn enrnenn Cash used for investments Loan. . ‘Cash from financing. Increase in cash, Net loss... Depreciation. Accounts receivable (reduced).... ‘Accounts payable (increased) Accrued salaries (increased). Other accruals (increased). Cash flow from operations.. Investments... Long-term debt (reduced) ...cssonensnnsnsnnnnens nen (2Q200. (Change in cash Beginning cash, Ending cash. rating Acti ‘ash received fi seas A UO Interest received. 3a5. Operating cash payments... (54,165). Interest payment. Net cash provided by operatio Sale of old machine... Down payment on new truck Net cash used in investing activities. Financing Activities Payment of debt... Net cash used in financing activities. ond.©2007 MeGraw-Hillirwin Chapter 11 Increase in cash. Beginning cash. Ending cash. Cases Case 11-1 Medieval Adventures Company" Note: This case is the same version that was in the Eleventh Edition. Approach This (obviously) is an armchair case, intended to show dramatically the difference between profit and cash flow from operations. The ease has mechanistic patterns built into it to help students see what is going on: relatively rapid growth is causing cash to be tied up in receivables and inventories faster than it is regenerated from collections. Although the case may seem trivial (at least after the calculations have been made) because of these mechanistic pattems, in fact many businesses have had severe (sometimes fatal) financial crises because management did not anticipate the basic phenomenon that this case develops. The graph included herein can be used in class to help illustrate this phenomenon, Medieval Adventures Company 600,000 500,000 400,000 a Sales 2 Net home —#— Net Operating Cash Flow + Cash Balance wie Loan a Accounts Receivable 100,000 san Feb March Ap May June July Aug Sep Oct Question 1 ‘The required monthly statements are shown on the Following pages. The peak need comes by the end of July, when a $40,000 loan would be needed to maintain a zero cash balance. In August, cash generated by operations finally tus positive, enabling partial repayments of the loan, October's $27,500 cash “This teaching nose was propared by Robert N. Anthony. Copyright © Robert N. AnthonyAccounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant gencrated by operations enables making the final $15,000 loan repayment and ending the month with a $12,500 cash balance. Question 2 ‘This question is the key one in terms of student insight from this case. The company has been paying its costs currently, but allowing customers two months to pay. This, coupled with constant growth, causes large net operating outflows for several months, which collectively cat up the firm’s initial capital. It is important for students to understand why it is that this situation eventually turns around: the unit margin is $20 and the monthly nonproduction costs are fixed at $10,000; thus, the continued unit sales growth eventually (in August) causes the current inflows (from sales two months ago) to exceed the current outflows (production costs for next month's sales plus $ 10,000). In other words, as the income statement shows, the firm is profitable, and eventually those profits get realized in cash, This need could have been avoided by projecting the cash flow figures that the students have developed after the fact. Then the company could have arranged the necessary line of credit. Banks are happy to provide such funds for companies that anticipate the need because that anticipation reflects good finan: ‘management. On the other hand, banks are hesitant to lend to a firm that has been taken by surprise by a cash shortage, Of course, a no-cost method to avoid the problem was also probably feasible. The company could have arranged credit with vendors to help finance the inventory, and could have been more aggressive in collecting from its customers in accord with the stated 30-day terms, If the company delayed its payments by 30 days and accelerated receivable collections from 60 to 30 days (thus shortening its “cash cycle” by 60 