(1)The Statement of Cash Flows Referencing this week?s readings and lecture, describe the following terms as they relate to the statement of cash flows: cash, operating activities, investing activities, and financing activities. What can creditors, investors, and other users glean from an analysis of the statement of cash flows? (2) Analyzing the Statement of Cash Flows Using the table below, explain the difference between net income and cash flow from operating activities for Techno in 2009 and analyze their cash flows for 2008 and 2009. (in thousands) 2009 2008 Net income $ 316,354 $ 242,329 Noncash charges (credits) to income Depreciation and amortization 68,156 62,591 Deferred taxes 15,394 22,814 $ 399,904 $ 327,734 Cash Provided (Used) by Operating Assets and Liabilities: Receivables (288,174) (49,704) Inventories (159,419) (145,554) Other current assets (1,470) 3,832 Accounts payable, accrued liabilities 73,684 41,079 Total Cash Provided by Operations $ 24,525 $ 177,387 Investment activities Additions to plant and equipment (94,1760) (93,136) Other investment activities 14,408 (34,771) Net investment activities ($ 79,768) ($ 127,907) Financing activities Purchases of treasury stock (45,854) (39,267) Dividends paid (49,290) (22,523) Net changes in short-term borrowing 125,248 45,067 Additions to long-term borrowings 135,249 4,610 Repayments of long-term borrowings (250,564) Net financing activities $ 165,353 ($ 262,677) Increase (decrease) in cash $ 110,110 ($ 213,197) Beginning cash balance 78,114 291,311 Ending cash balance $ 188,224 $ 78,114

4 Elements of a Statement of Cash Flows Eldad Carin/iStock/Thinkstock Learning Objectives After reading this chapter, you should be able to: 1. Explain how a statement of cash flows is calculated. 2. Discuss how cash is used for company operations. 3. Explore how cash is used for company investment opportunities. 4. Assess how cash is raised or spent from financing activities. 5. Explain how to analyze a statement of cash flows. eps81356_04_c04_133-160.indd 133 3/26/14 12:58 PM Introduction Pre-Test 1. What is the primary purpose of the statement of cash flows? a. to find out how much cash was made from sales b. to find out how much cash was taken in by borrowing money c. to find out how much cash was spent to invest on new equipment d. to find out how much cash flowed into and out of the business 2. Which is a section of the statement of cash flows? a. Investing Activities b. Financing Activities c. Operating Activities d. all of the above 3. Where would one find depreciation on the statement of cash flows? a. Adjustment in Investing Activities b. Adjustment in Financing Activities c. Adjustment in Operating Activities d. It would not be found on the statement of cash flows. 4. Where would one find cash spent on new equipment on the statement of cash flows? a. in the Investing Activities section b. in the Financing Activities section c. in the Operating Activities section d. It would not be found on the statement of cash flows. 5. Where would one find dividends on the statement of cash flows? a. in the Investing Activities section b. in the Financing Activities section c. in the Operating Activities section d. It would not be found on the statement of cash flows. Answers can be found at the end of the chapter. Introduction In Chapter 3, we examined the income statement, which indicates a company's financial results based only on the revenue it earns, with the bottom line showing whether the company made a profit. However, because accrual accounting allows companies to recognize sales on the date of completion, even if cash has not yet changed hands (review Chapter 3 for more information on revenue recognition), a company can show profitability on the income statement but still be cash poor. The statement that looks at how cash flows into and out of the business is the statement of cash flows. eps81356_04_c04_133-160.indd 134 3/26/14 12:58 PM What Is a Statement of Cash Flows? Section 4.1 In this chapter, we will explain how the statement of cash flows is calculated and explore how information is used from the balance sheet and income statement to prepare this statement. The Best General Company budget committee would likely review this statement to determine if there are flow issues that need to be addressed. 4.1 What Is a Statement of Cash Flows? The most common reason cash on hand is lower than profit from operations is that a company's customers have not yet paid their outstanding bills. Another common reason is that more inventory was purchased than the company was able to sell. Managers need to review the inflow and outflow of cash shown on the statement of cash flows to determine whether there is a cash flow problem. The bottom line of the statement of cash flows shows managers whether the company actually increased or decreased the cash on hand from all its activities during the reporting period. The statement of cash flows also indicates how a company is getting and using its cash. Like the income statement, the statement of cash flows shows the operating results throughout the period being reported. However, as noted, it also details how cash flowed into and out of the company from other activities, such as investing, which could include the purchase or sale of long-term assets, and financing, which could include taking on a new loan or issuing stock. The statement of cash flows details the flow of cash from three types of financial activities: 1. Operating Activities: This section provides a manager with information about the company's cash through the sales of its products or services. It also indicates how the company used cash to pay for needed goods or services to operate the business. 2. Investing Activities: This section provides a manager with details about the company's investments. It indicates whether the company used cash to purchase securities, or raised cash by selling securities or other long-term assets, such as a building or a division. It also provides details about cash spent on capital investments, such as upgrades to major assets held, which can include upgrades to a factory or renovation of a building. 3. Financing Activities: This section provides a manager with information about transactions that raised cash through adding long-term debt or issuing new stock. It includes information about cash used to pay down debt or buy back stock. The payment of dividends is also found here. Figure 4.1 shows the statement of cash flows for the year 2013 for Best General Company. To comply with SEC rules, companies normally show three years of results on the statement of cash flows. eps81356_04_c04_133-160.indd 135 3/26/14 12:58 PM Section 4.1 What Is a Statement of Cash Flows? Figure 4.1: Statement of cash flows for Best General Company This statement shows the flow of cash into and out of the company. Best General Company Statement of Cash Flows For the Year Ended December 31, 2013 Cash Flows from Operating Activities: Net Income Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and Amortization Increase in Accounts Receivable Increase in Inventories Decrease in Accounts Payable Increase in Accrued Liabilities Net cash provided by (used in) operating activities Cash Flows from Investing Activities: Additions to Property, Plant, and Equipment Sales of Property, Plant, and Equipment Other Non-Current Assets Net cash provided by (used in) investing activities Cash Flows from Financing Activities: Issuance of Common Stock Increase (decrease) in short-term borrowings Additions to long-term borrowings Reductions in Long-Term Debt Reductions in Other Non-Current Liabilities Dividends paid Net cash provided by (used in) financing activities $ $ $ $ eps81356_04_c04_133-160.indd 136 (100) 3,450 2,400 (600) (2,000) (500) 600 0 0 0 $ $ Net increase (decrease) in Cash and cash equivalents Cash and cash equivalents, beginning balance at December 31, 2012 Cash and cash equivalents, ending balance at December 31, 2013 Supplemental cash flows information: Cash paid for interest Cash paid for taxes 3,550 0 0 0 0 (2,550) (2,000) 0 $ (4,550) $ (1,100) 9,500 8,400 $ $ 800 150 3/26/14 12:58 PM What Is a Statement of Cash Flows? Section 4.1 Possible Formats The statement of cash flows can be organized into either the direct format or indirect format. The difference between these is the amount of detail provided. They both provide the same conclusion about how much cash was added to the business or deducted from it, but they offer different details about how cash flowed into and out of the business: Direct Method: This method groups major classes of cash receipts and cash payments separately. For example, cash from customers is grouped separately from cash received on interest-earning savings accounts, or from dividends paid on stock. Major groupings of cash payments include cash paid to buy inventory, cash disbursed to pay salaries, cash paid for taxes, and cash paid to cover interest on loans. This method is preferred by the Financial Accounting Standards Board (FASB) because research studies have shown that the additional information is useful for making decisions. The direct method improves the ability of financial report readers to predict future operating cash flows and earnings (Broome, 2004; Orpurt & Zang, 2009). Indirect Method: This method focuses on differences between net income and net cash flow from operations, and is used by most companies. The Securities and Exchange Commission (SEC) only requires the detail provided by the indirect method. Differences between these methods can be seen only in the Operating Activities section of the statement of cash flows, which is always the first section of the statement. Figure 4.2 provides a sample of the direct method as might be used by Best General Company, whereas Figure 4.3 shows the indirect method. As shown in Figure 4.2, the direct method provides a good deal of information, such as cash received from customers or cash paid to suppliers and employees. That detail cannot be found on the balance sheet or income statement. Meanwhile, as shown in Figure 4.3, the statement using the indirect method makes no mention of cash from sales or cash paid to buy supplies. It also does not show cash paid for salaries or the amount of cash gleaned in income tax refunds. What is shown are the results from various calculations using the income statement and balance sheet. eps81356_04_c04_133-160.indd 137 3/26/14 12:58 PM Section 4.1 What Is a Statement of Cash Flows? Figure 4.2: Operating activitiesdirect method This section of the statement of cash flows shows how cash flowed into and out of the business from operating activities. More detail about cash from customers and cash paid to suppliers is shown in the direct method of this statement. Best General Company Statement of Cash Flows (Partial) For the Year Ended December 31, 2013 Cash Flows from Operating Activities: Cash received from customers Cash paid to suppliers and employees Interest received Interest paid Income tax refund received Income taxes paid Other cash received (paid) Net cash provided by (used in) operating activities $ 93,000 (90,500) 200 (800) 0 (150) 1,700 $ 3,450 Figure 4.3: Operating activitiesindirect method This section of the statement of cash flows shows how cash flowed into and out of the business from operating activities. The indirect method does not show detail about cash from customers or cash paid out to suppliers and vendors. Best General Company Statement of Cash Flows (Partial) For the Year Ended December 31, 2013 Cash Flows from Operating Activities: Net Income Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and Amortization Increase in Accounts Receivable Increase in Inventories Decrease in Accounts Payable Increase in Accrued Liabilities Net cash provided by (used in) operating activities eps81356_04_c04_133-160.indd 138 $ $ 3,550 $ (100) 3,450 2,400 (600) (2,000) (500) 600 3/26/14 12:58 PM What Is a Statement of Cash Flows? Section 4.1 Companies often prefer the indirect method because of the limited amount of information it providesthis is an advantage when it comes to thwarting competitors' ability to mine significant details from the company's public statements. We will focus on this method in this chapter, since almost all companies use it, and managers are most likely to see it when reading financial reports. How the Statement of Cash Flows Is Calculated A statement that uses the indirect method starts with net income from the income statement. Adjustments are then made for line items in which cash was used. At the bottom of each of the three sections (Operating, Investing, Financing) is a line item that shows cash provided by or used for line items in that section, as shown in Figure 4.1. In order to compile a statement of cash flows using the indirect method, all a manager needs is two years' worth of balance sheets and income statements. The manager then develops a cash flow worksheet, similar to the one in Figure 4.4. The line items included in this worksheet are line items from the balance sheet. This worksheet is used to determine the change in value of each of these items on the balance sheet. For example, Cash and Cash Equivalents went down by $1,100, while Accounts Receivable increased in value by $600. In addition to these line items, the manager would also need the Net Income line item from the income statement, as well as Depreciation Expenses and Income Tax Expenses. If a company used cash for one-time investing activities (such as the purchase of new property, plant, or equipment) or financing activities (such as taking on a new loan obligation or issuing new stock), that information also would be needed to calculate net cash on hand at the end of period. For this simple example, we did not include these more complex transactions. Once the manager completes the worksheet, he or she will see that some accounts went up in value from year to year, while others went down. How these changes affect cash will vary depending on the type of account. When an asset account increases in value, it means there was an outflow of cash. For example, the Accounts Receivable account increased in value by $600. That means that there was an increase in the amount due from customers who have not yet paid their bills. Therefore, the cash not yet received from customers will reduce cash received from operating activities by $600. Sales were reported as revenue, but the cash was not collected. Accounts Receivable will be shown as a negative number on the statement of cash flows, as can be seen in Figure 4.3, to reflect the reduction in cash received in the current year. eps81356_04_c04_133-160.indd 139 3/26/14 12:58 PM Section 4.1 What Is a Statement of Cash Flows? Figure 4.4: Cash flow worksheet for Best General Company This worksheet shows the changes in the values of assets, liabilities, and equity from one year to the next. Best General Company Cash Flow Worksheet At December 31, 2013 and 2012 2013 Assets Cash and Cash Equivalents Accounts Receivable Inventories Other Current Assets Property, Plant, & Equipment Less: Accumulated Depreciation Other Non-Current Assets Liabilities Accounts Payable Short-Term Debt Other Current Liabilities Long-Term Debt Other Non-Current Liabilities $ 8,400 2012 $ 7,800 40,000 9,500 7,200 38,000 6,000 99,600 (9,600) 45,000 Change (2013-2012) $ (1,100) 600 2,000 6,000 99,600 (7,200) 45,000 0 0 2,400 0 $ 8,900 26,000 20,400 62,450 52,000 $ 9,400 26,000 19,800 65,000 54,000 $ (500) 0 600 (2,550) (2,000) $ 20,000 