Chapter 10 Statement of Cash Flows

Chapter 10 Statement of Cash Flows TO THE NET 1. a. Item 1 Business History Northrop Grumman Corporation ( Northrop Grumman or the company ) is an integrated enterprise consisting of businesses that cover the entire defense spectrum, from undersea to outer space and into cyberspace. b. Direct Method The principle advantage of the direct method is that it shows the operating cash receipts and payments. Knowledge of where operating cash flows came from and how cash was used in past periods may be useful in estimating future cash flows. c. All of the noncash transactions involving investing and financing activities are important to understanding investing and financing activities but they are not part of cash flow. This would be a noncash investing and financing activity. 2. a. NT 10-K Notification of inability to timely file Form 10-K b. Dell Inc. is delaying the filing of the Form 10-K for its fiscal year ended February 2, 2007 because the independent investigation being conducted by the Audit Committee of the company s Board of Directors has not been completed. c. Yes. When the statements are issued, they will likely result in changes to multiple years. 3. a. General Development of Business Molson was founded in 1786, and Coors was founded in 1873. Since each company was founded, we have been committed to producing the highest quality beers. Our brands are designed to appeal to a wide range of consumer tastes, styles and price preferences. Our largest markets are Canada, the United States and the United Kingdom. b. 1. Operating cash flow / current maturities of long-term debt and current notes payable December 28, 2008 December 30, 2007 $411,500,000 $616,000,000 $100,000 $100,000 + $4,200,000 4,115.00 143.26 287

2. Operating cash flow / total debt December 28, 2008 December 30, 2007 $411,500,000 $616,000,000 $4,436,300,000 $6,302,100,000 9.28% 9.77% 3. Operating cash flow per share December 28, 2008 December 30, 2007 $411,500,000 $616,000,000 $185,500,000 $181,400,000 $2.22 $3.40 4. Operating cash flow / cash dividends December 28, 2008 December 30, 2007 $411,500,000 $616,000,000 $139,100,000 $114,800,000 2.96 5.37 c. Operating cash flow / current maturities of long-term debt and current notes payable went from a very high number to a very, very high number. Operating cash flow / total debt decreased moderately. Operating cash flow per share decreased materially. Operating cash flow / cash dividends decreased materially. 4. a. Item 1 Business Ann Taylor Stores Corporation, through its wholly-owned subsidiaries, is a leading national specialty retailer of women s apparel, shoes, and accessories sold primarily under the Ann Taylor, LOFT, Ann Taylor Factory and LOFT Outlet brands. 288

b. Fiscal Year Ended January 31, 2009 February 2, 2008 February 3, 2007 (In Thousands) Net sales $2,194,559 $2,396,510 $2,342,907 Gross margin 1,054,806 1,251,264 1,257,010 Operating income (loss) (371,637) 155,386 223,837 Net cash provided by operating activities 172,818 257,197 295,931 c. A decrease in all items, especially operating income (loss). d. 1. Depreciation and amortization are added back to net income because they reduced net income but did result in cash outflow. 2. Change in Inventories is added to net income because it represented a decrease in inventories and therefore provided cash flow. 3. Change in accounts payable and accrued expenses is added to net income because these current liabilities increased and therefore provided cash flow. 289

QUESTIONS 10-1. The basic justification for a statement of cash flows is that the balance sheet and the income statement do not adequately indicate changes in cash. The balance sheet indicates the position of the firm at a particular point of time. Some idea of how the changes in cash occurred can be obtained by comparing consecutive balance sheets, but only a limited amount of information can be obtained this way. The income statement shows the income or loss for a period of time, but it does not indicate cash generated by operations. Neither the balance sheet nor the income statement summarize the cash flows related to investing or financing activities. Neither presents such items as sale of stock, retirement of bonds, purchase of machinery, or sale of a subsidiary. Thus, there is a need to summarize the cash flows in another statement. 10-2. 1. Cash flows from operating activities 2. Cash flows from investing activities 3. Cash flows from financing activities 10-3. The cash inflows (outflows) will be determined by analyzing all balance sheet accounts other than the cash and cash equivalent accounts. The cash inflows will be generated from the following accounts: 1. Decreases in assets 2. Increases in liabilities 3. Increases in stockholders' equity The cash outflows will be generated from the following accounts. 1. Increases in assets 2. Decreases in liabilities 3. Decreases in stockholders' equity 10-4. This statement is not correct. The land account may contain an explanation of a source and use of cash. 10-5. 1. Visual method 2. T-account method 3. Worksheet method 290

10-6. For the direct approach, the revenue and expense accounts on the income statement are presented on a cash basis. For this purpose, the accrual basis income statement is adjusted to a cash basis. For the indirect approach, start with net income and add back or deduct adjustments necessary to change the income on an accrual basis to income on a cash basis after eliminating gains or losses that relate to investing or financing activities. 10-7. Items have been included in income that did not provide cash and items have been deducted from income that did not use cash. Net income must be converted to a cash-from-operations figure for the statement of cash flows. 10-8. Cash and short-term highly liquid investments. This would include cash on hand, cash on deposit, and investments in short-term, highly liquid investments. 10-9. The purpose of the statement of cash flows is to provide information on why the cash position of the company changed during the period. 10-10. These transactions represent significant investing and/or financing activities, and one purpose of the statement of cash flows is to present investing and financing activities. 10-11. No. The write-off of uncollectible accounts against allowance for doubtful accounts would reduce accounts receivable and the allowance for doubtful accounts. It would relate to operations and be a noncash item. The net receivables amount would not change. 10-12. Discarding a fully depreciated asset with no salvage value will not result in cash flow. 10-13. This may be the result of noncash charges for depreciation, amortization, and depletion. Also, receivables or inventory may have decreased or accounts payable may have increased. 10-14. An increase in accounts payable would be considered to be an increase in cash from operations. 10-15. Investments in receivables, inventories, fixed assets, and the paying off of debt are examples of situations where cash will be used but will not reduce profits. 10-16. Depreciation is not a source of funds. Depreciation has been deducted on the income statement in arriving at income. Since depreciation is a nonfund charge to the income statement, it is added back to income to compute cash from operations. 291

