NON CASH ACTIVITIES

What business activities are considered non-cash activities? In order to prepare a cash flow statement, we need to understand which items on our income statement and balance sheet may not involve the transfer of cash, thus will not have a place on our statement of cash flows.

These non-cash activities may include depreciation and amortization, as well as obsolescence. Property, plant and equipment resides on the balance sheet. These items are taken on the income statement in small increments called depreciation or amortization.

If we purchase a new dump truck, we don't take the entire purchase price as an expense when we purchase it. We put it as an asset on our balance sheet, and then take depreciation expense over the life of the dump truck.

These non-cash items need to be properly recorded on the income statement but disregarded for the cash flow statement.

Cash and cash equivalents are those items on the balance sheet that are liquid assets. Cash can be spent, so it is the most liquid of the assets.

Cash equivalents might include money market accounts, treasury bills or commercial paper. It is essentially a place to sit money, to make a return on it. Cash sitting in a checking account may get no interest, but a money market account will earn interest while it sits. In this way, a company can put its idle cash to work.

These cash equivalents are pretty easy to move to a checking account if the cash becomes needed, but getting interest rather than just letting it sit there is a smart step!

Operating Activities

You have been asked to figure out cash flow for your company. Luckily, your supervisor has only asked you to do the operating activities section! But what items are included here? As you look through the income statement and balance sheet, what stuff do you need to be looking for? Also, what the heck is coming in (inflows) and going out (outflows)? Let's watch a video and then tackle the operating activities portion of our cash flow statement.

There are several sections that comprise the cash flow statement. The first portion of the cash flow statement includes what are called operating activities. These are cash transactions that happen in the normal course of business, affecting the revenue and expense accounts on your income statement. Operating activities can include the following items:

Collecting cash is the only cash inflow here! The other items all involve cash leaving your business, also called outflows. So from now on, money coming in will be called an inflow and money going out will be called an outflow.

This portion of the cash flow statement can help you to better understand the need to have an effective accounts receivable system! If you sell product, but can't collect the cash in a timely fashion, it may become difficult to meet your bill payment deadlines. If you don't pay your bills on time, vendors, your employees and the government (especially the government) might not be happy with you.

In our budgeting module, we put together a cash budget. A cash budget is an important component of the financial health of all companies. Having enough cash coming in from customers and clients to cover the cash going out to meet payment responsibilities is crucial to successfully running or managing a business.

Investing Activities

The second section of the cash flow statement involves investing activities. We will again be chatting about inflows and outflows as it relates to investments.

Watch this video to get an explanation of the investing activities part of the cash flow statement:

What happens when we buy an asset? Let's say we buy a truck for our business. As we discussed earlier, we put the purchase price of the truck as an asset on our balance sheet, then we take small amounts as an expense each month as depreciation to spread the expense out over time. If we purchased the truck for $25,000, from a cash perspective, we had a $25,000 outflow, right? So even though the truck goes to the balance sheet, we need to note the entire purchase price (if we paid cash) on our cash flow statement.

Now we sold a truck for cash! We will remove the truck from the balance sheet, and stop the depreciation, but whatever we received in cash for the truck will show up on our investing section on our cash flow statement. This will be an inflow.

We might also buy stock (cash outflow) or sell stock (cash inflow). Maybe we lend money to another company (cash outflow) or collect money on a loan we previously gave (cash inflow).

So if you invest in property, plant, equipment, stocks, bonds or another company, these are all investment activities on your cash flow statement. Here is a little chart to help make this a little easier:

Financing Activities

So the third part of the cash flow statement involves financing activities. If a company borrows money, this is a financing activity. There are some inflows from financing activities including borrowing money or selling common stock. Outflows from financing activities include paying the principal part of debt (a loan payment), buying back your own stock or paying a dividend to investors.

Ready to jump in? Let's start with this video explanation:

If a company borrows money, the entire amount of the cash comes in at one time, right? So that entire amount will be reflected on your cash flow statement.

Let's look at inflows and outflows from financing activities:

Can you think of any other activities that may be considered financing activities? If you look at your personal expenditures, a car loan or mortgage might be a financing activity!

Practice Question 8.1

We just purchased a new computer for the office, and paid cash. This purchase will affect:

The operating section of our cash flow statement.

Just the investing section of our cash flow statement.