days), the operating cash flow would have tumed positive in March and no cash crisis would have occurred. Question 3 ‘The purpose of this question is to give students practice in deriving @ cash flow statement from the income statement and balance sheets. Because of the work done in question 1, where cash flows were dealt with direetly, students can gain some confidence in these derivation procedures before they apply the procedures in more complex and realistic cases. The statements are as follows (in somewhat simplified format, befitting this introductory problem):Natineoe, Inerewsin accounts eeivabl. Ines in invert. Cash option, Proved of. Cashincease (deca Beginingofmonh cx ane... FExdoftmont ah tae. a, Sal $35 00 Costa ules, 3000 (ss Maga, eer Otter Expases. uu. Net ocome ‘no, Cosh vs ashlar $6280 Coleco, 20h, Loan fom bank. = Toal $179, Cash Outs Coss & expenses $2.0 en Cash lee, SILL Meno: et opening cash ow 5435000) Cashbalane wo ba... SILL29 Feb, $82,500. ALi, M0, 10 10. SILI 280. 41280 $1900 80,08, S70. (3850) S70 March $30,000, 485,00), 17.500) (42500), May $S0,000. 17.5) 2.500), 22500. AS Dx M, . Su... MD OPERATING BUDGET Mar, SW 20.00. And, 10.00) 0000 S720. $8000. 121300 $97.58, $30,000, 942.500) S xo Apr SIR ALS. 1,00 L000) gi. May $165,000, sum 0. atin 51,000. CASH BUDGET 00d 23h 2500 115000. 32.500) $2.00) Sa, Lido00 223i $12.00, $132.00, $0. (2,50) 2800), Sth 137500. 128i), $150,000. $1500. w S120) $32,500). Jaly so, wAd{.000.. (L000, Lue. 000. SA. 65000. lb. $167500, sss Su. $2.90) (40,0). Ang 341500 ASM, So. lun. 0 Se. 192i 192500. i850 f 250. So. 7st 52.500). Sept sos 25.000 0g00 10000 aio 51780 S450) Oct. ssi2st0 12s tug 10000 toqgoo Se 1500 524750 220.00 5.00 $1250 $7300 $1250Accounting’ Tex and Cases 122 —Jnstractor's Monal Anthony Hawkins! Merchant BALANCESHEET De. dam RR Mar Apr, May June yA Sep, at st th St St athh St Sth st Assets: Cait $4000 rane Sere Slavomn Shoe $0 $0 $1200 ecunts Revival 19250024100. SOS. SSDS Al. 467300 522500 577500 Invesioy $7500... J0SOO0.. 1250)... JANI. 18750).. 175000162500 210000 Toi. SCL... QAO... SOOO). SILI... $3528. SSI... SLU. SN... SOS STASI SAU. Lites and Egat Nate Payable $2800. $8000... $31... $4000)... § 2500 $1500 S— Common Sik... Sii,.280 0... .23H 0025000.» 280000 280000 280,000 Retained Eamings. 00000... SLO)... 210000... 220000... 36000) 48.000 $80,000 Tl. 3520)... OSU... WUT. $STONND... SHS) STIS) $0000©2007 MeGraw-Hillirwin Chapter 11 ‘ase 11-2 Amerbran Company (A} Note: This case is unchanged fram the Eleventh Edition, Approach This case is based on actual financial statements of American Brands, Inc, Although the numbers have been changed from those reported, the magnitudes and relationships have been preserved, This case provides additional practice in preparing a statement of cash flows. Since specific information is not given on cash collections and operating disbursements, it is expected that students will use the indirect approach in developing the cash generated by operations amount. The statements in Exhibit | also provide the raw data for the (B) case, which is a ratio analysis case that appears in Chapter 13. Answer to Question ‘The required cash flow statement appears below. The explanatory notes to the statement are as follows: Note 1 This is the net of the following components: Increase in accounts receivable eran RR BR), Increase in inventories (19,510) Decrease in prepaid expenses 1,022. Increase in accounts payable... shanmacnanmmanncrs aa ES Increase in accrued expenses payable 194.728. $140,493, Note 2. The two components of this acquisition, as given in the case, could be shown separately. Note 3. The decrease in long-term debt is less than the decrease in long-term liabilities because the latter also includes deferred taxes. Note 4. Lacking specific information to the contrary, it is assumed that reissuance of treasury stock for bonuses generated no cash, The stock dividend was, in effect, a 2-for-1 stock split. The only difference is that if it were a stock split, the total shown for common stock