10-17. The decrease in accounts receivable would increase cash from operations. 10-18. This is an example of noncash investing and financing. As such, it should be disclosed on a schedule that accompanies the statement of cash flows. 10-19. Cash flow per share is not as good an indicator of profitability as earnings per share. In the short-run, cash flow per share is a better indicator of liquidity and ability to pay dividends. 10-20. Since cash flow from operating activities is substantially greater than the cash paid out for dividends, it appears that the company can maintain and possibly increase dividend payments in the future, depending also on its investing and financing goals. 292

PROBLEMS PROBLEM 10-1 Operating activities: Net income $30,000 Adjustments to net income: Add: Depreciation 8,000 Decrease in accounts receivable 6,000 Increase in salaries payable 1,000 Less: Gain on sale equipment (2,000) Increase in inventories (3,000) Decrease in accounts payable (4,000) Net cash provided from operating activities $36,000 Calculations: Decrease in accounts receivable ($42,000 - $36,000) $ 6,000 Increase in salaries payable ($2,000 - $1,000) $ 1,000 Gain on sale of equipment ($5,000 - $3,000) $ 2,000 Increase in inventories ($28,000 - $25,000) $ 3,000 Decrease in accounts payable ($35,000 - $31,000) $ 4,000 PROBLEM 10-2 A. Investing activities: Proceeds from selling equipment $ 5,000 Purchase of equipment (35,000) Net cash used by for investing activities ($30,000) B. Financing activities: Payment of dividends ($12,000) Net cash used by for financing activities ($12,000) 293

PROBLEM 10-3 a. BBB COMPANY Statement of Cash Flows For the Year Ended December 31, 2009 Cash flow from operating activities: Net income $ 500 Non cash expenses, revenues, losses, and gains included in income: Depreciation $ 2,800 Gain on sale of land (800) Decrease in accounts receivable 400 Decrease in inventory 500 Increase in accounts payable 800 Increase in wages payable 50 Decrease in taxes payable (1,000) $ 2,750 Net cash flow from operating activities $ 3,250 Cash flows from investing activities: Land was sold for 1,800 Equipment was purchased for (3,500) Net cash used for investing activities $(1,700) Cash flows from financing activities: Dividends declared and paid (4,350) Common stock was sold for 3,800 Net cash used for financing activities $ (550) Net increase in cash and marketable securities $ 1,000 b. Net cash flow from operating activities was substantially more than the net income. Cash dividends were greater than the net cash flow from operating activities. The cash from issuing the common stock was sufficient to cover the net cash used for investing activities, increase the cash and marketable securities accounts, and partially cover the large cash dividend. The fact that a long-term source of funds (common stock) was used to cover part of the cash dividends is a negative observation. The large cash dividend in relation to net cash flow from operating activities would also be considered a negative situation. 294

PROBLEM 10-4 a. FRISH COMPANY Schedule of Change from Accrual to Cash Basis Income Statement For Year Ended December 31, 2009 Accrual Basis Adjustments Add (Subtract) Cash Basis Net sales $ Less expenses: Cost of goods sold 640,00 0 360,00 0 Increase in accounts receivable $ (27,000) $ Increase in accounts payable (15,000) Increase in inventories 35,000 Depreciation expense (15,000) 613,00 0 365,00 0 Selling and administrative expenses 43,000 Decrease in prepaid expenses $ (1,000) Increase in accrued liabilities (3,000) Depreciation expense (5,000) 34,000 Other expense 2,000 Amortization of patent $ (3,000) Amortization of bond premium 1,000 0 Income before income taxes $ Income tax 92,000 Net income $ 235,00 0 $ Decrease in income taxes payable 10,000 143,00 0 $ 214,00 0 102,00 0 112,00 0 b. 1. Direct Approach Receipts from customers $ 613,000 Payments to suppliers (365,000) Selling and administrative expenses ( 34,000) Income taxes paid (102,000) Cash flows from operating activities $ 112,000 295

2. Indirect Approach Net income $ 143,000 Add (deduct) items not affecting cash Depreciation 20,000 Amortization of patent 3,000 Amortization of bond premium (1,000) Increase in accounts receivable (27,000) Increase in accounts payable 15,000 Increase in inventories (35,000) Decrease in prepaid expenses 1,000 Increase in accrued liabilities 3,000 Decrease in income taxes payable (10,000) Cash flow from operating activities $ 112,000 PROBLEM 10-5 a. BOYER COMPANY Schedule of Change from Accrual to Cash Basis Income Statement For the Year Ended December 31, 2009 Accrual Basis Adjustments Add (Subtract) Cash Basis Sales $19,000 Increase in Receivables $ (400) $18,600 Less operating expenses: Depreciation 2,300 Depreciation expense (2,300 ) 0 Other operating expenses 12,000 Increase in inventories 800 Increase in accounts payable (500) 12,300 Operating Income $ 4,700 $ 6,300 Loss on sale of land 1,500 Loss on sale of land (1,500 ) 0 $ 6,300 Income before tax expense $ 3,200 Tax expense 1,000 Decrease in income taxes payable 400 1,400 Net income $ 2,200 $ 4,900 296

b. 1. Direct Approach Receipts from customers $ 18,600 Payments to suppliers (12,300) Income taxes paid (1,400) Cash flows from operating activities $ 4,900 2. Indirect Approach Net income $ 2,200 Add (deduct) items not affecting cash: Depreciation $2,300 Increase in receivables (400) Increase in inventories (800) Increase in accounts payable 500 Loss on sale of land 1,500 Decrease in income taxes payable (400) 2,700 Cash flow from operating activities $ 4,900 297