7,450 $ 20,000 3,900 $ 0 3,550 Shareholders' Equity Common Stock Retained Earnings Cash used to pay bills, as indicated in the Accounts Payable line under Liabilities in Figure 4.4, decreased in value by $500. That means cash was used to pay bills incurred in the previous accounting period. This, too, reflects an outflow of additional cash, and that number will appear as a negative number in the Operating Activities section of the statement of cash flows, as shown in Figure 4.3. How can a manager predict if a number will be a negative or positive number on the statement of cash flows? Table 4.1 can be a helpful guide for managers who need to make that determination. eps81356_04_c04_133-160.indd 140 3/26/14 12:58 PM Section 4.2 Operating Activities Table 4.1: Effect of inflows and outflows of cash by account type Inflow of cash Outflow of cash Decrease in an asset account Increase in an asset account Increase in a liability account Decrease in a liability account Increase in an equity account Decrease in an equity account An inflow of cash will show as a positive number on the statement of cash flows, which means the company received additional cash. An outflow of cash will show as a negative number on the statement of cash flows, which means the company received less or spent more cash. 4.2 Operating Activities The Operating Activities section of the statement of cash flows that uses the indirect method includes two parts. The adjustment part shows adjustments to cash on hand for expenses that do not require the use of cash, such as depreciation. The remainder of that section shows the changes needed to reflect cash on hand after the additions and subtractions for balance sheet account changes from one period to another. Figure 4.3 shows increase or decrease in Accounts Receivable, Inventories, Accounts Payable, and Accrued Liabilities. We will start with the adjustments based on the income statement. Adjustments The adjustments are changes to cash flow based on items on the income statement that do not require the use of cash, such as depreciation and amortization or deferred income taxes. Depreciation and Amortization The first line item in the adjustment section of the Operating Activities is usually Depreciation or Depreciation and Amortization (see Chapter 2 for a review of these concepts). Best General Company reported $2,400 in depreciation expenses. Depreciation expenses do not involve the use of cash; rather, they indicate the gradual reduction in the value of an asset to match expenses with revenue. The cash only changes hands when the asset is initially purchased. When an asset is bought using a loan, then cash also changes hands when the debt based on the asset is paid. Debt payoffs are shown in the financing activities section of the statement of cash flows. Because depreciation expenses do not require the cash, the number is added back in to show an increase in cash on hand. Managers then know that there is more cash available eps81356_04_c04_133-160.indd 141 3/26/14 12:58 PM Operating Activities Section 4.2 with this adjustment. Depreciation does lower the net income, as shown in a line item on the income statement. Deferred Income Taxes Another line item in the Operating Activities section of the statement of cash flows is Deferred Income Taxes. These are tax expenses that were incurred, but cash was not yet used to pay them. According to GAAP rules, a company must match expenses to the year incurred, even if cash is not paid out, so income tax expenses would be reported on the income statement even if cash was not yet paid to the government. Best General Company showed no deferred taxes on its financial statements. Accounts Receivable As we discussed above, the difference in the value for Accounts Receivable shown on the balance sheet between the current year and the previous year indicates whether customers have added to the amounts owed the company or decreased the amounts owed the company. If the number shows an increase, more customers owe money to the company and less cash was received from sales made with store credit. If the number shows a decrease, customers paid down accounts receivable from the prior year, plus paid additional cash for new credit sales. On the statement of cash flows in Figure 4.3, we see that Best General Company shows an increase of $600 in the value of its accounts receivable. This means the company has less cash on hand. The $600 must be subtracted from net income to discover how much cash is actually available to the company. Managers must be aware there is less cash available, and they may need to adjust spending or find a source of cash, such as a line of credit, when waiting for cash to be paid by customers. In order to improve cash on hand, managers may need to consider incentives for earlier cash payment from customers. They may also want to ask the accounting department for an aging schedule (discussed in Chapter 2) to find out which customers are behind on paying their invoices, and possibly cut off those customers from new purchases until their previous charges are paid. Inventories The Inventories line in the Operating Activities section on the statement of cash flows shows whether more or less cash was used to buy inventory. If the balance sheet indicates that a company's inventory decreased from the previous year, this means that some of the inventory was bought in the previous year. Thus, some of the sales involved inventories that were paid for in a previous year. This will result in an increase in cash on hand. eps81356_04_c04_133-160.indd 142 3/26/14 12:58 PM Operating Activities Section 4.2 If the opposite is true, and the balance sheet indicates that inventories increased, this means that more money was spent on inventory, which was not sold. In this case, cash on hand would be decreased because it was used to buy inventory that is still on the books. For example, Best General Company's inventory at the end of 2012 was $38,000, and it increased to $40,000 at the end of 2013. That means $2,000 of cash was used for additional inventory not sold, which reduces the cash on hand. The Cost of Goods Sold item on the income statement only includes the cost of inventory sold, so the cash on hand must be reduced to show the additional purchase of inventory. The cash spent for that additional inventory is shown by the difference between the current year and the previous year on the balance sheet. Best General's managers need to determine why more inventory was bought that could not be sold in 2013 than in 2012. They would need to determine whether this was caused by a downturn in the economy, a lack of customer interest in some of the inventory on hand, a reduction in the number of customers, or some other reason. Another possibility for why the cash spent on inventory increased is that the purchase price of the inventory went up. That, too, would need to be investigated by managers. They would need to determine whether a new vendor should be found to reduce costs, or whether the company needs to consider raising prices to maintain the profit margins. If managers determine that they must consider an increase in prices, the marketing and sales team would need to weigh in on what impact an increase in price may have on future sales. Accounts Payable The Accounts Payable line item reflects what is in the Accounts Payable account, which tracks invoices that have not yet been paid. This means that cash will need to be paid out in a future accounting period. An increase in the Accounts Payable number over the previous year indicates that there is more cash on hand. Bills will need to be paid during the next accounting period, but cash has been held back until they are due. The expenses that were incurred when these