Both the financing and investing section of our cash flow statement.

Direct Method versus Indirect Method

There are two ways we can build a cash flow statement. Both ways end up at the same answer, but in a different way.

The direct method, the income statement is reformulated on a cash basis, rather than an accrual basis from the top of the statement (the income part) to the bottom (the expense part).

The indirect method works from net income, so the bottom of the income statement, and adjusts it to the cash basis. We will look at both methods with the same data, so you can see the differences in analysis, but the same ending number.

The Indirect Method

Let's look at the indirect method first. The indirect method starts with your net income and adds or subtracts the items based on changes in their balances.

Remember the operating activities that affect cash flow:

There are related accounts on the balance sheet, so that when changes happen, we need to know how they affect the statement of cash flows:

This can be a confusing concept, so let's look at some examples.

1/1/20XX Accounts Receivable Balance $5000

1/31/20XX Accounts Receivable Balance $4000

The account balance decreased, so we need to add $1000 to our cash for the month because we received that much more in cash from our customers.

Let's look at another example:

1/1/20XX Accounts Payable Balance $8000

1/31/20XX Accounts Payable Balance $5000

The account balance decreased so we need to subtract $3000 from our cash for the month because we paid down our accounts payable balance.

If you are working on a cash flow statement, you can keep the little chart with you. Complete the practice question to check your understanding.

The Direct Method

Sales are great at your company, but cash flow is a mess! You are working on your cash flow statement trying to figure out what is going on. When you look at your income statement, you see sales of $20,000, which is an increase of 50 percent over last month! This is amazing. Why then, are you needing to take money out of your working capital line of credit to cover payroll? These are the questions a good cash flow statement can answer.

When working from the income statement and taking it back to cash basis from the accrual basis, some of the answers to these questions become very clear. Once you take a look you notice that payroll expense was higher to meet the higher sales demand. But since you offer net30 day terms to your customers, you are waiting on payment from them. The hope is this is a short term blip while your cash received from customers comes in to cover your line of credit payment. So what looks good on an income statement, could create temporary or long term cash flow issues!

Let's dig in a little further and discuss the direct method of preparing your cash flow statement. Step back over and watch this video for an overview of the difference between the direct method and indirect method of preparing the operating section of the statement of cash flows:

So the direct method, starts with the income statement and rebuilds it on the cash basis. Most companies operate on the accrual basis, where income is recognized when it is earned and expenses are recognized when they occur, so in order to see how much cash we spent or earned, we need to adjust those amounts to the actual cash we spent or received.

This is the method that will typically be used.

In this method, we wouldn't be concerned with changes in the accounts receivable balance. We would simply look at how much cash was paid by customers for the month. So, in our conversation about the indirect method, you noticed that the accounts receivable balance went down. If we look at this from a direct method:

Cash received by customers: $10,000

Cash spent on bills/expenditures: $5,000

Cash paid for payroll: $3,000

Net increase in cash for period: $10,000 $5,000 $3,000 = $2,000

So it wouldn't matter if sales for the month was $20,000, purchases were $2,000 and payroll was $3,000 for the month right? What might that show? Well, if sales was $20,000 but we only received $10,000 in cash we either have difficulties collecting our accounts receivable, or we have net 30 and the sales last month was much lower than this month, right?

Cash flow can be a huge challenge, especially for small businesses. So, if we struggle with collection on our receivables, or if we have a low sales month, or an unexpected expense. This is where the cash flow statement can be very important to the health of a company.

Practice Question 8.2

In a review of your income statement you are amazed to see a 25% increase over last month's sales! Your CEO though, is concerned about the lack of cash in your checking account. How would you explain this situation using the direct method?

We had lots of expenses this month with the higher sales, so we had to borrow money. I will have accounts payable hold some payments until we receive more cash.

Even though our sales was up by 25%, since the customers are delinquent on their payments we are going to have cash flow problems. It is the accounts receivable department not doing their job.

Even though our sales was up by 25%, that is on the accrual basis. Since those customers have net 30 terms, so we only collected based on the previous month's sales. By next month, our cash flow should be back on track.