PROBLEM 10-6 a. SAMPSON COMPANY Statement of Cash Flows For the Year Ended December 31, 2009 Net cash flow from operating activities: Net income $ 19,000 Noncash expenses, revenues, losses, and gains included in income: Depreciation expense $ 10,000 Increase in net receivables (7,000) Increase in inventory (13,000) Increase in accounts payable 5,000 Decrease in accrued liabilities (17,000) Net cash outflow from operating activities (3,000) Cash flows form investing activities: Plant assets increase (15,000) Cash flows from financing activities: Mortgage payable increase $ 11,000 Common stock increase 6,000 Dividends paid (21,000) Net cash flows from financing activities (4,000) Net decrease in cash $ (22,000) 298

b. SAMPSON COMPANY Statement of Cash Flows For Year Ended December 31, 2009 Cash flow from operating activities: Cash flow from customers $ 138,000 ($145,000 $7,000) Cash payments to suppliers (123,000) ($108,000 $10,000 + $13,000 $5,000 + $17,000) Cash outflow for other expenses (6,000) Tax payments (12,000) Net cash outflow from operating activities $ (3,000) Cash flows from investing activities: Plant assets increase Cash flows from financing activities: Mortgage payable increase $ 11,000 Common stock increase 6,000 Dividends paid (21,000) Net cash outflow from financing activities (4,000) Net decrease in cash $ (22,000) c. All major segments of cash flows were negative. Net cash outflow from operating activities was negative by $3,000, and yet dividends were paid in the amount of $21,000. Also, the company had a negative cash flow from investing activities. These negative cash flows were partially made up for by issuing a mortgage payable ($11,000) and common stock ($6,000). 299

PROBLEM 10-7 a. The usual guideline for the current ratio is two to one. Arrowbell Company had a 1.14 to 1 ratio in 2008 and a 0.85 to 1 ratio in 2009. The usual guideline for the acid-test ratio is one to one. Arrowbell Company had a 0.68 to 1 ratio in 2008 and a 0.49 to 1 ratio in 2009. The cash ratio dropped from 0.19 in 2008 to 0.12 in 2009. The working capital in 2008 was $197,958, and in 2009 it had declined to a negative $319,988. The short-term debt position appears to be very poor. Computation of Ratios Current Ratio = Current Assets Current Liabilities 2009 2008 $1,755,303 $1,599,193 = 0.85 = 1.14 $2,075,291 $1,401,235 Acid-Test Ratio = Cash Equivalents & Net Receivables & Marketable Securities Current Liabilities 2009 2008 $250,480 + $760,950 $260,155 + $690,550 = 0.49 $2,075,291 $1,401,235 = 0.68 Cash Ratio = Cash Equivalents & Marketable Securities Current Liabilities 2009 2008 $250,480 $260,155 = 0.12 = 0.19 $2,075,291 $1,401,235 Operating Cash Flow/Current Maturities of Long-Term Debt and Current Notes Payable = Operating Cash Flow Current Maturities of Long-Term Debt and Current Notes Payable 2009 2008 $429,491 $177,658 = 46.93% = 32.29% $915,180 $550,155 300

b. Suppliers will be concerned that Arrowbell Company will not be able to pay its creditors and, if payment is made, it will be later than the credit terms. The shortterm creditors are financing the expansion program. c. The debt ratio has increased in 2009 to 0.61 from 0.58 in 2008. The debt/equity ratio has increased in 2009 to 1.55 from 1.36 in 2008. (A similar increase in the debt to tangible net worth as the increase in the debt/equity ratio.) There was an improvement in the operating cash flow/total debt, but this ratio remains very low. This indicates that a substantial amount of funds are coming from creditors. In general, the dependence on creditors worsened in 2009. Not enough information is available to compute the times interest earned, but we can estimate this to be between 2 and 3, based on the earnings and the debt. We would like to see the times interest earned to be higher than this amount. The review of the Statement of Cash Flows indicates that long-term creditors are going to be concerned by the use of debt to expand property, plant, and equipment. They also are going to be concerned by the payment of a dividend while the working capital is in poor condition. Debt Ratio = Total Debt Total Assets 2009 2008 $2,625,291 $2,176,894 = 0.61 = 0.58 $4,316,598 $3,776,711 Debt/Equity = Total Debt Stockholders Equity 2009 2008 $2,625,291 $2,176,894 = 1.55 = 1.36 $1,691,307 $1,599,817 Debt to Tangible Net Worth = Total Liabilities Shareholders Equity Intangible Assets 2009 2008 $2,625,291 $2,176,894 = 155.22% = 136.07% $1,691,307 0 $1,599,817 0 Operating Cash Flow/Total Debt = Operating Cash Flow Total Debt 2009 2008 $429,491 $177,658 = 16.36% = 8.16% $2,625,291 $2,176,894 301

d. A banker would be especially concerned about the short-term debt situation. This could lead to bankruptcy, even though the firm is profitable. A banker would be particularly concerned why management had used short-term credit to finance longterm expansion. e. Management should consider the following or a combination of the following: 1. Discontinue the expansion program at this time and get the short-term debt situation in order. Tighten control of accounts receivable and inventory, along with using funds from operations to reduce short-term debt. 2. Issue additional stock to improve the short-term liquidity problem and the longterm debt situation. Because of the poor record on profitability and the way that management has financed past expansion, additional stock will probably not be well-accepted in the market place at this time. PROBLEM 10-8 a. Bernett Company had a decrease in cash of $23,000, although net cash flow from operating activities was $21,000. Net cash provided by financing activities was $116,000, while net cash used by investing activities was $160,000. The cash flows from operations and financing activities were not sufficient to cover the very significant net cash used by investing activities. b. 1. Current Ratio: Current assets: Cash $ 5,000 Accounts receivable 92,000 Inventory 130,000 Prepaid expense 4,000 Total current assets $ 231,000 (A) Current Liabilities: Accounts payable $ 49,000 Income taxes payable 5,000 Accrued liabilities 6,000 Current bonds payable 10,000 Total current liabilities $ 70,000 (B) (A) $231,000 (B) $70,000 = 3.30 302