invoices were received by the company were shown as expenses on the income statement in order to match expenses with revenues earned in the same period. This means the income statement showed less profit, even though cash was not used to pay these expenses. For example, the Accounts Payable line item for Best General Company decreased by $500 from $9,400 in 2012 to $8,900 in 2013, as shown in Figure 4.4. This means that an additional $500 in cash was used in 2013 to pay invoices for expenses that were incurred in 2012. This reduced the cash on hand by $500, so this reduces the amount of cash on hand that was generated from 2013 net income. eps81356_04_c04_133-160.indd 143 3/26/14 12:58 PM Operating Activities Section 4.2 Managers might want to ask for detail about the invoices not yet paid. If the value of Accounts Payable increases from the previous year, it could be a sign the company is having difficulty making payments. Invoices not yet paid will impact cash available during the next accounting period, when those invoices must be paid. Other Assets or Other Liabilities Any items not shown on an individual line item on the balance sheet or income statement will be found in line items called Other Non-Current Assets or Other Non-Current Liabilities. Accrued Liabilities (as seen in Figure 4.1) and Income Taxes Payable are two of the line items that would normally fall under Other Liabilities. When calculating how much cash is on hand, cash flow changes follow the same guidelines as individual items, as shown in Table 4.1. A decrease in the Other Assets line item from the previous year to the current year will mean that additional cash flowed into the business and would be added to net income. An increase in Other Liabilities would also increase cash on hand, so that difference would be added to net income. In both cases, the cash on hand would be increased. Outflows of cash, which means the amount of cash on hand is reduced, would be seen when there is an increase in an Other Assets account or a decrease in an Other Liabilities account. In both cases, this would mean that the cash on hand would be decreased. Bottom Line: Net Cash Provided by Operating Activities The bottom line of the Operating Activities section shows how much cash the company generated or spent from its operating activities. When looking at the bottom line of the Operating Activities section for Best General Company (Figure 4.1), we find that the total of cash on hand from operating activities is $3,450. This means the company generated just $3,450 from its operations. Managers should take a closer look at the numbers to see what is draining the company's cash. If Accounts Receivable has gone up dramatically, it might mean that customers are slowing their payments. Another critical number to review is Inventories. If inventories are increasing, cash is being used to buy and store those inventories that are not selling. This could mean sales are slowing or there could be another cause. Managers must take a closer look at the transactions involving inventory to determine what is causing the problem. Wherever there are significant differences from year to year, managers should investigate the reasons by asking for detailed reports from their accounting liaison so they can review the transactions used to generate the line items on the financial statements. eps81356_04_c04_133-160.indd 144 3/26/14 12:58 PM Investing Activities Section 4.3 A competent manager would also want to investigate the line items that indicate reduced cash available to find out what can be done to improve the cash flow and limit or eliminate the drain on cash. The Operating Activities section of the statement of cash flows is useful to determine which numbers account for the drain. This can be a critical factor in the company's ability to continue operations and pay its vendors, suppliers, and employees. If operations do not generate enough cash, a company could be headed for disaster. If cash flows increases, then discovering why this happened and what can be done to continue improving the generation of cash from the activities involved is also an important step for the manager. Anything that can be done to expand activities that generate more revenue or more cash will help the company's net income and cash on hand. Task Box 4.1: Investigating Operating Activities Analyzing Industry Competitors, Part G Review the Operating Activities sections of the statements of cash flows for the two companies you chose to investigate in Chapter 2 (see Task Box 2.9). Answer the following questions: 1. 2. 3. What have been the primary line items that increased cash on hand? What have been the primary line items that decreased cash on hand? Which company do you think did a better job of generating cash from its operations? Why? 4.3 Investing Activities The Investing Activities section of the statement of cash flows looks at what cash has been used to make improvements to the company's operations or to grow the company. In some cases, this section will show cash provided by investing activities, such as the sale of long-term assets. Line items found in this section can include: Purchase or sale of property, plant, and equipment Mergers or acquisitions Major improvements to existing buildings Major upgrades to existing factories and equipment Purchase or sale of marketable securities Figure 4.5 shows the Investing Activities section of the Best General Company statement of cash flows. Since the company's revenues are falling, it would not likely have the resources to spend on new investing activities. For this reason there were no major purchases or improvements in the current year. eps81356_04_c04_133-160.indd 145 3/26/14 12:58 PM Section 4.3 Investing Activities Figure 4.5: \u0007 nvesting activities section of the Best General Company I statement of cash flows This section shows the cash activities from the investing section of the company. Best General Company Statement of Cash Flows (Partial) For the Year Ended December 31, 2013 Cash Flows from Investing Activities: Additions to Property, Plant, and Equipment Sales of Property, Plant, and Equipment Additions or sales of Other Non-Current Assets Net cash provided by (used in) investing activities $ $ 0 0 0 0 Property, Plant, and Equipment Property, Plant, and Equipment is often the first line item in the Investing Activities section of the statement of cash flows. Best General Company shows no changes to its Property, Plant, and Equipment. Changes in this section would show the use of cash to buy new property, plant, or equipment. If the company sells property, plant, or equipment it already owns, the cash generated by the sale of these assets would be shown in this section of the statement of cash flows as a positive figure. For example, if Best General Company decides to invest money in a new store, the cash used for that investment would be shown in this section of the statement as a negative figure. Managers likely would already be aware of major sales or purchases of property, plant, and equipment prior to the preparation of this statement, but they may not know the full cash impact until they see it listed here. Investment in Assets Often, the next line that could be found in the Investing Activities section is Investment in Assets, which is different from the Property, Plant, and Equipment account in that it shows the detail of other investment activities to grow the company. For example, the company may invest cash for research and development of a new product line. This can be critical information that reveals what types of investments a company is making to grow its business or expand into new business areas. Explanations for these expenditures would be found in the management's