Preparing a Statement of Cash Flow

Now we are ready to put it all together! There will be three sections to our statement of cash flow:

Operating section

Investing section

Financing section

We have the two ways we can do this, using either the direct or indirect method. Watch this video for a quick review of the entire cash flow statement process:

Net and Gross Cash Flows

Gross cash flows don't exist in the operating portion of the cash flow statement. GAAP (generally accepted accounting principles) and IFRS (international financial reporting standards) for foreign companies, require us to disclose the gross cash flows for the investing and financing sections of the cash flow statement.

Gross cash flows essentially include the purchase price in cash of a new piece of property or equipment, and the cash gain of the sale of a piece of property or equipment.

So if a company purchased $25,000 of new equipment and sold $10,000 of equipment, the net cash flow would be $15,000. But in the investing and financing sections, we need to keep those separate. It is still important to note the difference in balance netted, then backing it out to the gross calculation!

Here is an outline of how noncash balance sheet accounts affect the investing and financing sections of your cash flow statement:

*Retained earnings will need more analysis

So you will notice, this chart looks at the overall change in the balance, but to calculate the gross cash flow by looking at the detail in all of the each of the accounts to fill out the cash flow analysis to meet the requirements of GAAP and IFRS reporting requirements.

Preparing a Statement of Cash Flow

Ok, so let's put together all of the great stuff we have learned about cash flow! A reminder the indirect method is working from the bottom of the income statement and adjusting it to the cash basis. So we would take the net income, and work from there.

So here is our income statement on the accrual basis:

Our net income is $10,250, so we will start there and work up to our cash flow statement

The first step is to add back our depreciation, because that is a non-cash expense!

This balance will move to the cash flow statement!

The second step is to analyze the net changes in the balance sheet accounts that we discussed earlier. Accounts receivable, accounts payable and the other current assets and liabilities will also affect the cash flow of the company.

So let's assume the following changes:

This information will come in handy in the next step!

So how do these items affect cash? Going back to our chart from our discussion about indirect cash flow analysis we know that:

So, here is the final deal!

Cash Flow Statement: Operating Activities-Indirect Method

So the income statement and balance sheet only show part of the picture. A company can have awesome sales, but if they struggle to collect on their accounts receivable, they may have issues with their cash flow! It is important as a manager to look at the big picture, in order to find ways to increase profits and create a positive cash flow!

Cash Flow Analysis

So, why is all of this information so important? What would happen if your company has sales of $100,000 a month, but they only collect $50,000 a month in cash, and their accounts receivable has a high balance in the 90+ days outstanding column?

What if in addition to the issues with your accounts receivable, the balance sitting in accounts payable is really high, and the company is very far behind in payments. The cash account is perpetually at zero or less, and there have been problems with payroll checks bouncing.

The boss calls you in to discuss how to improve cash flow. You look over the income statement. Sales are great, and the expenses are low. Payroll is in line with where it has always been, so if you just looked at the accrual based income statement you wouldn't have any concerns.

Ah, but then you wander over to the balance sheet. Cash in the negative, $200,000 in receivables, and $200,000 in payables. What is going on?

Let's go back to the first sentence of this learning outcome. Only $50,000 a month is being collected on $100,000 in sales. The ball is being dropped here, right? But do we blame the folks in collections, or might the problem be earlier in the ordering cycle?

Perhaps going back to the customer acquisition system is required here. What is the process to give terms to your customers? Is there a formal system for checking the credit on new customers? Do you require cash payments from new customers until their credit application can be processed? Do you have an online payment system, so customers can easily pay their outstanding invoices with a credit card?

Once the customer acquisition process and collection procedures are corrected, cash flow will improve, bills will be paid on time, and the cash balance with be positive!

Easy to see how important analyzing the cash flow is and how it can be used to improve or evaluate your business processes and procedures.

When we look at cash flow, we can also look at a forecasted cash flow to help us see where our company is at from a cash standpoint, and where we could make improvements. This forecasting can also be helpful for a new business or to evaluate cash needs in an existing business during periods of growth or slumps.

A forecasted cash flow statement can be created based on historical data, or, in a new company, can be created from budgeted amounts that include intended collections processes for accounts receivable and expenditure payments for accounts payable.

By preparing a forecasted cash flow, you can see where problems are before they become big problems!

Practice Question 8.3

Accounts receivable increases by $4,000 while accounts payable decreases by $2,000. What is the net change in cash?

An increase of $2,000

An increase of $6,000

An decrease of $6,000

check_circle

That is the correct answer!

Break-Even Point

How many apples does Farmer Joe need to sell to break even?