2. Acid-Test Ratio: Cash $ 5,000 Accounts receivable 92,000 $ 97,000 (A) Total current liabilities $ 70,000 (B) (A) $97,000 (B) $70,000 = 1.39 3. Operating Cash Flow/Current Maturities of Long-Term Debt and Current Notes Payable: Operating cash flow [from (a)] $ 21,000 (A) Current maturities of long-term debt and current notes payable $ 10,000 (B) (A) $21,000 (B) $10,000 = 2.10 4. Cash Ratio: Cash $ 5,000 (A) Total current liabilities $ 70,000 (B) (A) $5,000 (B) $70,000 =.0714% c. 1. Times Interest Earned: Income before taxes $ 99,000 Plus interest expense 11,000 $ 110,000 (A) Interest expense $ 11,000 (B) (A) $110,000 (B) $11,000 = 10 times per year 303

2. Debt Ratio: Total Liabilities: Accounts payable $ 49,000 Income taxes payable 5,000 Accrued liabilities 6,000 Bonds payable 175,000 Total liabilities $ 235,000 (A) Total assets $ 411,000 (B) (A) $235,000 (B) $411,000 = 57.18% 3. Operating Cash Flow/Total Debt: Operating cash flow [from (a)] $ 21,000 (A) Total debt [from (d.2.)] $ 235,000 (B) (A) $21,000 (B) $235,000 = 8.94% d. 1. Return on assets: Net income $ 69,000 (A) Average assets [($219,000 + $411,000)/2] $ 315,000 (B) (A) $69,000 (B) $315,000 = 21.90% 2. Return on Common Equity: Net income $ 69,000 (A) Average common equity [($96,000 + $50,000 + $106,000 + $70,000)/2] $ 161,000 (B) (A) $69,000 (B) $161,000 = 42.86% 304

e. Operating Cash Flow/Cash Dividends: Operating cash flow [from (a)] Cash dividends $ 21,000 (A) $ 49,000 (B) (A) $21,000 (B) $49,000 = 0.43 f. In general, the liquidity ratios look very good except for the cash ratio. The cash ratio is approximately 7%. g. Overall, the debt position appears to be good. Times interest earned is very good, and the debt ratio and cash flow/total debt are good. h. The profitability appears to be extremely good. Both the return on assets and return on common equity are very high. i. Operating cash flow/cash dividends indicates that operating cash flow was less than half the cash dividends. j. Alternatives appear to be as follows: 1. Reduce the rate of expansion or possibly stop expansion at this time. This would reduce the need to increase receivables and inventory in the future and provide cash to pay accounts payable. 2. Issue additional long-term debt. 3. Issue additional common stock. Possibly a combination of these alternatives should be considered. This company is very profitable, has a good debt position, and in general a good liquidity position, except for the most immediate ability to pay its bills. This needs to be corrected or there is the possibility of bankruptcy. The growth rate of this company is very high. Immediate cash is needed to fund the growth. 305

PROBLEM 10-9 a. Zaro had substantially more net cash flow from operating activities than it had net income. Major reasons for this were depreciation, decrease in accounts receivable, and decrease in inventory. The substantial cash flows from operating activities were used for investing activities and financing activities. Cash was particularly used for the financing activity of paying dividends. b. 1. Current Ratio: Current assets: Cash $ 30,000 Accounts receivable, net 75,000 Inventory 90,000 Prepaid expense 3,000 $ 198,000 (A) Current Liabilities: Accounts payable $ 25,000 Income taxes payable 2,500 Accrued liabilities 5,000 Current portion of bonds payable 20,000 $ 53,000 (B) (A) $198,000 (B) $53,000 = 3.74 2. Acid-Test Ratio: Cash $ 30,000 Accounts receivable, net 75,000 $ 105,000 (A) Current liabilities $ 53,000 (B) (A) $105,000 (B) $53,000 = 1.98 306

3. Operating Cash Flow/Current Maturities of Long-Term Debt and Current Notes Payable: Operating cash flow $ 51,000 (A) Current maturities of long-term debt and current notes payable $ 20,000 (B) (A) $51,000 (B) $20,000 = 2.55 4. Cash Ratio: Cash Current liabilities $30,000 (A) $53,000 (B) (A) $30,000 (B) $53,000 = 0.57% c. 1. Times Interest Earned: Income before taxes $ 34,000 Plus interest expense 8,000 (B) $ 42,000 (A) (A) $42,000 (B) $8,000 = 5.25 times per year 2. Debt Ratio: Total Liabilities: Accounts payable $ 25,500 Income taxes payable 2,500 Accrued liabilities 5,000 Bonds payable 90,000 $ 123,000 (A) Total assets $ 253,000 (B) (A) $123,000 (B) $253,000 = 48.62% 307

d. 1. Return on assets: $20,000 $20,000 = ($253,000 + $274,000)/2 $263,500 = 7.59% 2. Return on Common Equity: $20,000 ($85,000 + $54,000 + $85,000 + $45,000)/2 $20,000 $134,500 = 14.87% e. All liquidity ratios are very good. f. The debt position is good. g. Profitability is good. h. Substantial cash flow came from operating activities. A relatively small amount of funds were used for investing activities and paying down bonds. This left substantial cash available. 308

PROBLEM 10-10 a. THE LADIES STORE Statement of Cash Flows For the Year Ended December 31, 2009 Cash flow from operating activities: Cash receipts from customers $ 150,000 Cash receipts from interest $ 5,000 Cash payments for merchandise (110,000) Cash payments for interest (2,000) Cash payments for income taxes (15,000) Net cash flow from operating activities $ 28,000 Cash flows from investing activities: Cash outflow for purchase of truck $ (20,000) Cash outflow for purchase of investment (80,000) Cash outflow for purchase of equipment (45,000) Net outflow for investing activities (145,000) Cash flows from financing activities: Cash inflow from sale of bonds $ 100,000 Cash inflow from issuance of note payable 40,000 Cash inflow from financing activities 140,000 Net increase in cash $ 23,000 b. The major inflow of cash was from financing activities. The major outflow of cash was for investing activities. 309