discussion and analysis, or in the notes to eps81356_04_c04_133-160.indd 146 3/26/14 12:58 PM Investing Activities Section 4.3 the financial statements. The company's investor relations office can also provide more details about a line item on the company's financial statement. Best General Company does not show any investment in assets. Marketable Securities Like individual investors, companies do not want to sit on significant amounts of cash that are not earning a return, so they sometimes buy and sell marketable securities throughout the year. Generally, these transactions involve placing cash in a financial instrument that will provide a better return than a low-interest savings account. Best General Company does not indicate investments in marketable securities, but many companies will show cash being held in marketable securities. Usually the financial management team will manage these investment activities and be certain that cash is available for operating activities when needed. Acquisitions and Dispositions Some companies decide to grow their business by acquiring another company already operating in the industry in which they want to expand. Other companies may decide they no longer want to continue operations in a particular part of their business and decide to sell that part to another company. Occasionally, a company may sell off a major segment of its operations to streamline the company. This could result in more cash taken in than laid out. Acquisitions are purchases of another company. Dispositions are sales of a portion of the assets of a company, such as the sale of a division or a factory. When a company acquires another company, it usually uses cash as part of that purchase agreement. The value of other assets may also be impacted by an acquisition or disposition. For example, details about changes to other assetssuch as inventory; marketable securities; property, plant, and equipment; intangible assets; and goodwillare located in the notes to the financial statements. The notes also contain details regarding liabilities acquired, such as accounts payable, other debt, and deferred taxes. Reading the details about acquisitions and divestitures can provide insight into changes the company is making that might affect future operations. Considering what the company is selling and what the company is buying can be particularly informative. Reading through management's discussion and analysis of these entities can provide additional clues as to how the acquisitions will fit into the company's long-term plans. The primary reason to review this section of the statement of cash flows is to see how the company is managing its cash to buy, sell, or upgrade its assets. If the company shows significant cash expenditure in this section, it indicates plans have been carried out to expand operations or to make improvements to company operations. eps81356_04_c04_133-160.indd 147 3/26/14 12:58 PM Investing Activities Section 4.3 An important question managers should seek to answer when reviewing this section is whether the company is using most of its cash for investments to keep existing factories operating or whether it is using the cash to upgrade its assets in order to keep up with technology. Best General Company does not indicate any acquisitions or dispositions. Task Box 4.2: Investing Activities Analyzing Industry Competitors, Part H Review the Investing Activities sections for the two companies you have chosen to analyze. Answer these questions: 1. 2. 3. 4. Which company is using more cash to upgrade its facilities? What types of upgrades is each company doing? Is either company using cash to merge or acquire other companies? How are they using their cash for this purpose? Is either company buying or selling marketable securities? Is this a significant portion of their use of cash? Explain. Is either company acquiring new businesses? Is either company selling portions of its business? How do you think these changes will affect the company's operations and its profitability in the future? Do you think these changes are good or bad for the company? The Bottom Line: Investing Activities The bottom line of the Investing Activities section of the statement of cash flows shows the total amount of cash used for investing activities, and it will read \"net cash used in investing activities.\" Some companies may have taken in more cash than they used. In that case, the bottom line would be \"net cash provided by investing activities.\" However, if a manager sees a positive number in this section, it warrants a closer look. A company that sells off assets because it's having difficulty paying its bills is not enjoying strong performance. One sure sign that the company is having financial difficulty would be a negative cash outflow from operations and a positive cash inflow from investing activities. This would likely mean the company is not getting enough cash from its operations and is selling off assets to continue to exist. Once the company is out of assets to sell, it will likely go bankrupt. eps81356_04_c04_133-160.indd 148 3/26/14 12:58 PM Section 4.4 Financing Activities 4.4 Financing Activities When a company needs a major influx of cash to expand operations or fund its current operations and it can't secure enough from operating activities, it will seek to raise money from outside sources. This might involve issuing stock to raise money from new investors or taking out a loan. Companies can also sell bonds, which are another form of debt, to raise cash. Any cash raised or invested related to these types of funding activities can be found in the Financing Activities section of the statement of cash flows. Figure 4.6 shows Best General Company's Financing Activities section of the statement of cash flows. This section would show the proceeds from any new debt issued. It would also show short-term borrowings followed by repurchases of stock that has already been sold on the market, if the company made any of those transactions. Best General did not issue debt or repurchase stock, and reduced long-term debt and other non-current liabilities. No dividends were paid to shareholders. Let's take a closer look at each of these types of transactions. Figure 4.6: \u0007 inancing activities section of the statement of cash flows for F Best General Company This section of the statement of cash flows shows the inflow and outflow of cash from the company's financing activities. Best General Company Statement of Cash Flows (Partial) For the Year Ended December 31, 2013 Cash Flows from Financing Activities: Issuance of Common Stock Increase (decrease) in short-term borrowings Additions to long-term borrowings Reductions in Long-Term Debt Reductions in Other Non-Current Liabilities Dividends paid Net cash provided by (used in) financing activities $ $ 0 0 0 (2,550) (2,000) 0 (4,550) Common Stock Transactions Common stock transactions can include cash raised from the issuance of new stock or cash used to buy back stock from investors. Best General Company showed no changes in cash from the sale or purchase of stock. eps81356_04_c04_133-160.indd 149 3/26/14 12:58 PM Financing Activities Section 4.4 Managers would want to be aware of major new cash raised from new investors or a cash outflow to buy back common stock held by investors. Both types of transactions will impact the cash available for ongoing operations. If the managers have significant holdings of common stock, such as through an employee compensation program, the value of their holdings will be impacted by common stock transactions. A new stock issue would increase the number of shares among which the profits must be split, which could lower the value of the stock held by managers. A buyback of stock being held