1 CASH FLOW STATEMENT (AND FINANCIAL STATEMENT) - At the most fundamental level, firms do two different things: (i) They generate cash (ii) They spend it. Cash is generated by selling a product, an asset or a security. - Selling a security involves either borrowing or selling an equity interest (i.e. a share of stock) in the firm. - Cash is spent by paying for material and labor to produce a product and by purchasing assets. - Payment to creditors and owners also require spending cash. Cash flow from asset = Cash flow from creditors + Cash flow from owners. A statement of cash flow is a summary of a firm s cash receipts and cash payments during the period of time. A flow of funds statement is a summary of a firm s changes in financial position from one period to another. It is also called sources and uses of funds statement or a statement of changes in financial position. Source of funds- - Sources and uses of cash. - Activities that bring in cash are called sources of cash. - Activities involving spending of cash are called uses (or application) of cash. - This can be traced in the balance sheet by finding out how it obtained its cash and how the firm spent its cash during a given period. For example Increase in net fixed asset. Where did the money come from? - This can be answered by first identifying those changes that used up cash (uses) and those that brought cash in (sources). - A firm uses cash by either buying assets or making payments i.e. An increase in an asset account means that the firm, on a net basis, bought some assets, a use of cash. - If an asset account went down, then, on a net basis, the firm sold some assets (net sources). - Similarly if a liability account goes down, then the firm has made a net payment (use of cash). Therefore, it can be concluded that: An increase in a left-hand side (assets) account, or a decrease in right-hand side (liability or equity) account, is a use of cash. Likewise, a decrease in an asset account or an increase in a liability (or equity) account is a source of cash. Any decrease (-) in an asset item Any increase (+) in a claim item. i.e. a liability or shareholder s equity Uses of fund Any increase (+) in an item Any decrease (-) in a claim item (i.e. a liability or shareholders equity item The financial manager makes decisions to ensure that the firm has sufficient funds to meet financial obligations when they are due and to take advantage of investment opportunities.
2 By arranging a company s flow of funds in a systematic fashion, the analyst can better determine whether the decisions made for the firm resulted in a reasonable flow of funds or in questionable flows, which warrant further inspection From the balance sheet identity, the value of a firm s assets is equal to the value of its liabilities plus the value of its equity. Cash flow from asset = cash flow to lenders + cash flow to shareholders The firm flow of fund comprises the individual changes in balance sheet items between two points in time at the beginning and ending period. The differences in the individual balance sheet accounts items represent the various net funds flow resulting from decisions made by management during the period Balance sheet=stock of funds Changes in balance sheet items= net flow of funds Similarly, the cash flow from the firm s assets must equal the sum of the cash flow to lenders plus the cash flow to shareholders (or owners). The cash flow identity says that, the cash flow from the firm s assets is equal to the cash flow paid to suppliers of capital to the firm. - The argument is that a firm generates cash through its various activities, and that cash is either used to pay lenders or else it is paid out to the owners of the firm. - Cash flow statement help the financial manager to assess and identify: (i) A company s ability to generate future net cash inflows from operations to pay debts, interests and dividends. (ii) A company s need for external financing (iii) The reasons for differences between net income and net cash flow from operating activities (iv) The effects of cash and non cash investing and financing transactions The statement of cash flows explains changes in cash (and cash equivalent, e.g. treasury bills,) by listing the activities that increased cash and those that decreased cash. Cash flow from assets involves three broad components: operating cash flow, capital spending Additions to net working capital. Operating cash flow Operating cash flow refers to the cash flow resulting from the firm s day to day activities of producing and selling. Expenses associated with the firm s financing