PROBLEM 10-11 a. 1 Tightening of credit by suppliers could lead to cash flow problems. b. 5 For a profitable firm, a substantial decrease in receivables would not contribute to bankruptcy. c. 5 Change in notes payable to bands is not part of cash flows from operating activities. d. 5 & 2 Proceeds from selling land is not part of cash flows from operating activities. (Note: 2 is also correct. There is no amortization of goodwill) e. 4 Cash inflows from operating activities represents an internal source of cash. f. 3 Revenue from services represents an operating inflow. g. 3 Inventory represents an operating activity. h. 5 Short-term investments in marketable securities is part of cash and cash equivalents. i. 5 Cash inflows from sale of property, plant, and equipment represents cash inflows related to investing activities. j. 4 The sale of common stock will increase working capital. k. 1 Working capital is defined as current assets less current liabilities. l. 2 Management should use the statement of cash flows to determine cash flow from investing activities. m. 2 This is a noncash investing and financing activity. 310

PROBLEM 10-12 a. Don Szabo Company Statement of Cash Flows Years Ended December 31, 2009, 2008, 2007 Total 2009 2008 2007 Increase (decrease) in cash: Cash flows from operating activities: Cash received from customers $ 508,381 $ 173,233 $ 176,446 $ 158,702 Cash paid to suppliers & employees (451,801) (150,668) (157,073) (144,060) Interest received 326 132 105 89 Interest paid (1,357) (191) (389) (777) Income taxes paid (12,225) (6,626) (4,754) (845) Net cash provided from operations 43,324 15,880 14,335 13,109 Cash flow from investing activities: Capital expenditures (21,156) (8,988) (5,387) (6,781) Proceeds from property, plant & equipment disposals 1,452 1,215 114 123 Net cash used in financing activities (19,704) (7,773) (5,273) (6,658) Cash flows from financing activities: Net increase (decrease) in short-term debt 12,300 ----- 5,100 7,200 Increase in long-term debt 13,000 4,100 3,700 5,200 Dividends paid (22,250) (6,050) (8,200) (8,000) Purchase of company stock (11,412) (8,233) (3,109) (70) Net cash used in financing activities (8,362) (10,183) (2,509) 4,330 Net increase (decrease) in cash & cash equivalents 15,258 (2,076) 6,553 10,781 Cash & cash equivalents at beginning of year 50,768 24,885 18,332 7,551 Cash & cash equivalents at end of year $ 66,026 $ 22,809 $ 24,885 $ 18,332 Reconciliation of Net Income To Net Cash Provided by Operating Activities Total 2009 2008 2007 Net income $ 11,358 $ 7,610 $ 3,242 $ 506 Provision for depreciation & amortization 30,700 12,000 9,700 9,000 Provision for losses on accounts receivable 473 170 163 140 Gains on property, plant & equipment disposals (4,620) (2,000) (1,120) (1,500) Changes in operating assets & liabilities Accounts receivable (5,350) (2,000) (1,750) (1,600) Inventories (8,100) (3,100) (2,700) (2,300) Other assets (57) ----- ----- (57) Accounts payable 12,300 ----- 5,100 7,200 Accrued income taxes 1,200 1,200 ----- ----- Deferred income taxes 5,420 2,000 1,700 1,720 Net cash provided by operating activities $ 43,324 $ 15,880 $ 14,335 $ 13,109 311

b. The three-year analysis revealed that 45% of cash flows from operations went into investing activities. The company is not replacing its productive assets. Cash flows used in financing activities are 19% of the cash flows from operating activities. At first glance, one might assume the company is paying down debt. Closer analysis reveals that the company actually increased its debt levels, but payment to stockholders in the form of dividends and share purchases used more cash than was raised in the borrowing. The company is borrowing, and therefore, increasing debt. Further analysis reveals that a substantial part of the borrowing is short-term rather than long-term. Such money is riskier. c. DON SZABO COMPANY Statement of Cash Flows For Year Ended December 31, 2009 (Inflow & Outflow by Activity) Cash flows from operating activities: Inflow Outflow Inflow % Outflow % Cash received from customers $ 173,233 96.95 Cash paid to suppliers & employees $ 150,668 83.35 Interest received 132 0.08 Interest paid 191 0.11 Income taxes paid 6,626 3.67 Net cash provided by operations 173,365 157,485 97.03 87.13 Cash flows from investing activities: Capital expenditures 8,988 4.97 Proceeds from property, plant & equipment disposals 1,215 0.68 Net cash used in investing activities 1,215 8,988 0.68 4.97 Cash flows from financing activities: Net increase (decrease) in short-term debt ----- Increase in long-term debt 4,100 2.29 Dividends paid 6,050 3.35 Purchase of company stock 8,233 4.55 Net cash used in financing activities 4,100 14,283 2.29 7.90 Total cash flows $ 178,680 $ 180,756 100.00 100.00 (180,756) Increase (decrease) in cash $ (2,076) 312

d. 97% of cash inflows came from operations and 2% came from financing activities. Significant cash inflows coming from operations is positive. 83% of cash outflows were payments to suppliers and employees. 5% of outflows were used for investment in property, plant, and equipment. 8% of cash outflows were used to pay dividends and purchase shares. Almost as much was spent to pay stockholders as for outflows for capital expenditures. PROBLEM 10-13 Owens appears to be the growth firm. Operating activities may represent a use of cash because of the expansion of receivables and inventory. The expansion of fixed assets would use cash in investing activities. Financing activities are providing cash for expansion. Alpha appears to be the firm in danger of bankruptcy. Cash is used in operations, capital expenditures appear to be nominal, and financing activities are using instead of providing cash. Arrow appears to be the older firm expanding slowly. Arrow is generating significant cash from operating activities, while nominal cash is used for investing activities. Financing activities are using cash instead of providing cash (dividends, repayment of long-term debt, etc.). PROBLEM 10-14 a. Accounts receivable, January 1, 2009 $ 30,000 Sales 480,000 $ 510,000 Accounts receivable, December 31, 2009 (40,000) $ 470,000 b. Accounts receivable increased by $10,000 during the year 2009. Thus cash collected from customers was $10,000 less than sales. PROBLEM 10-15 a. Revenues from customers $ 150,000 Decrease in accounts receivable 8,000 $ 158,000 b. No. Depreciation expense is a noncash charge reducing income. 313