by investors would decrease the number of shares among which profits must be split, which could raise the value of the stock held by managers. Short-Term Borrowings Companies also raise cash throughout the year using lines of credit and other types of short-term borrowings or loans. These types of short-term loans are for 90 days or less. Since cash is raised and cash is used throughout the year, the number found on the statement of cash flows is the net of these borrowings. Best General Company shows no change in the amount of its short-term loans. Long-Term Debt When companies need cash for periods of more than 12 months, such as a mortgage for the purchase of new property or a loan for the purchase of new equipment, cash raised from this new debt can be seen on this line item. Sometimes cash is raised by the issuance of new bonds, which will also be shown in the long-term debt section of the statement of cash flows. Details about this new debt can often be found in the notes to the financial statement. Cash Dividends Paid Some companies pay out a portion of their profits in cash to their shareholders. This payout of cash is called dividends. Best General Company did not pay out any cash dividends in the operating period reported. See \"New World of Financial Report Oversight\" in this chapter for differences between U.S. and international companies' reporting of cash dividends paid. eps81356_04_c04_133-160.indd 150 3/26/14 12:58 PM Financing Activities Section 4.4 New World of Financial Report Oversight Cash dividends can appear in different sections of the statement of cash flows, depending on whether a company is based in the United States or abroad. The U.S. GAAP require dividends paid out to shareholders be shown in the Financing Activities section of the statement of cash flows. Dividends received from the company's investments (such as stock owned in another company) are shown in the operating activities section of the statement of cash flows. The International Financial Reporting Standards (IFRS) rules allow companies to show dividends in either the operating activities section or the financing activities section, as long as the way they are shown is consistent as either operating or financial activities. There is no time frame for when the U.S. rules will converge with the international rules, but when reading financial statements from non-U.S. companies, look carefully for information about dividends in both the operating activities and financial activities sections of the statement of cash flows. If the company paid out dividends, this can be a significant difference to consider when comparing cash flows. Consider This: 1. 2. Review a statement of cash flow for a non-U.S. company and one for a U.S. company. Do you see any differences in how the statement is shown internationally? The Bottom Line: Financing Activities The bottom line of the Financing Activities section of the statement of cash flows is shown as \"net cash used in financing activities\" if more cash was used than taken in or as \"net cash provided by financing activities\" if more cash was taken in than used. Often, an older, well-established company will use the cash raised to reduce debt or buy back stock on the market. A younger company may show that it raised more cash from issuing new stock or taking a new debt. Managers should review this section to determine how much cash was raised by borrowing additional funds and how much was raised by taking on new debt. If the company is substantially increasing its debt, this could be explained by the purchase of new assets to grow the company or it could be a sign that the company is having problems raising enough cash for operations. By reviewing this section in conjunction with the Operating Activities section and the Investing Activities section, a manager should be able to determine how the company's cash is being raised and how it is being invested. (See \"World of Business\" for cases that show why all three sections are important to analyze when considering the financial health of a company.) eps81356_04_c04_133-160.indd 151 3/26/14 12:58 PM Section 4.4 Financing Activities Task Box 4.3: Financing Activities Analyzing Industry Competitors, Part I Compare the Financing Activities sections of the statements of cash flows for the two companies you have chosen. Answer the following questions: 1. 2. 3. 4. Are your companies using cash or raising cash from their financing activities? If a company is raising cash, what information can you find in the management's discussion and analysis about the plans for this cash? Are the companies buying back stock or issuing stock? How do they plan to use this cash? Are the companies taking on more debt or paying down debt? If they are taking on more debt, how does the company plan to use this cash? World of Business Cash and Bankruptcy: WorldCom and Lehman Brothers The statement of cash flows used to be the key statement for judging financial performance. That changed in 2002 when it was discovered that American telecommunications giant WorldCom had hid expenses and inflated its cash flow by $3.8 billion. To make it look like it was taking in more cash from operations, the company moved day-to-day expenses into the category of capitalized expenses. By doing this, WorldCom showed the use of that cash in the Investing Activities section of its statement of cash flows, rather than in the Operating Activities section. WorldCom also \"capitalized\" these expenses by writing them off over several years. Ultimately, in 2002, this manipulation resulted in the largest corporate bankruptcy in the history of the United States up to that time. Suzanne Plunkett/Associated Press WorldCom filed for the largest bankruptcy in U.S. history after senior executives falsely reported inflated cash flows. eps81356_04_c04_133-160.indd 152 However, this record was beaten in 2008 by both banking giant Washington Mutual, which lost billions because of its mortgage financing activities, and financial services firm Lehman Brothers. Interestingly, Lehman Brothers did not hide its cash flow problem. Instead, it showed net income increasing each year, even though cash from operations kept decreasing. For example, in 2007, net income was $4.19 billion, while cash from operations was a negative $45.6 billion. The company survived during that (continued) 3/26/14 12:58 PM Section 4.4 Financing Activities World of Business (continued) period by borrowing more each year to cover its cash needs. The Financing Activities section of the cash flow statement included this information. (Thapa, 2007) The lesson: Managers should not review solely the results from the Operating Activities section to determine a company's cash flow. Rather, they should always be sure to look at all three sections of a company's statement of cash flows for changes in cash. Consider This: 1. 2. What would you do if you discovered that the company at which you are employed was not accurately reporting cash flow? Should banks that manage people's money face more scrutiny in their cash flow reporting? The Bottom Line for Cash Flows A summary of cash inflows and outflows is shown in the bottom section of the statement of cash flows. Figure 4.7 shows this summary for Best General Company. Figure 4.7: Bottom lines of the statement of cash flows for Best General Company The bottom lines of a statement of cash flows reveal whether there is an increase or decrease in cash, followed by additional detail regarding cash paid for interest or taxes. Best General Company Statement of Cash Flows (Partial) For the Year Ended December 31, 2013 $ (1,100 ) 9,500 $ 8,400 Net increase (decrease) in Cash and cash equivalents Cash and cash equivalents, beginning balance at December 31, 2012 Cash and cash equivalents, ending balance at December 31, 2013 Supplemental cash flows information: Cash paid for interest Cash paid for taxes $ 800 150 Often managers will focus on this bottom line and not carefully review the changes to cash in each of the three sections: operations, investing, and financing. Managers must pay attention to key changes in each of the three sections and not just look for the bottom line in order to make decisions about the company's cash flows for future operations. As discussed in each section above, different accounts impact the inflow and outflow of cash. eps81356_04_c04_133-160.indd 153 3/26/14 12:58 PM Section 4.5 Analyzing a Statement of Cash Flows Managers need to review the details of those accounts to further analyze any cash flow opportunities or problems. 