of its assets are not included since they are not operating expenses. Capital spending refers to the net spending on non - current assets. (i.e. the purchases of noncurrent assets less sales of non-current assets). Addition to net working capital is the amount spent on net working capital. It is measured as the change in net working capital over the period being examined and represents the net increase in current assets over current liabilities. In financial analysis, investment and financing decisions are separated. Thus in preparing cash flows from assets, short-term debts are excluded from the calculation of net working capital. Hence net working capital exclude short term debt. Cash flow statement helps the financial manager to assess and identify
3 A company s ability to generate future net cash inflows from operations to pay debts, interests and dividends. A company s need for external financing The reasons for differences between net income and net cash flow from operating activities The effects of cash and non cash investing and financing transactions Preparing Cash flow Cash flow calculations can be broken down into three basic parts. (i) Cash flow from operating cash flow (ii) Cash flow associated with capital spending (iii) Cash flow associated with working capital requirements. Step 1: preparing operating cash flow It measures the project s change in the firm s after-tax operating cash flows. To calculate operating cash flow, we want to calculate revenues minus costs (excluding depreciation) since it are not a cash outflow. Interest should not be included as it is a financing expense. The easiest way to calculate operating cash flow is to take the information provided on the firm s projected income statement and simply converting the accounting information into cash flow information. Under this method, the calculation of a project s operating cash flow involves three steps: a. Determine the company s earnings before interest and taxes (EBIT). b. Subtract out the change in taxes (ignore any interest expenses). c. Adjust the value for the fact that depreciation, a non-cash flow item, has been subtracted out in the calculation of EBIT. Thus, operating cash flow is calculated as follows: Operating cash flow = profit before interest & taxes Less (minus) taxes Add (plus) depreciation Operating cash flow xxx xxx xxx xxx Example 1 Assume that a new project will annually generate additional revenues of $ 1,000,000 and additional fixed and variable costs of $ 500,000, while increasing depreciation by $ 150,000 per year. In addition, assume that the firm s marginal tax rate is 34 percent. Required Calculate the firm s operating cash flows. Solving
4 Revenue $ 1,000,000 -Cash fixed & variable cost 500,000 -Depreciation 150,000 EBIT $ 350,000 Less taxes (34 %) -119,000 Add depreciation +150,000 Operating cash flow 381,000 Operating cash flow = Change in earnings before interest and taxes - Changes in taxes + Change in depreciation = $ 350,000 - $ 119,000 + $ 150,000 = $ 381,000 Example 2 Step 2: calculating Net Working Capital - A new project involves additional investment in working capital e.g new inventory, new sale outlet, or additional investment in account receivable. - There may be also short-term financing e.g. increase in account payable. - Thus the change in net working capital is the additional investment in current assets minus any additional short-term liabilities that were generated. Step 3: Calculating cash flow change in the firm s capital spending. - A part from initial cash outflow associated with a project s initial outlay, there may also be additional capital- spending requirement over the life of the project. E.g. updating the accounting system to keep abreast with the new technology. Step 4: Putting together all the calculations, as follows: Project cash flow = change in earnings before interest & taxes (EBIT) - (minus) change in taxes + (plus) change in depreciation - (minus) change in net working capital - (minus) change in capital spending. Alternatives forms of the cash flow statement The cash flow statement may be presented using either A direct method (which is encouraged by the financial Accounting Standards Board as it is easier to understand). Indirect method (which is likely to be the method followed by a good majority of firms because it is easier to prepare). ALDINE MANUFACTURING COMPANY STATEMENTS OF EARNINGS (IN THOUSANDS)¹ YEARS ENDED MARCH 31 20X2 20X1 EXPLANATIONS Net sales² $ 3,992 $ 3, Measures profitability over a Period of time. Cost of goods sold³ 2,680 2, Amount received, or receivable, From customers.