at par would have remained $161,417 rather than doubling to $322,834. Note 5. The three major categories of cash flows generated a net of SI 1,785 of cash. Since the increase to be explained is only $4,960, “miscellaneous activities” must have used $6,825 of cash. Some students may include this line in operating activities, rather than as a fourth category; if they do, the net cash flow from operations becomes $567,303, AMERBRAN COMPANY Statement of Cash Flows For the year ended December 31, 20x1 thousands) Net cash flow from operating acti Net income. \Noneash items included in income: Depreciation and amortization. LS.974, Deferred taxes (17,548). $328,173. “This teaching nose was propared by Robert N. Anthony. Copyright © Robert N. AnthonyAccounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant ‘Net change in receivables, inventories, and payables (Note 1). 140,498 Write-off of obsolete equipment. cs 66.046. Income from subsidiary... 459.610). Net cash flow from operating activities (514,128), (Cash flows from investing activities: Acquisitions of property, plant, and equipment.. - evn of 26Q075), Proceeds from disposals, 33,162. Acquisition of Company X (Note 2) csuroneusinininnnnennen 133.721 Net cash used by investing activities. 360,634). Cash flows from financing activities Increase in short-term debt 79.664. Decrease in long-term debt (Note 3) (34.600). Dividends paid. tt rate eet COL SB Purchase of treasury stock (Note 4) 130.609). ‘Net cash used by financing activities, (201.209). Cash flows from miscellaneous activities (Note 5) 46.825), Net increase in cash... Cash at beginning of year. Cash at end of year.. Case 11-3: Great Value Variety Stoi Note: 4 new case for the Twelfth Edition. Approach ‘The premise motivative to case is that traditional ratio analysis and the definition of funds as working capital used in many finance classes may not reveal a company’s liquidity crisis as early as would a careful analysis of the firm’s cash flows. This case requires two class sessions. Trying to use it for only one session is likely to result in student ind frustration unless the instructor provides handouts before class with all of the ratio analysis, 1 of working capital flow to cash flow calculations done for the students. My two-day approach involves six steps: (I) Calculate the ratios for just one year, being sure the students jerstand what each ratio indicates (a few ratios have not yet been formally presented in the text, but students seem to eatch on to them quickly). (2) Use a transpareney spreadsheet with all of the ratios for all of the years, and discuss trends. (3) Discuss the working capital concepts of funds and how it differs from the cash concept. (4) Do the conversion from working capital to cash for at least one year. (5) Use a transparency to compare net income, working capital, and cash flow generated by operations, as well as financing and investing activities, for the 10-year period. (6) Give a brief “post mortem” along the lines mentioned below. Note the year 2007 is included in these handouts, the instructor may not want to show 2007 letting the students predict what 2007 may look like. “This teching note was prepared by James S. Reece. Copirigh © James S Reece Question |©2007 MeGraw-Hillirwin Chapter 11 Ratios are shown in Exhibit A. Graphs of groups of related ratios are also shown below. Although the case calls for calculation for days’ receivables, in the accompanying graph of tumover ratios that ratio has been converted to receivables turnover, so it could readily be graphed using the same scale as for inventory and asset turnover. (Receivables turnover is simply 365 divided by days" receivables.) It should be noted that profitability ratios were gradually declining through FY2005, but the “big fall” did not start until 1963. Similarly, turnover ratios were gradually deteriorating (the improvement in 2007 is deceptive—primarily the result of crisis management). Liquidity declined over the decade and solvency ratios also began to deteriorate in 2001 Question 