CASES CASE 10-1 COMPARING THREE COMPANIES All three companies are generating increasingly positive amounts of cash from their operating activities. All three companies are making significant cash investments into various assets or other long-term assets. It would appear that Company X made a very substantial investment in 2012, judging by the amount as compared with the two prior years. The trend in financing activities is not identical for the three companies. In 2010 and 2011, Companies X and Y used cash in their financing activities for things like the payment of dividends, repurchase of stock, or net repayment of debt. In 2012, financing activities, such as the issuance of stock or debt, provided substantial amounts of cash to Companies X and Y. Such actions were probably needed to fund the investing activities for the year. For Company Z, financing activities have provided cash for all three years although the amount increased significantly in 2012, again probably to fund the investing activities for the year. 314

CASE 10-2 CASH FLOW THE DIRECT METHOD (This case represents an opportunity to review a cash flow statement presented on a direct method.) a. ARDEN GROUP, INC. AND CONSOIDATED SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Total Column Added (In thousands) Fifty-Three Weeks Ended January 3, 2006 Fifty-Two Weeks Ended December 29, 2007 Fifty-Two Weeks Ended December 30, 2006 Total Cash flows from operating activities: Cash received from customers $ 1,448,042 $ 479,578 $ 485,819 $ 482,645 Cash paid to suppliers and employees (1,316,749) (437,970) (438,044) (440,735) Interest and dividends received 8,279 2,513 3,186 2,580 Interest paid (333) (109) (99) (125) Income taxes paid (53,850) (15,545) (20,660) (17,645) Net cash provided by operating activities 85,389 28,467 30,202 26,720 Cash flows from investing activities: Capital expenditures (13,851) (5,159) (3,824) (4,868) Purchases of investments (26,902) (25,130) (945) (827) Sales of investments 38,309 35,556 2 2,751 Proceeds from the sale of property, plant and equipment 264 21 28 215 Net cash provided by (used in) investing activities (2,180) 5,288 (4,739) (2,729) Cash flows from financing activities: Purchase and retirement of Company stock (19,999) 0 0 (19,999) Principal payments under capital lease obligations (446) 0 (225) (221) Cash dividends paid (88,586) (82,188) (3,161) (3,267) Net cash used in financing activities (109,061) (82,188) (3,386) (23,487) Net increase (decrease) in cash and cash equivalents (25,852) (48,433) 22,077 504 Cash and cash equivalents at beginning of year 36,338 58,919 36,842 36,338 Cash and cash equivalents at end of year $ 10,486 $ 10,486 $ 58,919 $ 36,842 b. Net cash provided by operating activities totaled $85,389,000. This was slightly less than the $88,586,000 cash dividends paid. There also was $19,999,000 for the purchase and retirement of company stock. Cash and cash equivalents at end of year declined from $36,842,000 to $10,486,000. 315

c. ARDEN GROUP, INC. AND CONSOIDATED SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended January 3, 2009 (In thousands) Percent Inflow Outflow Inflow Outflow Cash flows from operating activities: Cash received from customers $ 479,578 92.64 Cash paid to suppliers and employees 437,970 77.37 Interest and dividends received 2,513.49 Interest paid 109.02 Income taxes paid 15,545 2.75 Net cash provided by operating activities 482,091 453,624 93.13 80.13 Cash flows from investing activities: Capital expenditures ----- ----- Purchases of investments 5,159.91 Sales of investments 35,556 25,130 6.87 4.44 Proceeds from the sale of property, plant and equipment 21 -----.00 ----- Net cash provided by (used) in investing activities 35,577 30,289 6.87 5.35 Cash flows from financing activities: Purchase and retirement of Company stock ----- ----- ----- ----- Principal payments under capital lease obligations ----- ----- ----- ----- Cash dividends paid ----- 82,188 ----- 14.52 Net cash used in financing activities ----- 82,188 ----- 14.52 Changes in cash: Total cash inflows (outflows) 517,668 566,101 100.0 100.0 Total cash outflow 566,101 Net decrease in cash $ 48,433 d. Over ninety percent of the inflow related to net cash provided by operating activities. Over eighty percent of the outflow related to net cash provided by operating activities. Cash dividends paid was over fourteen percent of the total outflow. 316

CASE 10-3 THE GLOBAL TECHNOLOGY (This case provides the opportunity to review a cash flow statement presented on the indirect method.) a. 1. 2006 2007 2008 Net income 100.0 136.60 137.35 Net cash provided by operating activities 100.0 161.30 219.32 2. Cash flow provided by operating activities increased materially more than net income. b. Depreciation and amortization are added back to net income because they did influence cash flow. c. Yes. Acquisitions, net of cash acquired and proceeds received from divestiture, and purchases of d. They apparently wanted to have ample funds for expansion. e. Net cash provided by operating activities was materially more than net income. Substantial funds for purchase of property and equipment. f. Cash flow was not involved in the issuance of equity in connection with acquisitions, net; but these were significant investing and financing activities. 317