5 Gross profit $ 1,312 $ 1, Directly related to operating levels: Wages, raw materials, supplies, and Manufacturing overhead. Selling, general, and Administrative expenses⁴ Salesmen s commissions, Advertising, officers salaries, e.t.c Earnings before interest And taxes⁵ $ 400 $ Operating income. Interest expense⁶ Cost of borrowed funds. Earnings before taxes⁷ $ 315 $ Taxable income. Income taxes (federal And state) Amount earned for stockholders. Earnings after taxes⁸ $ 201 $ 198 Cash dividends Increase in retained earnings $ 58 $ 68 Note: Depreciation expenses for 20X1 and 20X2 were $ 114 and $ 112, respectively. ALDINE MANUFACTURING COMPANY BALANCE SHEETS (IN THOUSANDS). MARCH 31 ASSETS 20X2 20X1 Cash $ 178 $ 175 Accounts receivable Inventories, at lower of cost or market 1,329 1,235 Prepaid expenses Accumulated tax prepayments Current assets $ 2,241 $ 2,196 Fixed assets at cost 1,596 1,538 Less: Accumulated depreciation (857) (791) Net fixed assets $ 739 $ 747 Investments, long term 65 - Other assets, long term Total assets $ 3,250 $ 3,148
6 LIABILITIES AND SHAREHOLDERS EQUITY Bank loans and notes payable $ 448 $ 356 Accounts payable Accrued taxes Other accrued liabilities Current liabilities $ 823 $ 783 Long -term debt Shareholders equity Common stock, $ 1 par value Additional paid-in capital Retained earnings 1, Total shareholders equity $ 1,796 $ 1,738 Total liabilities and shareholders Equity $ 3,250 $ 3,148 SOURCES USES Increase, retained earnings $ 58 Decrease, net fixed assets 8 Decrease, accounts receivable 62 Increase, inventories $ 94 Increase, bank loans 92 Increase, prepaid expenses 4 Increase, accounts payable 12 Increase, tax prepayments 6 Increase, other accruals 27 Increase, long-term investment 65 Increase, long term debt 4 Decrease, accrued taxes 91 Increase, cash 3 $ 263 $ 263
7 SOURCES USES Funds provided by operations Net profit $ 201 Dividends $ 143 Depreciation 112 Additions to fixed assets 104 Decrease, accounts receivable 62 Increase, inventories 94 Increase, bank loans 92 Increase, prepaid expenses 4 Increase, accounts payable 12 Increase, tax prepayments 6 Increase, other accruals 27 Increase, long-term investment 65 Increase, long term debt 4 Decrease, accrued taxes 91 CASH INFLOWS AND OUTFLOWS Increase, cash 3 $ 510 $ 510 Operating Activities Cash Inflows From sales of goods or services From returns on loans (interest income) and equity securities (dividend income)* Cash outflows To pay suppliers for inventory To pay employees for services To pay lenders (interest)** To pay government for taxes To pay other suppliers for other operating expenses Explanation Shows impact of transactions not defined as investing or financing activities. These cash flows are generally the cash effects of transactions that enter into the determination of net income. Thus, we see items that not all statement users might think of as operating flows items such as dividends and interest received, as well as interest paid. * These inflows and outflows are typical for a nonfinancial firm and are classified according to the operating, investing, and financing activity definitions of SFAS No. 95. **It would seem logical to classify interest and dividends received as investing inflows, whereas interest paid certainly looks like a financing outflow. In fact, three out of seven Financial Accounting Standards Board members dissented from classifying interest and dividends received and interest paid as cash flows from operating activities but the majority ruled.
8 Investing Activities Cash Inflows From sale of fixed assets (property, plant, equipment) From sale of debt or equity securities (other than cash equivalents) of other entities Cash Outflows To acquire fixed assets (property, plant, equipment) To purchase debt or equity securities of other entities Explanation Shows impact of buying and selling fixed assets and debt or equity securities of other entities. Financing Activities Cash Inflows From borrowing From the sale of the firm s own equity securities Cash Outflows To repay amounts borrowed (principal) To repurchase the firm s own equity securities To pay shareholders dividends Explanation Shows impact of all cash transactions with shareholders and the borrowing and repaying transactions with lenders.