The break even point can be defined as the exact point where sales-expenses = zero. So essentially, you are not making money, but you are not losing money either. This is the point where selling one less item would create a loss and selling one more item would create a profit situation. There are two methods we can use to figure out our break even point:

1. The equation method

2. The formula method

We will discuss both methods in detail, but let's start with a new company and a new product! The widgets are starting to get boring. Whether we are talking about apples, widgets or kayaks, the process is the same.

The Minnesota Kayak Company has come to you to help them determine the break even point on a new line of racing kayaks they plan to introduce to the market. These are some pricy kayaks and they want to insure that the use of their manufacturing facility will make sense for this new line.

Are you ready to get busy?

Methods to Determine the Break-Even Point

So the Minnesota Kayak Company has these awesome new kayaks they are going to introduce to the market. They are a new company and need help in determining pricing, costs and how many kayaks they will need to sell in a month to break even. They are looking to you to help them determine if the selling price and costs will help them to reach their goals. They give you the following information to work with:

With this information, it is your task to find the breakeven point using the three different methods. Let's look first at the equation method:

The equation method utilizes the profit equation introduced earlier.

Also, let's revisit the contribution margin concept and some shortcuts.

Contribution margin = Selling price Variable expenses

Profit= P

Contribution Margin= CM

Quantity= Q

Fixed Expenses = F

Variable Expenses = V

So in our kayak example we are looking for a break even point meaning that the profit = $0

We can then put together our break even point utilizing the equation method as follows:

Minnesota Kayak needs to sell 28 kayaks at $500 each to break even.

The formula method gets to the same answer in a different way. It is kind of a shortcut to the equation method:

So regardless of the method used, you get to the same result!

Target Profit Analysis

Minnesota Kayak has a few investors who are interested in getting a return on their investment. They have talked with your supervisor, and between them all, would like to get $30,000 a month in profit to divide between them. You have been tasked with figuring out how many kayaks need to be sold in order to get the investors their return!

Target profit analysis helps us to know how much in dollar sales a company will need to reach a certain profit point. This is one of the key uses of the CVP analysis. Once the basic data is calculated, it can offer a great deal of insight and help in planning.

Minnesota Kayak Company needs to sell 28 kayaks in our example to break even. The equation method or the formula method can be used with the same result. Remember the formula method is simply a shortened version of the equation method, so both ways should come to the same conclusion.

With the previous information you can then figure out, the dollar sales needed to break even:

What if they now want to show a $30,000 a month profit?

So with that information we now have the following:

With this information, how many kayaks do we need to sell to show a $30,000 profit at the end of the month? It is the same exact formula we used to calculate the break-even point! Remember, we put -0- for the profit in when we were looking to break-even. We simply replace the -0- with $30,000 and now we can calculate how many kayaks we need to sell to meet our profit goal. Pretty neat huh?

Using the equation method:

So we now need to sell 138 kayaks to profit $30,000! How much in sales do we need?

138 $500 each= $69,000 in sales.

Note: Whenever you are doing break-even or target profit analysis, you should round units up. If you used your calculator to divide $37,700 by 275, you would have gotten 137.090909. Why did we round up to 138 kayaks? Well, you can't sell only 0.09 of a kayak, so you will either sell 137 or 138. If you round down to 137 units and then plug it into the formula to calculate profit, then your profit only ends up being $29,975 - just short of our $30,000 target profit we stated. So we have to round up to 138 kayaks to meet our target profit (and in this case, slightly exceed, as selling 138 kayaks leads to a profit of $30,250).

How would we get there using the formula method?

So in our kayak case

So again, we need 138 kayaks sold to make a $30,000 profit!

138 kayaks $500 selling price per kayak = $69,000 in sales.

We can now plug in any amount of desired profit and calculate how many units we need to sell! This is amazing information for business owners and managers to have available. But see the importance of good numbers for your fixed and variable costs? Keep in mind how much a small difference in costs can affect our profit!

Margin of Safety

The margin of safety is the difference between actual sales and the break even point. Now that we have calculated break even points, and also done some target profit analysis, let's discuss the importance of the margin of safety. This amount tells us how much sales can drop before we show a loss. A higher margin of safety is good, as it leaves room for cost increases, downturns in the economy or changes in the competitive landscape.