CASE 10-4 THE RETAIL MOVER (This case represents a firm on the verge of bankruptcy. The company is W.T. Grant. The years in the case are not the actual years. a. 1. 2005 2006 2009 Total current assets $ 628,408,895 $ 719,478,441 $ 1,044,689,000 Total current liabilities 366,718,656 458,999,682 661,058,000 Working capital 261,690,239 260,478,759 383,631,000 Working capital was fairly constant between 2005 and 2006. Working capital increased materially in 2009 in relation to 2006. 2. Current ratio 2005 2006 2009 Current Assets Current Liabilities = 1.71 1.57 1.58 The absolute current ratios appear to be too low. There was a substantial decline in the current ratio between 2005 and 2006. b. 2006 2009 Net income $ 39,577,000 $ 10,902,000 Cash (outflow) from operating activities $ (15,319,217) $ (93,204,000) A net increase in receivables and inventories were the major reasons for the substantial difference between net income and cash (outflow) from operating activities in both 2006 and 2009. c. There was an apparent write down in customers installment accounts receivable and merchandise inventories. The substantial decrease in deferred finance income is apparently related to the write down in customers installment accounts receivable. d. Company perspective The company was apparently desperate for liquidity. The company would have preferred a longer term, but under the circumstances would take whatever they could get. Bank perspective This loan appears to be a major blunder on the part of the bank. Apparently the short-term commercial notes were no longer available, probably because of the financial condition of the company. 318

CASE 10-5 NON-CASH CHARGES (Companies frequently announce noncash charges. This case provides an opportunity to discuss if noncash charges are noncash charges in the long run.) a. True. Cash inflow from operations will equal the revenue from operations in the long run. b. 1992 $800 million 1992 1999. It was estimated that the accrual would be sufficient to cover the company s uninsured costs for cases received until the year 2000. c. $545 million in 1996 Cash payments associated with charge will begin after the year 2000 and will be spread over 15 years or more. d. Cash inflow will be recorded when received. The related revenue will likely be recorded in the same period that the cash is received. This is an example of conservatism. e. If they do not win the suit, the expenses (cash outflow) for asbestos claims will likely be substantially higher than previously provided for. f. Asbestos related expenses (cash outflow) will likely be more than previously estimated. g. 1. 1996 $875,000,000 2. 1997 $97,000,000 1996 $101,000,000 1995 $251,000,000 3. 1997 $300,000,000 1996 $267,000,000 1995 $308,000,000 Note: On Thursday, October 5, 2000, Owens Corning voluntarily filed a petition for reorganization under Chapter 11 bankruptcy protection in the United States Bankruptcy Court in Wilmington, Delaware. Owens Corning News release, January 17, 2003 Owens Corning file Joint Plan of Reorganization with Asbestos Creditors in Chapter 11 Case.... The plan sets forth a proposed consensual framework to determine creditor distributions, with recoveries based on aggregate asbestos claims of $16 billion, and a preferred recovery to holders of bank claims of $400 million, in addition to pro rata recovery on the balance of their claims.... 319

CASE 10-6 SORRY GIVE IT BACK (This case is a follow up to the case Noncash Charges. Owens Corning Fiberglass declared bankruptcy because of asbestos cases.) In bankruptcy, Owens Corning was demanding the return of dividends paid prior to bankruptcy. Owens Corning is now out of bankruptcy. We were not able to determine how the dividend issue was settled. CASE 10-7 CASH MOVEMENTS AND PERIODIC INCOME DETERMINATION a. Income determination is not an exact science. A substantial amount of subjectivity is used in income determination. Many estimates are typically involved when determining income. b. Cash flow is determined in an objective manner. c. In theory, this is a true statement. United States accounting principles provide for by-passing the income statement for some apparent revenue or expense items. The balance of these items is presented in shareholders equity in the balance sheet. Examples are net unrealized loss in noncurrent marketable equity securities, cumulative translation adjustments, and cumulative pension liability adjustments. In the long run the revenue (expense) from these items goes through the income statement. d. In the short run, a negative cash flow from operations could be compensated for by cash flow from investing and financing activities. e. Revenue and expense items that were more positive for income in the past than they were for cash flow will need to materialize in future cash flow. An example would be sales on account (credit). Collection will need to be made. 320

CASE 10-8 THE BIG.COM (This case represents an opportunity to review Amazon.com over a ten-year period.) a. Except for 2001, when cash and cash equivalents, end of period declined, the net cash inflows increased. b. Debt ratio 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Total liabilities (a) $2,205 $3,102 $3,077 $3,343 $3,198 $3,475 $3,450 $3,932 $5,288 $5,642 Total assets (b) $2,471 $2,135 $1,637 $1,990 $2,162 $3,249 $3,696 $4,363 $6,485 $8,314 Debt ratio % (a) (b) 89.24 145.29 187.97 167.99 147.92 106.96 93.34 90.12 81.54 67.86 The debt ratio increased materially between 1999 and 2002 (total liabilities more than total assets). The debt ratio then declined materially between 2002 and 2008 (total liabilities less than total assets). The trend is very positive. c. Net cash provided by financing activities (1998 2002) There was substantial cash provided by financing activities during the period of 1998 2002. d. The trend in net cash provided by operating activities 2002 2008 was very positive. It went from a negative amount in 2000 to very material net cash provided by operating activities. e. Net sales increased materially each year. The net income (loss) trended up materially, but with material fluctuations. f. Net loss was material in each of these years. The market apparently responded to these losses. Stockholders (deficit) was material and total liabilities was material. 1. Total market capitalization 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Outstanding shares of common stock (a) 345 357 373 388 403 410 416 414 416 428 Market price per share (b) 76.12 15.56 10.82 18.89 52.62 44.29 47.15 39.46 92.64 51.28 (a) x (b) 1999 26,261,400,000 2000 5,554,920,000 2001 4,035,860,000 2002 7,329,320,000 2003 21,205,860,000 2004 18,138,900,000 2005 19,614,400,000 2006 16,336,440,000 2007 38,538,240,000 2008 21,947,840,000 321