9 Alternative cash flow statements showing direct versus indirect methods DIRECT METHOD ALDINE MANUFACTURING COMPANY STATEMENT OF CASH FLOWS FOR THE YEAR ENDED MARCH 31, 20X2 (IN THOUSANDS) CASH FLOW FROM OPERATING ACTIVITIES Cash received from customers¹ $ 4,054 Cash paid to suppliers and employees² (3,539) Interest paid (85) Taxes paid³ (211) Net cash provided (used) by operating activities $ 219 CASH FLOW FROM INVESTING ACTIVITIES Additions to fixed assets $ (104) Payment for long-term investment (65) Net cash provided (used) by investing activities $ (169) CASH FLOW FROM FINANCING ACTIVITIES Increase in short-term borrowings $ 92 Additions to long-term borrowing 4 Dividends paid (143) Net cash provided (used) by financing activities $ (47) Increase (decrease) in cash $ 3 Cash and cash equivalents, March 31, 20X1 175 Cash and cash equivalents, March 31, 20X2 $ 178 Supplementary Schedule: A reconciliation of net income to net cash provided by operating activities Net income $ 201 Depreciation 112 Cash provided (used) by current assets and Operating-related current liabilities Decrease, accounts receivable 62 Increase, inventories (94) Increase, prepaid expenses (4) Increase, tax prepayments (6) Increase, accounts payable 12 Decrease, accrued taxes (91) Increase, other accrued liabilities 27 Net cash provided (used) by operating Activities $ 219 ¹² ³ See table (Worksheet for preparing statement of cash flows) for details.
10 INDIRECT METHOD ALDINE MANUFACTURING COMPANY STATEMENT OF CASH FLOWS FOR THE YEAR ENDED MARCH 31, 20X2 (IN THOUSANDS) CASH FLOW FROM OPERATING ACTIVITIES Net income $ 201 Depreciation 112 Cash provided (used) by current assets Operating-related liabilities Decrease, accounts receivable 62 Increase, inventories (94) Increase, prepaid expenses (4) Increase, tax prepayments (6) Increase, accounts payable 12 Decrease, accrued taxes (91) Increase, other accrued liabilities 27 Net cash provided (used) by operating Activities $ 219 CASH FLOW FROM INVESTING ACTIVITIES Additions to fixed assets $ (104) Payment for long-term investment (65) Net cash provided (used) by investing activities $ (169) CASH FLOW FROM FINANCING ACTIVITIES Increase in short-term borrowings $ 92 Additions to long-term borrowing 4 Dividends paid (143) Net cash provided (used) by financing activities $ (47) Increase (decrease) in cash $ 3 Cash and cash equivalents, March 31, 20X1 175 Cash and cash equivalents, March 31, 20X2 $ 178 Supplemental cash flow disclosures Interest paid $ 85 Taxes paid³ 211
11 Table Sales $ 3,992 + (-) Decrease (increase) in accounts receivable 62 = Cash received from customers¹ $ 4,054 Cost of goods sold (minus depreciation for the year) $ 2,568 + (-) Increase (decrease) in inventory 94 + (-) Decrease (increase) in accounts payable (12) + (-) Increase (decrease) in prepaid expenses 4 + Selling, general, and administrative expenses (-) Decrease (increase) in other accrued liabilities (27) = Cash paid to suppliers and employees² $ 3,539 Income taxes (federal and state) $ (-) Increase (decrease) in accumulated tax prepayments 6 + (-) Decrease (increase) in accrued taxes 91 = Taxes paid³ $ 211 ¹² ³ See Statement of Cash Flows for the year ended March 31, 20X2. Example 2. PRUFROCK CORPORATION Balance Sheets as of December 31, 1991 and 1992 ($ in millions) Change Assets Current assets Cash $ 84 $ 98 + $ 14 Accounts receivable Inventory Total $ 642 $ 708 +$ 66 Fixed assets Net plant and equipment $ 2,731 $ 2,880 + $ 149 Total assets $ 3,373 $ 3,588 + $ 215
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