4.5 Analyzing a Statement of Cash Flows We discussed many ways to analyze the information on the statement of cash flows within each section of the statement. Now we will take a look at a way to summarize the net cash inflows and outflows and determine how a company is raising and using most of its cash. This is similar to the common-sized balance sheet and income statement we discussed in previous chapters. We will collect all line items that generated cash in one section of this analysis and collect all items that used cash in the second section. Then we will determine the percentage of cash raised and used by each type of activity. Figure 4.8 shows the results for Best General Company using the template described above. Figure 4.8: \u0007 ercentage of cash inflows and outflows for 2013 for P Best General Company The chart summarizes the key changes in cash inflows and outflows for Best General Company for the year ended 2013. Best General Company Percentage of Cash Inflows and Outflows For the Year Ended December 31, 2013 Inflows of Cash: Net Cash from Operating Activities Accrued Liabilities Total Cash Inflows Outflows of Cash: Accounts Receivable Inventories Accounts Payable Reductions in Long-Term Debt Reductions in Other Non-Current Liabilities Total Cash Outflows eps81356_04_c04_133-160.indd 154 Amount $ 3,450 600 $ 4,050 Amount $ $ 600 2,000 500 2,550 2,000 7,650 % of Cash Inflows 85.2% 14.8% 100.0% % of Cash Outflows 7.8% 26.2% 6.5% 33.3% 26.2% 100.0% 3/26/14 12:58 PM Analyzing a Statement of Cash Flows Section 4.5 To determine the percentage of cash inflows, we divide the cash inflows for each line item by the total cash inflows. To determine the percentage of cash outflows, we divide the cash used for each line item by the total cash outflows. For example, to determine the percentage of cash outflows for Accounts Payable at Best General Company, look at Figure 4.8, where the company shows a $500 outflow of cash for Accounts Payable. The total for net cash outflows was $7,650. To find the percentage, divide $500 by $7,650. The percentage of cash outflows for the Accounts Payable account is 6.5%. The purpose of this analysis is to determine the primary sources of cash inflow and outflow by type of account. In most cases, the line item for net cash from operating activities will be zero in the outflows section, but occasionally, if the net cash from operating activities is a negative number, that means operating activities contributed to the outflow of cash. If that occurs, the inflows section will show zero cash from operations. Best General Company showed an increase of $3,450 for net cash from operating activities, so we include that in the Inflows of Cash section. A manager looking at this analysis would see that cash was used for building up inventories and paying down debt. No cash was used to increase revenues, even though not enough cash was generated from sales to cover the company's operating expenses. Best General Company's budget committee would need to address this major problem as part of budget planning for the next year. What activities should the committee recommend to improve cash generated from revenues? (The downloadable template we have developed can make it easier to answer this question.) In addition to showing cash inflows and outflows, some transactions do not include cash. The World of Business gives examples of non-cash transactions. Task Box 4.4: Analyze Cash Flow Trends Analyzing Industry Competitors, Part J Use the downloadable template to analyze the cash flows of the two companies you have chosen. Compare the use of cash and the cash flow trends and answer these questions: 1. 2. 3. eps81356_04_c04_133-160.indd 155 Do both companies have a positive or negative cash flow from operations? If not, why do you think that is so? What are the primary uses of cash for each of your companies? What trends do you see in the use of cash? 3/26/14 12:58 PM Summary and Resources World of Business Reporting Non-Cash Transactions Sometimes at the bottom of a statement of cash flows, managers will see a section called noncash transactions. The types of information that could be shown here include: Net change in the fair value of investments. For example, if inventory dropped in value, this loss in value would be shown here. If the company made a significant donation of assets, the value of that donation would be shown here. Fuse/Thinkstock If the company borrowed money using If the value of a company's inventory a capital lease purchase arrangement, decreases, the company can show the loss that transaction's value would be in the non-cash transactions section of the shown here. statement of cash flows. If the company exchanged non-cash assets or liabilities for other non-cash assets or liabilities, details about the exchange would be shown here. For example, the acquisition of a company often includes non-cash assets or liabilities. Summary and Resources Chapter Summary The purpose of the statement of cash flows is to determine how cash flowed into and out of the company during a certain period of time. The statement can be in either direct or indirect format; the indirect format is more commonly used because it reveals less financial information to financial report readers outside the company. The direct method requires companies to reveal additional information about how cash is used, such as amounts for cash received from customers or cash paid out to vendors. The statement has three sections: operating activities, investing activities, and financing activities. The Operating Activities section: This section summarizes the inflows and outflows of cash from operating activities of the company, such as cash received from customers based on changes to the value of the accounts receivable account or cash paid out to vendors based on changes in value to the accounts payable account. The Investing Activities section: This section summarizes the outflows of cash used for investments to grow the business or the inflows of cash received from selling major assets. The Financing Activities section: This section summarizes financing activities, such as cash inflows from taking on new debt or issuing new stock. It also summarizes outflows for the paydown of outstanding debt or the buyback of stock from investors. eps81356_04_c04_133-160.indd 156 3/26/14 12:58 PM Summary and Resources The bottom line of this statement indicates whether cash on hand increased or decreased from the company's operating, investing, and financing activities during the accounting period being reported. We demonstrated how to do a quick analysis of the statement of cash flows. Reading the notes to the financial statements and the management's discussion and analysis can provide additional information about the company's cash inflows and outflows. Takeaways for Chapter 4 Be sure to review all three sections of the statement of cash flows to determine how cash flows into and out of