2. The primary cause of student problems in answering Question 2 is that the changes in working capital components at the bottom of the statement of changes in financial position have the opposite signs from those needed for question 2. For example, an increase in inventory causes an increase in working capital, and thus is shown as a positive amount in the bottom section of the SCFP; but an inventory increase is a use of cash that must be subtracted in making the adjustments called for in question 2. I warn the students of this complication on the assignment sheet. This is, of course, an ideal case for use of a spreadsheet; the instructor may wish to make the data in Exhibits 1 and 2 available to the student as spreadsheet files to facilitate all of their calculations. ‘The results of these calculations are graphed below, along with net income and working capital generated by operations. This graph vividly demonstrates the premise: a cash flow analysis would have revealed Big Value's developing problem two or three years sooner than either net income or working capital gencrated by operations signaled it. Indeed, over the decade, Big Value had positive operating cash flow in only three years. The $100 million borrowings in 2004 and 2006 were needed to compensate for the lack of cash generated by operations, as receivables and inventories ballooned Post Mortem This is a disguised case based on the W.T. Giant bankruptcy. ‘The above analysis shows that net income was relatively flat through FY2005, yet sales doubled over the period, Nevertheless, the year-end FY2005 stock price was double that of year-end FY 1998. Until 2006, Big Valuc’s p/e ratio (20) execeded that of similar variety chains. The company was showing increased sales and had paid dividends since 1906; apparently this overwhelmed the fact that the growth was profitless, Big Value filed for Chapter XI bankruptcy on October shortly after the case and was liquidated soon thereafter.EXHIBIT A Big Value Variety Stores 1998 19992000 20012002, 200320 200520062007 Seleated Ratios Profit Margin. oA DMRR. OOM MIB US. ORS DOI OD 00610) Reta on 9) ewe LE eM ele ALLS B en DUM MARL or LOB a6 oneal $57 Ret OSES ea al O60 ee OBL oo O89. ee. oe nana 0.164 Days’ eeivables BQ core MSecodDLS dW coell ened Bec ll cee nllDnlO67 993 An 163 a 206 sv Boel Tbr nnde$6 se 1B QUIK HO. neni erin DB oonislBnenbd Qed sume Boerne MS nnlL 8S 068 Total Liability Equi) oe L DB roel AS ned erred Declare Men DAB ivan OS4 8502 Debt Capitalization. a LA roel creed MoD Mer rnlDSaononlADS 0.655 EXHIBIT Big Value Variety lores 1990 1999 200020012002 2003 2H 2005 2006-2007 Cash Flow From Operations Working capital from operations... BRB. ID AO ABM ADD AB Bucs MM ABR DBL (1707) Accounts recivable decrease (increase)......-($3.2)... AST 3) AAD ADR. (S88) Mace ADM). (608)...(72.2) 1096 Inventory derease (Mt eA8C) an eosnnin( lO Boo PRD eau Q4D)un (RS) ul BA). B82}. .u( 10081811) 8.2 er cument ase decease nr 86) aM Doo OD) OB ln OL nf ld).(06) 07 Accounts payable nese (ote Spendl he 6rd Barred S non Boereld Dn(LSQ}..n(28) (1) Other current liabilities inerease (decrease), db. ADE) a ld (510) Cs ow fo (RS eo AD BOB DD Bf OH I 8 Note: 2007 figures are not inthe cave,©2007 MeGraw-Hillirwin Chapter 11 Profitability Ratios 02 OL 0 01 02 03 04 “05 06 07 “08 09 “1 “Ll “12 “13 “14 “15 -16 + 1998 1999-2000 200120022003 «2004-2008. 2006.- 2007 8+ Profit Margin + ROE —e- ROA Turnover Ratios RokuBESE ASE Ree Rake 1998 1999-2000 2001-—-2002--2003- 2004-2005 20062007 3 Revbis Se Invent —e— AssetsAccounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant Liquidity Ratios 27 26 25 24 23 22 2 b i pb Lo LS, 14 13, 12 Ld I 08 tg ie ted 1998 1999 2000-2001 22-28-2004 20520062007 + Current Ratio > Quick Ratio Solvency Ratios 1998 1999-2000 2001» 2002,--2003.-«S-2008 = «2005-2006. = 2007 3+ Liab/Equity + Debt/Capital©2007 MeGraw-Hillirwin Chapter 11 Income and Funds Flows -100 -120 -140 -160 -1s0 + 1998 1999 2000-2001 «= 2002-2003 2004S 2005 2006-2007 s+ Net Income 3 Opns Wkg Cap —e— Opns Cash