2. Compare the total stock market price with total stockholders equity. Total Stock Market Price Stockholders Equity 1999 $26,261,400,000 $266,000,000 2000 5,554,920,000 (967,000,000) 2001 4,035,860,000 (1,440,000,000) 2002 7,329,320,000 (1,353,000,000) 2003 21,205,860,000 (1,036,000,000) 2004 18,158,900,000 (227,000,000) 2005 19,614,400,000 246,000,000 2006 16,336,440,000 431,000,000 2007 38,538,240,000 1,197,000,000 2008 21,947,840,000 2,672,000,000 Total stock market price is materially more than the total stockholders equity. g. Price/earnings ratio 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Market price (a) $76.12 $15.56 $10.82 $18.89 $52.62 $44.29 $47.15 $39.46 $92.64 $51.28 Fully diluted earnings per share (b) ($2.20) ($4.02) ($1.53) ($0.40).08 1.39.78.45 1.12 1.49 Price/earnings * * * * 657.8 31.9 60.4 87.7 82.7 34.4 *Negative earnings h. Yes. Many positive items including the following: 1. Increase in sales 2. Increase in gross profit 3. Increase in net income 4. Increase in net cash provided in operating activities CASE 10-9 GLASS (This case represents an opportunity to review a firm that has had material changes for asbestos.) a. 1. Current ratio 2006 2007 2008 Current assets (a) $2,432.7 $2,694.6 $2,444.7 Current liabilities (b) $2,365.7 $2,529.5 $2,003.3 (a) (b) 1.03 1.07 1.25 2. Debt ratio Total liabilities (a) $8,964.0 $7,137.2 $6,935.9 Total assets (b) $9,320.7 $9,324.6 $7,876.5 (a) (b) 96.2% 76.5% 88.1% 322

3. Gross profit margin Gross profit (a) $1,169.3 $1,595.3 $1,676.6 Net sales (b) $6,650.4 $7,566.7 $7,884.7 (a) (b) 17.6% 21.1% 21.3% 4. Operating cash flow/total debt Operating cash flow (a) $150.3 $636.4 $707.6 Total debt (b) $8,964.0 $7,137.2 $6,935.9 (a) (b) 1.7% 8.92% 10.2% b. The current ratio has improved substantially but is still relatively low. The debt ratio is relatively high and fluctuated. Gross profit margin improved materially in 2007 and improved slightly in 2008. Operating cash flow/total debt improved materially but is still relatively low. c. Asbestos related 1. 2006 2007 2008 Millions Recognized in expense $120.0 $115.0 $250.0 2. Asbestos related payments $162.5 $347.1 $210.2 3. The expense is related to an estimate related to that specific year. Cash payments represent specific cash payments during the period. 4. 2006 2007 2008 Millions Expense did not require cash ----- ----- ----- Payments did require cash $162.5 $347.1 $210.2 d. 1. Total capitalization 2006 2007 2008 Outstanding shares of 154,235,079 157,350,941 167,149,4790 common stock (a) Market price (b) $18.45 $49.50 $30.06 (a) x (b) $2,845,637,208 $7,788,871,580 $5,024,513,249 2. Share owners equity $356,700,000 $2,187,400,000 $1,040,600,000 Total capitalization $2,845,637,207 $7,788,871,580 $5,024,513,249 Total capitalization is materially more than share owners equity. 323

CASE 10-10 SPECIALTY RETAILER (This case represents an opportunity to review the profitability of three specialty retail stores.) a. There can be material differences between income and net cash provided by operating activities, as was the case with these firms. Following GAAP and accrual accounting, net income would be considered to be the better long run indicator. b. Abercrombie & Fitch Co. Net cash provided by operating activities and net income materially declined in 2009 No current maturities of long-term debt Operating cash flow/total debt declined materially but is still substantial Operating cash flow per share declined materially Operating cash flow/cash dividends declined materially but is still very substantial Limited Brands, Inc. Net cash provided by operating activities increased materially Net income declined materially No current maturities of long-term debt Operating cash flow/total debt increased materially but would be considered to be relatively low Operating cash flow per share increased materially Operating cash flow/cash dividends increased materially but would be likely to be considered to be relatively low GAAP, Inc. Net cash provided by operating activities declined materially Net income increased materially Operating cash flow/current maturities of long-term debt and current notes payable increased materially and is significant Operating cash flow/total debt decreased materially but is significant Operating cash flow per share decreased materially Operating cash flow/cash dividends decreased materially but appears to be adequate c. Abercrombie & Fitch and GAAP Inc. had a material decline in net cash provided by operating activities. Both of these firms still had a good to very good operating cash flow/total debt and operating cash flow/cash dividends. 324

CASE 10-11 EAT AT MY RESTAURANT CASH FLOW (This case provides an opportunity to review the cash flow of three restaurant companies.) a. There was a material difference between net cash provided by operating activities and net income. The net cash provided by operating activities was materially higher. Under generally accepted accounting principles, net income would be the better indicator of long-term profitability. b. Yum Brands, Inc. Net cash provided by operating activities declined slightly, while net income increased moderately Operating cash flow/current maturities of long-term debt and current notes payable increased very materially Operating cash flow/total debt declined materially but would likely be considered to be good Operating cash flow per share increased moderately Operating cash flow/cash dividends decreased materially but appears to be good Panera Bread Net cash provided by operating activities increased slightly Net income increased materially No current maturities of long-term debt and current notes payable Operating cash flow/total debt was very material and increased materially Operating cash flow per share increased materially No cash dividends Starbucks Net cash provided by operating activities decreased moderately Net income decreased very materially Operating cash flow/current maturities of long-term debt and current notes payable decreased moderately Operating cash flow/total debt decreased moderately to material. It appears to be material Operating cash flow per share decreased slightly No cash dividends c. No. 325

THOMSON ONE This Thomson One exercise, using the Merck & Company, provides for the review of cash flow and cash flow ratios. 326