the business. Don't just look at the bottom line or focus solely on operating activities. If operating activities result in a net cash outflow, there is cause for concern because it means the company's operations are not generating enough cash to operate the business. Managers should be aware of how cash is being used to grow the business or if cash was raised by selling off parts of the business. Managers must be aware if the company is taking on major new debt or selling additional shares of the company to investors. Both actions will impact the value of the company's shares. This can be especially important for managers whose compensation is partially based on stock incentives. Post-Test 1. In which section of the statement of cash flows would you find dividends? a. Investing Activities b. Financing Activities c. Operating Activities d. all of the above 2. Depreciation is: a. an adjustment added to net income in the Operating Activities section b. an adjustment subtracted from net income in the Operating Activities section c. an adjustment added to cash inflows in the Investing Activities section d. an adjustment added to cash outflows in the Investing Activities section 3. Which of these line items on the balance sheet could be included as an increase or decrease in cash from operating activities? a. Accounts Receivable b.\tInventory c. Accounts Payable d. all of the above 4. Which of these line items that could be found on the income statement might be included as an adjustment on the statement of cash flows? a.\tDepreciation b.\tAmortization c. Deferred Taxes d. all of the above eps81356_04_c04_133-160.indd 157 3/26/14 12:58 PM Summary and Resources 5. Where is the Property, Plant, and Equipment line item on the statement of cash flows? a. in the Investing Activities section b. in the Financing Activities section c. in the Operating Activities section d. it would not be found on the statement 6. How would the sale of a factory be shown on the statement of cash flows? a. add to cash inflow in the Operating Activities section b. add to cash inflow in the Investing Activities section c. add to cash outflow in the Investing Activities section d. add to cash inflow in the Financing Activities section 7. What is the net cash flow from Operating Activities given this information: net income, $10,000; depreciation expense, $1,500; increase in accounts receivable, $3,000; decrease in inventory, $1,500; increase in accounts payable, $2,500? a.\t$14,000 b.\t$18,000 c.\t$12,500 d.\t$16,000 8. What is the net cash flow from Investing Activities given this information: increase in property, plant, and equipment, $15,000? a. $\t15,000 b. ($\t15,000) c. $\t3,000 d.\t($ 3,000) 9. What is the net cash flow from Financing Activities given this information: decrease in short-term notes payable, $10,000; increase in long-term bonds payable, $15,000? a. $\t15,000 b. ($\t15,000) c. $\t5,000 d.\t($ 5,000) 10. What is the change in cash using the results of operating activities in question 7, investing activities in question 8, and financing activities in question 9? a. $\t10,000 b. ($\t10,000) c. $\t2,500 d.\t($ 2,500) Answers: 1 (b), 2 (a), 3 (d), 4 (d), 5 (a), 6 (b), 7 (c), 8 (b), 9 (c), 10 (c) Answers and Rejoinders to Chapter Pre-Test 1. d.\t\u0007 While the answers to (a), (b), and (c) will be found on the statement of cash flows, the primary purpose of this statement is to show how much total cash flowed into and out of the business. 2. d.\t\u0007 three activities (Investing, Financing, and Operating) are sections of the All statement of cash flows. eps81356_04_c04_133-160.indd 158 3/26/14 12:58 PM Summary and Resources 3. c.\t\u0007 Depreciation is in the Operating Activities section of the statement of cash flows. 4. a.\t\u0007 Purchases or sales of property, plant, or equipment would be found in the Investing Activities section of the statement of cash flows. 5. b.\t\u0007 Dividends would be found in the Financing Activities section of the statement of cash flows. Rejoinders to Chapter Post-Test 1. Dividends are shown as part of the financing activities. 2. Depreciation is an adjustment in the Operating Activities section of the statement of cash flows that is added to net income. 3. All of the line items could be shown as an increase or decrease in cash in the Operating Activities section of the statement of cash flows. 4. All of the line items could be shown as an adjustment to cash in the Operating Activities section of the statement of cash flows. 5. Property, Plant, and Equipment would be found in the Investing Activities section of the statement of cash flows. 6. The cash proceeds from the sale of a factory would be a cash inflow in the Investing Activities section of the statement of cash flows. 7. Start with net income of $10,000. Add back in $1,500 for depreciation expense. Subtract $3,000 because of the increase in accounts receivable. Add $1,500 because the decrease in inventory means that some inventory was sold from the previous year. Add $2,500 because the increase in accounts payable means some cash was held back to pay bills in the next year. After these calculations, you will find that net cash inflow is $12,500. 8. The increase in property, plant, and equipment would indicate that the company used cash to purchase new property, plant, or equipment. This means the net cash from investing activities would be reduced by $15,000. 9. The decrease in Short-Term Notes Payable means $10,000 cash was used to reduce these liabilities. The increase in Long-Term Bonds means cash was increased $15,000 by taking on more long-term debt. So the net increase from financing activities would be $5,000 ($15,000 - $10,000). 10. The answer would be $2,500 increase in cash and cash equivalents, as shown below: Net cash from Operating Activities $12,500 Net cash from Investing Activities (15,000) Net cash from Financing Activities 5,000 Change in cash: $2,500 Discussion Questions 1. Why is it important to analyze the statement of cash flows? 2. What problems would you look for if the net cash flows from operating activities were negative? 3. What questions would you seek to answer if the company's net cash from financing exceeded the net cash from operations? 4. What questions would you seek to answer if the net change in cash reduced cash holdings? 5. What can you learn from the use of cash in the Investing Activities section? eps81356_04_c04_133-160.indd 159 3/26/14 12:58 PM Summary and Resources Further Reading/Resources Broome, O. W. (2004, March/April). Statement of cash flows: Time for change! Financial Analysts Journal, 60(2), pp. 16-22. Busch, G. (2010, July 13). Cash flows matter: A look back at Lehman Brothers & investment banks. Value Investing Center. Retrieved from http:/ /valueinvestingcenter.com/ 2010/07/13/cash-flows-matter-a-look-back-at-lehman-brothers-investment-banks Robero, S., & Berenson, A. (2002, June 26). WorldCom says it hid expenses, inflating cash flow $3.8 billion. New York Times. Retrieved from http:/ /www.nytimes.com/2002/06/26/ business/worldcom-says-it-hid-expenses-inflating-cash-flow-3.8-billion.html Siegel, M. A. (2006, March). Accounting shenanigans on the cash flow statement. The CPA Journal, 76(3), pp. 38-43. Key Terms dispositions Sales of a portion of the assets of a company, such as the sale of a division or a factory. financing activities Cash that flowed into or out of the business from transactions involving debt or stock. eps81356_04_c04_133-160.indd 160 investing activities Cash that flowed into or out of the business from transactions involving the purchase or sale of longterm assets. operating activities Cash that flowed into or out of the business from transactions involving the day-to-day operations of the business. 3/26/14 12:58 PM