If you remember back to our example with our friends at Monte Corporation and the widgets, when a new competitor came into the market, it created a crisis!

The formula used to calculate the margin of safety

We can take this formula one step further to figure the margin of safety percentage

Now let's look at an example:

Let's go back to our kayaks. Remember our basic information:

Also, remember, Minnesota Kayak Company needs to sell 28 kayaks at $500 each to break even. So in this example, $14,000 in sales is their break even point.

Let's assume their current sales of kayaks is 50 kayaks per month at $500 each, so $25,000. Using the formulas above, what is their margin of safety?

What is their margin of safety percentage?

We can check our calculations, by multiplying the margin of safety percentage of 44% by actual sales of $25,000 and we end up with $11,000.

So the margin of sales percentage tells us that Minnesota Kayak Company can sell 44% fewer dollars worth of kayaks and still break even. The higher the margin of safety percentage, the better!

The Break-Even Point and the Sales Mix

What if your company sells more than one product? Most companies sell more than one product. How do we go about figuring the break even point when we decide to adjust our sales mix?

This is a complex question. After watching the video, take a look at an additional example, with three products in the mix.

Let's say your company makes three products:

Product 1:Sells for $40 with variable costs of $20 each.

Product 2:Sells for $10 with variable costs of $2 each

Product 3:Sells for $20 with variable costs of $15 each.

Note the difference in contribution margin for each product.

Product 1contributes $20 to cover fixed expenses per item sold.

Product 2contributes $8 to cover fixed expenses per item sold.

Product 3contributes $5 to cover fixed expenses per item sold.

So, let's look at the current sales mix, contribution margins and fixed costs.

Now, let's also assume that this mix uses all of the manufacturing space, all of the time!! What happens if we suddenly have a huge demand for product #3, the one contributing the least to the contribution margin? We look at reallocating space to produce more of product #3, but that means we need to produce less of products #1 and #2 that contribute more to our contribution margin

Let's take a look at what happens if our sales mix shifts. We are making a couple of assumptions

1. We have production space and labor for 2750 products total.

2. Variable costs remain the same per item, regardless of quantity.

So, if we shift our production to making more of product #3

We are still making the exact same number of products, but due to the contribution margin being lower on product #3, we are now showing a net loss rather than a profit.

Companies make these kinds of decisions on a daily basis. As a manager, you may be asked to determine a product mix that is profitable for your company. Keep the contribution margin, manufacturing space and labor in mind as you work through this process.

MGMT 2145 - Business Plan Development - Fall 2023 - Burrows GRADEBOOK ? CONTENTS BOOKMARKS HIGHLIGHTS Module 8: Business Plan Assignment Start Here Introduction Article Information Module 1: Business/Community . Research articles: Google any article on SmallBuisness, You must find an article that relates to the subject matter(s) discussed within Module 8 or find an article Module 1: Business Plan Questions of interest. (5 points) Module 2: Introduction to Cash F. a. Title of Article, Author, Date of Article (if given) Module 2: Creative Thinking b. Source (Which website used) Module 2: Own Your Own Business Module 3: Development of Prod. Q a. Title of Article, Author, Date of Article (if given) Module 3: Business Plan Assign. BIU Module 4: Determination of Mar. Type to add text.. Module 5: Determination of Fina.. Module 4 & 5: Business Plan As. b. Source (Which website used) Module 6: Development of Mark. BIU Module 6: Creative Thinking Type to add text.. Module 7: Development of Oper. Body: Brief Summary of the Article Consider the following questions. (6 points) . Who?, What?, When? Where?, Why?, How? . It may not be possible to answer every one of these questions - use them as a general guideline when writing your summary. Submit Summary Here Click to choose file. Opinion/Reflection Reflect on what you learned from reading this article. Consider the following: (10 points) a. How can/does this information apply to real life? b. How might you or someone else use this information now or in the future? c. What did you find most interesting and why? d. What questions might you have after reading this article and how might you be able to find out the answers? e. Did you agree or disagree with the content? Why or why not? a. How can/does this information apply to real life? U Type to add text. b. How might you or someone else use this information now or in the future? I U Type to add text. c. What did you find most interesting and why? IVE Type to add text.. d. What questions might you have after reading this article and how might you be able to find out the answers? IVE Type to add text.. We. Did you agree or disagree with the content? Why or why not? IVE Type to add text.